Currency Substitution, Capital Flight and Real Exchange Rates

Journal of International Money and Finance, 1994

This paper presents a 'shopping cost' money service model in which it is shown that the real exchange rate influences the desired ratio of domestic-to-foreign-currency bank deposits. Empirically, it is found that if the real exchange rate value of the Canadian dollar falls then US dollar deposits of Canadians rise relative to Canadian M2. This relationship is found to be cointegrated.

SAJESS, 2022

Exchange rate volatility and declining capital inflow are important policy issues that inform macroeconomic policies and strategies of developing countries. Most developing economies have small potential resource base, faces foreign exchange volatility and limited market of agricultural products, thus investigating the role of capital flight is significant for these states. Cognizant of this, the study will try to answer the paradox of capital outflow and exchange uncertainty. The research will investigate the influence of exchange rate differential on capital flight in East Africa economies for the year 1988-2018 using panel secondary data. The empirical analysis was guided by investment creation theorem. The study adopted ordinary least squares estimation to analyse the relation between the study variables. The study estimations has identified that exchange rate positively influences capital outflow in East African states. The positive effect of currency change on capital outflow implied that capital outflow was sensitive to currency depreciation. Accelerated currency devaluation erodes domestic investors confidence to hold local currency, citizens will likely move to foreign markets and assets to avoid negative effect of devaluation. Government policymakers should pursue strategies and policies that can slow currency uncertainty in order to tame capital outflow. These policies and strategies include fostering of both fiscal and monetary disciplines and good governance.

2011

This paper analyzes the impact of capital inflows and the exchange rate regime on the real effective exchange rate. A wide range of developing countries (42 countries) is considered with estimation based on panel cointegration techniques. The results show that both public and private inflows cause the real effective exchange rate to appreciate. Among private inflows, portfolio investment has the biggest effect on appreciation, almost seven times that of foreign direct investment or bank loans, and private inflows have the smallest effect. Using a de facto measure of exchange rate flexibility, we find that a more flexible exchange rate helps to dampen appreciation of the real effective exchange rate caused by capital inflows.

Theoretical and Applied Economics Volume XXI (2014), No. 11(600), pp. 121-140, 2014

The objective of this work is to determine the role of the misalignment of the real exchange rate in capital flight for a sample of developing countries over the period 1980-2010. Firstly, we calculated the degrees of misalignment for all countries of our sample, which degrees were introduced as a determinant of capital flight. Then, we examined the effect of the overvaluation and the undervaluation on capital flight. The results show that a strong undervaluation may discourage capital flight, while a strong overvaluation can stimulate it.

Journal of Macroeconomics, 2012

The views expressed in this Working Paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the authors and are published to elicit comments and to further debate. This paper analyzes the impact of capital inflows and exchange rate flexibility on the real exchange rate in developing countries based on panel cointegration techniques. The results show that public and private flows are associated with a real exchange rate appreciation. Among private flows, portfolio investment has the highest appreciation effect-almost seven times that of foreign direct investment or bank loans-and private transfers have the lowest effect. Using a de facto measure of exchange rate flexibility, we find that a more flexible exchange rate helps to dampen appreciation of the real exchange rate stemming from capital inflows.

2016

We provide a theory of the determination of exchange rates based on cap-ital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from in-ternational imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus affecting both the level and volatility of exchange rates. Our theory of exchange rate determination in imperfect financial markets not only helps rationalize the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, it also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. Our framework is flexible; it accommodates a number of important modeling features within a...

The main aim o f the paper is to show that credit boom-bust cycles in developing countries might reinforce economic volatility even without market imperfections. We first introduce currency substitution as a factor which becomes intertwined with liquidity preference in the case o f a financially liberalized country. Next, we argue that financial reforms which accompany financial liberalization brought about currency substitution within deposits. Consequently, changes in liquidity preference lead to quantity rather than price changes in the form o f shifts in the composition o f total bank deposits between active and inactive balances. However, since we observe shifts between two different currencies the shifts from active to inactive balances involve currency substitution as well. We argue that changes in liquidity preference being entangled with currency substitution under the circumstances described, act as a built-in macroeconomic destabilize because domestic bank's reserve requirements are higher fo r foreign exchange denominated accounts than fo r those denominated in home currency. Statistical evidence is provided to support the claim by performing a cointegration analysis under structural breaks between total volume o f credits o f the Turkish commercial banking system and currency substitution indicator. The results revealed that there is a negative relationship between currency substitution and credit expansion.

SSRN Electronic Journal, 1998

The World Economy, 2003

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.

COMMON defense of flexible exchange rates is that they insulate the domestic economy and money supply from foreign monetary disturbances.' This view has been challenged by a number of critics who question the assumption behind the monetary independence argument that domestic and foreign currencies are not considered substitutes in demand by domestic residents.