|PRIVATE CAPITAL FLOWS AND THE REAL EXCHANGE RATE IN DEVELOPING COUNTRIES
Jean-Louis COMBES, Tidiane KINDA, Patrick PLANE
CERDI-CNRS, Université d’Auvergne
This paper analyses the impact of capital inflows and different components of private capital inflows on the real exchange rate and assesses the potential role of the exchange rate flexibility as a hedge against the real appreciation. Based on a sample of 42 developing countries over the period 1980-2006, the paper applies the pooled mean group estimator (Pesaran, 1999) that allows short-run heterogeneity while imposing long-run homogeneity of the exchange rate across countries. The results show that the aggregated capital inflows as well as public and private flows appreciate the real exchange rate. Among private flows, portfolio investment has the highest appreciation effect on the real exchange rate, almost seven times the appreciation level due to FDI or banks loans. FDI and bank loans are relatively more related to an increase in the productive capacity compared to portfolio flows. Private transfers (mainly remittances) lead to the lowest appreciation of the real exchange rate compared to the other type of private capital. This suggests more counter-cyclical remittances aiming to smooth the consumption during hard time. Countries often implement various policies to offset or avoid the loss of competitiveness associated with the appreciation of the real exchange rate following capital inflows. This paper assesses the effectiveness of one of the main macroeconomic tools available to countries when facing significant capital inflows: the exchange rate policy. Using a de facto measure of exchange rate flexibility, we find that allowing greater flexibility of the exchange rate helps to dampen the appreciation of the real exchange rate stemming from capital inflows.
Policy makers often seek to attract external resources to finance saving gaps but also for their potential to generate growth and promote economic development (Dornbusch, 1998). Empirical finding on the growth potential of capital account openness is however mixed (Kose et al. 2006). Beyond their potential economic benefits, significant increase in capital inflows could also create important challenges because of their potential to generate more vulnerable financial system and macroeconomic overheating. The vulnerability in the financial system could be due to a sharp increase in lending that may exacerbate the maturity mismatch between bank assets and their liabilities and in some case the currency mismatch between the lending and the borrowing currency of the banks. The lending boom following the capital inflows episodes could also strengthened the vulnerability of the financial sector with the associated asset prices bubbles. In term of macroeconomic overheating, the symptoms could be the acceleration of economic growth and inflation during the episode of capital inflows, and particularly the appreciation of the real exchange rate that summarizes different macroeconomic adjustments. The loss of competitiveness with a more appreciated real exchange rate is thus one of main potential consequence associated with capital inflows -particularly large inflow of capital- (Edward, 1998). Under a flexible exchange rate regime, the real appreciation of the exchange rate is due to the appreciation of the nominal exchange rate. In the case of fixed exchange rate, the real appreciation is due to higher inflation following the increase in money supply. Real exchange rate appreciation jeopardizes export competitiveness, widening the current account deficit and could also increase the vulnerability to a financial crisis. Significant appreciation of the real exchange rate could indeed lead to a drying up or a sudden stop of capital flows leading to a sharp adjustment of the current account. Beyond its negative effect on the investment, a significant appreciation of the real exchange rate could thus create major challenges for macroeconomic stability and management.
The sharp increase in external finance, particularly private capital during the last decade and before the current financial crisis shed some light on the transfer problem1. The spectacular rise in private flows was driven by the surge of foreign direct investment (FDI) and current private transfers (mainly remittances). While commercial bank loans constitute the main component of private capital flows to developing countries during the mid of the 80s, foreign direct investment and remittances become the two major components, particularly in low-income countries2. These changes in the landscape of capital flows to developing countries raise the importance to reassess the transfer problem with particular focus on private flows and their different components.
Developing countries often use various policies to dampen the real appreciation of their exchange rate following episodes of capital inflows. These include macroeconomic policies such as sterilization, exchange rate flexibility, and fiscal tightening as well as more structural policies such as capital controls, trade liberalization, and better regulation and supervision of the financial system. While sterilization is the most used policy, fiscal tightening and exchange rate flexibility remain the most effective ones (IMF, 2007). This chapter focuses on the exchange rate policy, and assesses if this policy could effectively offset the real appreciation of the exchange rate due to capital inflows.
Based on a sample of 42 developing countries over the period 1980-2006, this chapter uses the pooled mean group estimator (that allow short-run heterogeneity while imposing long-run homogeneity) to analyze the impact of capital inflows and their components on the real exchange rate. The results show that the aggregated capital inflows as well as public and private flows appreciate the real exchange rate. Among private flows, portfolio investment has the highest appreciation effect on the real exchange rate, almost seven times the appreciation due to FDI or banks loans. Private transfers lead to the lowest appreciation of the real exchange rate. Flexibility of the exchange rate helps countries to avoid the appreciation of their real exchange rate stemming from capital inflows.
The chapter is organized as follows: Section 1 discusses the transfer problem and stresses the potential heterogeneity according to the type of capital flows. Section 2 reviews the main macroeconomic fundamentals explaining the real exchange rate. Section 3 describes the main trends and compositions of external financing to developing countries. The panel co-integration method (the pooled mean group estimator) and the data are discussed in section 4 and 5 respectively. The empirical results are presented in the following sections. Based on a de facto measure of flexibility of the exchange rate, we assess how the real appreciation of the exchange rate due to capital inflows could be offset with higher flexibility of the exchange rate. The last section offers the conclusion.
SECTION I: THE TRANSFER PROBLEM
Higher consumption and investment during capital inflows explain current account deficit. In developing countries, particularly in poor countries, consumption relies more on domestic goods and their supply capacity is limited. In the opposite, the increase of the investment may be more associated with higher import. Capital inflows associated with higher consumption should have higher pressure on the relative price of domestic goods, leading to more appreciation of the real exchange rate compared to capital inflows financing an investment growth3. The impact of capital flows on the real exchange rate depends also on the type of the flows and the exchange rate regime. Compared to borrowing from commercial banks, FDI lead in general to less credit and money expansion since these flows are less (or shortly) intermediated through the local banking system. The inflation potential of FDI can thus be lower than that of commercial banks loans. FDI flows are related to investments and equipments and could develop the local productive capacity (Chapter 4). The spillovers effects of FDI could also improve the productivity through the transfer of technology and managerial know-how. FDI is also a more stable capital flow compared to bank lending and portfolio investment. The appreciation of the real exchange rate due to FDI should thus be lower compared to the real appreciation associated with the more volatile private flows such as portfolio investments (Lartey, 2007). Portfolio investments are indeed speculative flows, looking for higher short-term yields, exacerbating macroeconomic overheating.
Remittances could rise when the recipient economy suffers an economic downturn. This suggests that remittances act more as a buffer stock, helping to smooth consumption (Chami et al., 2005). In this case, remittances contribute to the stability of recipient economies by compensating for foreign exchange losses due to macroeconomic shocks. Remittances could however be for investment purposes and pro-cyclical as other type of foreign investment flows (FDI, portfolio investment, bank loans)4. According to the fact that remittances are procyclical or countercyclical, their effects on the real exchange rate differ. Countercyclical remittances, flowing during economic slowdown have a limited appreciation effect on the real exchange rate. However, procyclical remittances represent additional capital inflows and could exacerbate the macroeconomic overheating, leading to further appreciation of the real exchange rate. In addition, if remittances are disproportionately devoted to spending on traded goods (to import consumer durables for instance), their effects on the real exchange rate tend to be weakened (Chami et al. 2008). The impact of remittances on the real exchange rate could be lower than the impact of public transfers (grants). Grants are directed to governments which spend more on non-traded goods (a large part of their budget is for wages and purchases of domestic services) and invest sometimes in non-profitable projects.
There is an extensive literature on the determinants of the real exchange rate. In the case of developing countries, Edwards (1989), Hinkle and Montiel (1999), Edwards and Savastano (2000), and Maeso-Fernandez, Osbat, and Schnatz (2004) provide comprehensive surveys of the literature. A number of these studies focus on the impact of capital flows on the real exchange rate, the so-called transfer problem. Lane and Milesi-Ferretti (2004) find that countries with net external liabilities have a more depreciated real exchange rate. Based on a sample of 48 industrial and emerging economies, Lee, Milesi-Ferretti, and Ricci (2008) show that higher net foreign assets appreciate the real exchange rate. Studies on the specific impact of diverse types of capital flows on the real exchange rate are particularly limited, except those focusing on official flows or FDI, and recently on remittances. Empirical evidences on the impact of capital flows on the real exchange include cross-country analyses as well as country-case studies, and have mixed results.
A number of cross-country analyses highlight the appreciation of the real exchange rate due to official flows (Bulir and Lane, 2002; Prati, et al., 2003; Elbadawi et al., 2008). In the opposite other authors do not find evidence of appreciation of the real exchange due to official inflows (Yano and Nugent, 1999; Ouattara and Strobl, 2004).
Several case studies such as White and Wignaraja (1992) in Sri Lanka, Younger (1992) in Ghana, and Kasekende and Atingi-Ego (1999) in Uganda find that aid inflows are associated with the appreciation of the real exchange rate. However, other case studies do not conclude to a real appreciation of the exchange rate associated with public flows [Bandara (1995) in Sri Lanka; Nyoni (1998) and Li and Rowe (2007) in Tanzania; Aiyar et al., (2007) in Ethiopia, Ghana, Mozambique, Tanzania and Uganda]. Cerra et al. (2008) for instance find that grants inflows lead to the appreciation of the real exchange rate if they are used to enhance productivity in the tradable sector. If grant flows are used to improve productive capacity in the non-tradable sector, the authors find evidence of real depreciation of the exchange rate.
The potential effect of private transfers or remittances on the real exchange rate appreciation is largely admitted even though empirical results are mixed (Chami et al., 2008). On the one hand, authors such as Bourdet and Falck (2003), Amuedo-Dorantes and Pozo (2004), Montiel (2006), and Saadi-Sedik and Petri (2006) find that remittances inflows appreciate the real exchange rate. On the other hand, Izquierdo and Montiel (2006) and Rajan and Subramanian (2005) do not conclude unanimously that remittances are associated with the appreciation of the real exchange rate.
Studies on the impact of private capital flows on the real exchange rate are more limited. Athukorala and Rajapatirana (2003) conclude that FDI inflows lead to a depreciation of the real exchange rate while other private capital flows are associated with a real appreciation. Lartey (2007) examines the impact on the real exchange rate of capital inflows -disaggregated in official development assistance, FDI, and other capital flows. The author finds, using static and dynamic models (GMM) that FDI and ODA appreciate the real exchange rate. The magnitude of the appreciation is higher for ODA. However, the aggregate “other capital flows” does not affect the real exchange rate. Saborowski (2009) finds that capital inflows and particularly FDI lead to a real appreciation of the exchange rate in developing countries.
These studies focus on the impact of the aggregated or particular type of capital flows (grants, FDI, or remittances) on the real exchange rate. This chapter proposes a comprehensive analysis of the impact of different components of private flows (FDI, portfolio investment, bank loans, and private transfers) on the real exchange rate, while controlling for official flows. Most of the studies focus in a particular country or a group of countries by imposing the short-run and long-run homogeneity between countries. This chapter considers a sample of developing countries and applies a new panel cointegration method that imposes long-run homogeneity between countries while allowing the short-run dynamics to differ between countries.
SECTION II: THE DETERMINANTS OF THE REAL EXCHANGE RATE
The Real Effective Exchange Rate (REER) in the analysis is a CPI-based real exchange rate defined as a weighted geometric mean of bilateral nominal exchange rate and consumer price indices. An increase of the REER indicates an appreciation and, hence, a potential loss of competitiveness. The REER of a country i is defined as:
With REERi, NEERi, and NBERi representing the real effective exchange rate, the nominal effective exchange rate, and the nominal bilateral exchange rate of country i respectively. CPIi and CPIj denote the consumer price index of country i and country j. wj is the weight of the j-th partner in the bilateral trade of the country i. The weights represent for each country i, the average share of trade with its main partners j during the period 1999-2003. The analysis considers the ten main trade partners and excludes oil exporting countries (those for which petroleum related products represent at least 50% of the exports). Weights are calculated at the end of the period of observations in order to focus on the competitiveness diagnosis for the most recent years. This choice allows taking into account the significant increase of the weight of some large emerging countries such as China, India or Brazil in international trade during the recent years. The increasing importance of these large emerging market trade partners is even more pronounced for other developing countries.
Over the last thirty years, the economic literature on the real exchange rate has developed in a way that allowed determining the influence of a limited range of variables affecting the long-run real value of a currency (e.g. Williamson, 1994; Edwards, 1998). These variables, called the “fundamentals”, include external factors (e.g. the international terms of trade) or domestic factors (e.g. trade openness). The macroeconomic fundamentals, determining the real exchange rate include productivity gap, trade openness, terms of trade, and capital inflows.
The productivity gap aims at capturing the potential Balassa-Samuelson effect. The so-called Ballasa-Samuelson effect assumes that the productivity in tradable sectors grows faster than in non-tradable sectors. This results in higher wages in the tradable sectors that spill over to the non-tradable sectors and put upward pressure on wages. Since prices in tradable sectors are internationally determined and homogeneous across countries, higher wages in the non-tradable sectors result in higher relative price of non-tradables. This implies an increase in domestic inflation and an appreciation of the REER. A rise in the terms of trade is expected to appreciate the equilibrium REER to the extent that it improves the trade balance; the income effect dominating the substitution effect. Trade openness also affects the prices of non-tradables through an income effect and a substitution effect. Higher restriction on trade has a negative effect on tradables prices through the income effect and a positive through the substitution effect. The income effect is less likely to dominate the substitution effect (Edwards, 1988). It is thus expected that restricted trade will exert downward pressure on the relative price of tradable to non-tradable goods, thereby leading to an appreciation of the equilibrium REER. Capital inflows involve stronger demand for both tradables and non-tradables and lead to a higher relative price of non-tradables and the appreciation of the REER. This is needed for domestic resources to be diverted toward production in the non-tradable sector in order to meet the increased demand. As explained above, the effect of capital inflows on the real exchange rate could varies according to the type of flows. Other fundamentals could include government consumption for which an increase could lead to a stronger demand for non-tradables, increasing their relative prices. This induces an appreciation of the equilibrium REER. Higher debt service or the payment of interests on debt increases the demand for foreign currencies and is associated with the depreciation of real exchange rate.