Exchange rate dynamics of emerging and developing economies: Not all capital flows are alike

Abstract

The increasing cross-border capital flows have raised the question of whether capital inflows and outflows have different impacts on exchange rates in emerging markets than they do in developed markets and economies. To explore the potential heterogeneity in the impacts that can arise from the different types and directions of capital flows, we classify them according to whether they involve foreign direct investment (FDI) or foreign portfolio investment (FPI) and examine these inflows and outflows separately. The characteristics of these different types of capital flows and their effects on the real exchange rate in both advanced and emerging markets during 2002–2017 are investigated using a set of estimation approaches. To capture the relationship between real exchange rates and capital flows while controlling for other variables, a dynamic panel data model is utilized for the dataset covering emerging countries. Key findings suggest that the composition of capital flows determines the impact of those flows on real exchange rates, whereby FPI brings a faster appreciation of the real exchange rate than FDI and capital outflows bring a sharper degree of exchange rate adjustment than capital inflows. F20F30.