Print Email Download Reference This Send to Kindle Reddit This
submit to reddit

The Real Exchange Rate Fluctuations Finance Essay

Policymakers in developing countries often seek to attract external resources on the assumption that they will finance savings gaps and promote growth and economic development (Dornbusch, 1998). However, evidence of the growth potential of capital account openness is mixed (Kose et al., 2006).

Significant increases in capital inflows can make the financial system more vulnerable by exacerbating maturity mismatches between bank assets and their liabilities, and in some cases, mismatches between the currencies in which banks lend and borrow. In addition, macroeconomic overheating can provoke accelerated inflation with possible price bubbles appreciating the real effective exchange rate (REER).

The loss of competitiveness caused by an appreciated REER is one of the main negative consequences associated with capital inflows (Calvo, Leiderman, and Reinhart, 1993; Bandara, 1995; Edwards, 1998; Agenor, 1998; Lartey, 2008).

Real Effective Exchange Rate:

Real effective exchange rate (REER) is a key macroeconomic relative price that plays an important role in the broad allocation of resources in production and spending behavior in the economy. REER is a measure of competitiveness. So, it determines and influences the performance of export sector (Caballero and Corbo, 1989).

Because of this allocative and competitiveness roles of REER, both developing and emerging economies are encouraged by IMF to keep the actual REER close to the equilibrium real exchange rate. EREER is defined as the value of the REER consistent with a simultaneous attainment of internal and external equilibrium.

Exchange Rate Misalignment:

Exchange rate misalignment is defined as the sustained departure of actual REER from its EREER. In case of misaligned exchange rate, REER fails to perform the allocative role and does not provide the appropriate signals to guide the allocation of resources (Montiel, 2003; and Edwards, 1988).

This would result in detrimental consequences for economic growth as it impairs the efficiency of capital and discourage capital accumulation (Corbo and Rojas, 1995, Servin and Solimano, 1991).

Exchange rate misalignment can arise in fixed exchange rate regime, flexible exchange rate regime or any hybrid of these two regimes. Market determined exchange rates may deviate substantially from their “equilibrium values” implied by fundamentals in the short term due to: (i) foreign exchange market failure arising from herding and feedback trading which are based on price movements rather than fundamentals and in turn leads to unwarranted changes in exchange rate; (ii) the transitory shocks may lead to a high degree of volatility in exchange rate due to shallow and thin foreign exchange markets in developing countries like Pakistan. Although there is no mandatory obligation for the central bank to intervene in foreign exchange market under flexible exchange rate regime, however, the large divergence of REER from its equilibrium can prompt central bank to intervene in the foreign exchange market due to the aforementioned cost associated with exchange rate misalignment.

However, Exchange rate misalignments are difficult to detect as there is no consensus on the methodology to estimate the equilibrium exchange rate (Hinkel and Montiel, 1999). Indicators used to estimate the equilibrium exchange rate include nominal and real effective exchange rates, productivity and other competitiveness measures, terms of trade, current external account and balance of payments outlook, interest rate differentials, and parallel market exchange rates. A problem is that these indicators may not always allow policymakers to identify the degree of misalignment precisely enough to pinpoint the appropriate timing and amount of intervention.

Real Exchange Rate Fluctuations:

Real exchange rate overvaluation can also undermine export competitiveness and weaken the external position, while an undervalued exchange rate may create inflationary pressures. In addition, the maintenance of real exchange rate close to the equilibrium level also prevents the countries from currency and banking crises. There is a consensus in the economic literature that the substantial misalignment of real exchange rate was the one of the major factor behind the Asian crises of 1998.

Capital Inflows:

An optimistic view of foreign capital inflows is that they are likely to augment national savings, promote investment, and accelerate growth in developing countries like Pakistan. However, Pakistan’s actual experience deviates largely from theoretical predictions. The main reason for this irregularity between theory and experience lies in the nature of these flows. While capital flows have been large, they have essentially been unsustainable, temporary, and highly volatile in nature.

Some researchers have examined that capital inflows create some difficulties for the recipient countries in the form of real appreciation of their currencies. These difficulties include loss of competitiveness by exporters, spending boom, asset market bubbles, banking crises and the undermining of a strategy to achieve monetary stability by pegging the exchange rate.

The ‘Dutch Disease’ Dimension:

The Dutch Disease hypothesis within the framework of this study predicts that a large influx of capital flows will exert an appreciating affect on the REER. In turn, the non tradable sector will be influenced at the expense of the tradable sector via a ‘spending’ effect and a ‘resource movement’ effect.

RATIONALE

This study is motivated by the significance of the exchange rate as a crucial policy fundamental with profound implications for the macro-economy. The exchange rate can impact the economy through two potential channels: (i) by influencing a country’s macroeconomic stability, and (ii) by affecting the size of its tradable sector. Unfortunately, Pakistan has fared poorly on both counts. On the other hand, Capital flows to Pakistan have been huge and persistent. Since 2000, capital flows have ranged between approximately 7 and 20% of GDP. This raises important questions about the impact of such flows on economic outcomes in Pakistan. Also, these flows have contributed to stop-go cycles in economic growth while on the other they have exerted appreciating effects on the REER and distorted the relative incentives to operate in the tradable relative to the non tradable sector. Therefore, special emphasis places on the effect of capital inflows on the REER to establish whether or not capital flows are a cause of disease for the tradable sector and thereby for economic growth in Pakistan.

LITERATURE REVIEW

A considerable amount of literature has been produced to understand the impact of capital inflows on the real effective exchange rate in both developed as well as developing economies. In this chapter the literature related to real exchange rate response to capital inflows are reviewed to explore the in-depth knowledge of real exchange rate, its fluctuation and determinants in Pakistan’s economy.

Elbadawi and Soto (1994) analyzed the impact of capital flows among other fundamental variables on long-term exchange rates in Chile. Time period taken for the study was from 1960 to 1992. During this period, the real exchange rate and its fundamentals were found to be co integrated. The co integration technique and dynamic error-correction specification were used and produced fairly consistent results as expected from economic theory. The results indicate that the short-term capital flows and portfolio investment have no effect on the ERER (although they can affect the real exchange rate in the short run).Whereas long-term capital inflows and foreign direct investment have a significant appreciating effect on the ERER.

Athukorala and Rajapatirana (2003) investigated the nexus of real exchange rate (RER) and capital inflows through a comparative analysis of the experiences of emerging market economies in Asian and Latin America. The time period taken was 1985-2000. The paper shows 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 results reveal that the composition of capital flow matters in determining their impact on the real exchange rate.

Chakraborty (2003) examined the relationship between capital inflows and real effective exchange rate for India. The study has been conducted in India for the time period between 1993Q2 to 2001Q1. The study defined the net capital inflows as the aggregate of FDI, portfolio investment and external commercial borrowing and rate of growth of domestic credit and rate of inflation are used as proxies for monetary and fiscal policies, respectively. By using an unrestricted VAR framework, the results of the study reveal that the real effective exchange rate is response to one standard deviation innovation to foreign capital inflows.

Siourounis (2003) analyzed the empirical relationship between capital flows and nominal exchange rates. This study was conducted for five major countries: U.S, U.K, Germany, Japan and Switzerland. The data on variables covered the period from January 1988 to December 2000. Vector Auto Regressions were used to estimate dynamic models including a measure of net capital flows, the nominal exchange rate, equity return differentials and interest rate differentials. Overall, the empirical results indicated that the increased capital mobility is responsible for exchange rate movements.

Opoku-Afari et al. (2004) examined the real effects of capital inflows (aid, permanent and nonpermanent inflows) on the real effective exchange rate (RER) in Ghana by using annually data over the period 1966-2000.The study used the Vector Autoregressive (VAR) techniques and multivariate orthogonal decomposition technique to model the long-run equilibrium real exchange rate in Ghana. The results reveal that a Capital inflow is the only variable that generates real appreciation in the long-run whereas technology change, trade and terms of trade all tend to depreciate the real exchange rate. The only variable that has a significant (depreciating) effect on the real exchange rate in the short-run is trade. This implied that changes in exports are the major driver of exchange rate misalignment. It is also shown that the real exchange rate is slow to adjust back to equilibrium, implying policy ineffectiveness or inflexibility.

Ouattara and Strobl (2004) assessed the impact of foreign aid inflows on the real effective exchange rate of the CFA franc countries between the time periods 1980-2000. Dynamic panel analysis is used to test the hypothesis that foreign aid inflows cause real appreciation in the recipient country. The results depict that this hypothesis is rejected in the case of the CFA countries. On the contrary, foreign aid inflows are associated with a real depreciation of the franc.

Lartey (2006) investigated whether different forms of capital inflow, particularly Foreign Direct Investment (FDI), have variable effects on the real exchange rate or not. The focus of the study was sub-Saharan African countries. The period 1980-2000 has been considered. Dynamic panel techniques were used to estimate an empirical real exchange rate model specifying a set of capital inflow variables. The study concluded that FDI causes the real exchange rate to appreciate. The results also indicate that an increase in official aid causes a real appreciation and the magnitude was greater than the one associated with FDI.

Due and Sen (2006) conducted a study to examine the interactions between the real exchange rate, volatility of flows, level of capital flows, monetary and fiscal policy indicators and the current account surplus for Indian economy. These are taken from the time period ranging from 1993Q2 to 2004Q1. The results of the study indicate that the variables are co integrated and each Granger causes to the real exchange rate. The generalized variance decomposition analysis evidence, suggest that determinations of the real exchange rate, in descending order of important include net capital flows and their volatility, government expenditure, current account surplus and the money supply.

Noy and Vu (2007) studied the impact of capital account policies on FDI inflows. Annual panel dataset of 83 developing and developed countries are used for this purpose. Time period taken for the study was from 1984 to 2000. It has been found in the study that capital account openness is positively but only very moderately associated with the amount of FDI inflows after controlling for other macroeconomic and institutional measures. The study also implies that capital controls are easily circumvented in corrupt and politically unstable establishments.

Otker-Robe et al. (2007) analyzed the experiences of a number of European countries in coping with capital inflows. The paper discussed the nature of the inflows, their implications for macroeconomic and financial stability, and the policy responses used to manage with them. The findings of the study suggest that there is little room to regulate capital flows effectively for the countries that become more integrated with international financial markets. The most effective ways to deal with capital inflows would be to strengthen financial system supervision and regulation, deepen the financial markets, where needed, and improve the capacity to design and implement sound macroeconomic and financial sector policies.

Li and Rowe (2007) conducted a study to find the relationship between aid inflows and the real effective exchange rate. The study employs a reduced-form equilibrium real exchange rate approach to explain movements in Tanzania’s real effective exchange in recent decades. The results suggested that the long-run behavior of the real effective exchange rate is influenced by terms of trade movements, the government’s trade liberalization efforts, and aid inflows. Positive terms-of-trade movements are associated with an appreciation, periods of improving trade liberalization are associated with depreciation, and increases in aid inflows are associated with depreciation in the real effective exchange rate. Although the last result is not empirically unique and does have theoretical underpinnings, a detailed analysis of this relationship over the last decade shows that the Bank of Tanzania’s response to aid inflows is likely the main reason for the finding.

Lartey (2008) examined the effects of both the level and share of capital inflow on resource reallocation and real exchange rate movements in a small open economy within the context of the Dutch disease. This paper found that there exist a trade-off between resource reallocation and the degree of real exchange rate appreciation. The results show that an increase in capital inflow eventually causes an increase in demand, a rise in the relative price and an expansion of non tradable output. The increase in the relative price of non tradable culminates in an appreciation of the real exchange rate, which implies a loss of international competitiveness that hurts the tradable sector. The results also imply that a policy designed to minimize real exchange rate appreciation during capital inflow episodes should encompass measures aimed at stabilizing prices of non tradable.

Kim and Yang (2008) examined how capital inflows, especially portfolio inflows, affect the domestic economy, focusing particularly on asset prices. The paper empirically investigated the effects of capital inflows on asset prices by employing a VAR model. The empirical results found that capital inflows shocks indeed contributed to the stock price increase in Korea, but not much to land prices. Capital inflows shocks had a limited effect on nominal and real exchange rates, which is related to the huge foreign exchange reserve accumulation. A catch-all solution to the problems that capital inflows present does not seem to exist. Therefore, the most should be made of the available instruments at hand.

Martins (2009) investigated the determinants of the real exchange rate (RER) in Ethiopia. The determinant factors mainly studied are foreign aid and remittances. This investigation used the time series model and quarterly data for the period 1995-2008. Several co integration approaches are used for interesting methodological comparisons. The results suggest two main (long-run) determinants of the RER in Ethiopia. The first determinant i.e. trade openness is found to be correlated with RER depreciations, while a positive shock to the second one i.e. terms of trade tends to appreciate the RER. Moreover, Foreign aid is not found to have a statistically significant impact, while there is only weak evidence that workers’ remittances could be associated with RER appreciations. Also, the lack of empirical support for the Dutch disease hypothesis suggests that Ethiopia has been able to effectively manage large capital inflows, thus avoiding major episodes of macroeconomic instability.

Rashid (2009) evaluated empirically the effects of capital inflows on nominal and real effective exchange rate volatilities. The study uses monthly data for an eighteen-year period, from January 1990 to December 2007. The Granger causality test is used to explore the causal relation. It is found that there is statistically significant causation running from the change in net foreign reserve-GDP ratio to the exchange rate volatility. However, the estimates provide evidence that the volatility of real effective exchange rate is more sensitive to change in net foreign reserve as compared to the volatility of nominal exchange rate. The key message of the analysis is that there is a significant causal relationship between foreign capital inflows and exchange rate volatility. The findings suggest that there is a need to manage the capital inflows in such a way that they should not fuel the exchange rate volatility.

Saborowski (2009) argued that financial sector development could dampen the appreciation effect of capital inflows for the improved efficient allocation of resources. Annually data for the period 1990-2006 has been used for 84 countries. The study found that the exchange rate appreciation effect of FDI inflows is indeed attenuated when financial and capital markets are larger and more active. Furthermore, one of the main dangers associated with large capital inflows in emerging markets is the destabilization of macroeconomic management due to a sizeable appreciation of the real exchange rate. It can be mitigated partly by developing a deep financial sector. Also, the impact of capital inflows on the real exchange rate can be significantly reduced by the use of a more flexible exchange rate regime.

Combes et al. (2010) investigated the impact of capital inflows and the exchange rate regime on the real effective exchange rate. This study considered a wide range of 42 developing countries for the period 1980–2006. Using panel co integration techniques, the study reveals that both public and private inflows cause an appreciation of the real effective exchange rate. Among private inflows, portfolio investment has the biggest effect on appreciation i.e. almost seven times that of foreign direct investment or bank loans, and private inflows have the smallest effect.

Combes et al. (2011) conducted a study to examine the effect of different components of private capital inflows on the REER and have assessed the potential of exchange rate flexibility as a hedge against real appreciation in developing countries. Panel co integration techniques are applied to support the results that public and private flows are associated with a real exchange rate appreciation. Portfolio investment among private flows has the highest appreciation effect. Almost seven times that of foreign direct investment or bank loans. Whereas private transfers has the lowest effect. Using a de facto measure of exchange rate flexibility, the study implies that a more flexible exchange rate helps to dampen appreciation of the real exchange rate stemming from capital inflows. Furthermore, the study suggested that when implementing policies to attract capital flows, developing countries should consider that a significant REER appreciation might destabilize macroeconomic management.

In the conclusion, it can be seen from the above articles that several researches are conducted to examine the impact of capital inflows on the real effective exchange rate in various European and Asian countries. So, this study is conducted to examine the effects of capital inflows on the real effective exchange rate in Pakistan. Major determinants of real effective exchange rate that are found in literature includes terms of trade, degree of trade openness, government spending, foreign project-based assistance (AST), foreign direct investment (FDI) and worker’s remittances.

Problem Statement

To what extent does capital inflows affect real effective exchange rate in Pakistan and in what direction?

Objectives of the Study

The objective of this study is twofold:

To estimate the long-run equilibrium of the real effective exchange rate (REER) and calculate the degree of overvaluation of the real effective exchange rate (REER) in Pakistan for the period 1981–2010.

To test the hypothesis concerning the effect of capital inflows on the REER in Pakistan i.e. Dutch Disease hypothesis.

Hypothesis Formulation

Ho: There is no significant impact of terms of trade, degree of trade openness, government spending, foreign project-based assistance (AST), foreign direct investment (FDI) and worker’s remittances on the dependent variable i.e. real effective exchange rate (REER).

H1: There is a significant impact of terms of trade, degree of trade openness, government spending, foreign project-based assistance (AST), foreign direct investment (FDI) and worker’s remittances on the dependent variable i.e. real effective exchange rate (REER).

Theoretical Framework

The theoretical framework given below shows the relationship between the dependent variable i.e. real effective exchange rate (REER) and the independent variables i.e. terms of trade, degree of trade openness, government spending, foreign project-based assistance (AST), foreign direct investment (FDI) and worker’s remittances. All other factors are assumed to be constant.

METHODOLOGY

This chapter explains the methodology for estimating the equilibrium real effective exchange rate and determining the effects of capital inflows on real effective exchange rate in Pakistan for the period 1981-2010.

Sources of Data

The secondary data of all selected variables is taken to estimate the multi-linear regression model (MLRM) in order to examine the effects of capital inflows on real effective exchange rate.

Time Period of the Study

Time period of thirty years i.e. 1981-2010 is taken for conducting the study.

CONTRIBUTION OF THE STUDY

This study would enhanced the knowledge of effects of the capital inflows on the real effective exchange rate and helps the policymaker to understand the impact of large capital flows on the real effective exchange rate so that they would be aware of the darker side of the large capital inflows.

INDEPENDENT VARIABLES DEPENDENTVARIABLE

Terms of Trade (TOT)

Liberalization Index (Proxy for Degree of Openness)

Government Spending

(GS)

Real Effective Exchange Rate (REER)

Foreign Direct Investment (FDI)

Worker’s Remittances (REMIT)

Foreign Project-Based Assistance (AST)

Print Email Download Reference This Send to Kindle Reddit This

Share This Essay

To share this essay on Reddit, Facebook, Twitter, or Google+ just click on the buttons below:

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.


More from UK Essays