CAPITAL FLOWS AND THE REAL EXCHANGE RATE : EVIDENCE FROM SELECTED ASEAN COUNTRIES

Abstract

Recent years have seen ever increasing volume of capital inflows. With the trend of globalization and movement towards a relatively borderless world, we expect an even greater amount of capital flows. These flows are thought to be closely linked to many macroeconomic variables, with possible repercussions particularly on the exchange rate. The objective of this study is to take a new look at the relationship between capital flows and real exchange rate, analyzing this link with empirical data from selected countries from ASEAN, namely Philippines and Singapore. The choice of the sample is dictated by the availability of the data. The thesis starts with an extensive review of literature on the intriguing relationship between the real exchange rate and capital flows. The idea is to highlight and distill the relevant theoretical and empirical issues dominating the literature. Next, we present a theoretical framework to formally set up the relationship between the real exchange rate and capital flows. In this framework, the real exchange rate is posited as a function of international capital inflows. This framework is based on the idea that the more open an economy is, the more will be the response of the real exchange rate to international capital movements. Given that Singapore and Philippines are considered very open, we would expect the data to indicate that the real exchange rates for these countries are less elastic to capital inflows. Interestingly, our empirical results indicate that the real exchange rate is more elastic in the case of Singapore than that for Philippines. This is a bit striking in the sense that Singapore appears to be relatively more open than Philippines. One explanation could be that the share of foreign direct investment in the total capital inflows is greater in Philippines than in Singapore. However, the results have to be interpreted with sufficient caution because of the data problem typical of countries like Philippines.