Capital Inflows and the Real Exchange Rate: A Comparative Study of Asia and Latin America

The nexus of real exchange rate (RER) and capital inflows is examined through a
comparative analysis of the experiences of emerging market economies in Asian and Latin
America during the period 1985-2000. It is found that the degree of appreciation in RER
associated with capital inflow is uniformly much higher in Latin American countries compared to
their Asian counterparts, despite the fact that the latter experienced far greater foreign capital
inflows relative to the size of the economy. The econometric evidence suggests that both the
composition of capital flows and differences in the degree of response of RER to capital flows
matter in explaining these contrasting experiences. While RER appreciation is a phenomenon
predominantly associated with other (non-FDI) forms of capital inflows (OCFW), a given level
of OCFW brings about a far greater degree of appreciation of the real exchange rate in Latin
America where the importance of these flows in total capital inflow is also far greater. On the
policy front, Asian countries seem to have used fiscal contraction and nominal exchange rate
adjustment more effectively to cushion the RER against the appreciation pressure of capital
inflows. There is, however, no evidence to suggest that sterilized intervention can generate a
lasting impact on the real exchange rate.