Three essays on the macroeconomic impacts of capital flows and policy responses in emerging market economies

Abstract

This thesis presents three essays on the macroeconomic impacts of capital flows and policy responses in emerging market economies. This study explores the impact of capital flows on real exchange rate and foreign reserve accumulation and the effects of policy responses on the volume and composition of capital inflows. Together, these studies form the argument that promoting financial sector development and government effectiveness helps emerging market economies manage and benefit more from capital inflows. The first essay (Chapter 2) argues that financial development helps reduce the impact of non-FDI inflows on real exchange rate appreciation. Using dynamic panel techniques and data from 78 developing economies for the period 1993-2009, the empirical results indicate that non-FDI has an appreciation impact on real exchange rate. However, the appreciation effects of FDI are not clear-cut. The results also suggest that improving mobilization of financial resources through financial sector development helps dampen the real appreciation effects of non-FDI inflows. These results are useful for policy makers in their attempt to reconcile the dilemma of attracting foreign capital to enhance investment while maintaining competitiveness to promote exports and growth. The second essay (Chapter 3) analyzes the effects of financial development and capital flows on reserve accumulation in East Asian economies. Using annual data from 12 Asian economies between 1980 and 2009, the empirical results suggest that financial development can reduce a central bank's motivation to hoard foreign reserves by reducing the impact of capital flows on foreign reserve demand. Based on the empirical observations, this study then constructed a simple model of foreign reserve accumulation in which the optimal level of foreign reserves depends on the level of financial development. The theoretical model implies that, with an asymmetric preference in exchange rate, the actual level of foreign reserves held by a central bank is usually higher than the optimal level of foreign reserves needed for a liquidity supply. The third essay (Chapter 4) assesses the impact of capital controls and sterilization on the volume and composition of capital flows in emerging market economies. Using a fixed{u00AD}effect panel estimate on 15 emerging market economies during the period 1996-2009, this study finds that: (i) capital controls affect the composition, but not the volume of capital inflows, (ii) there is no cross-country evidence that sterilization can encourage more short{u00AD}term inflows, and (iii) the administering and enforcing capacity matters to the effects of capital controls on the volume and composition of capital inflows. These results help reconcile why some countries are successful in shaping the volume and composition of capital flows while others are not. The central findings from the three essays indicate that enhancing financial sector development and government effectiveness appears to help emerging market economies to be able to manage capital flows better and to benefit more from capital inflows. The studies on threshold conditions in this thesis also help reconcile why the evidence in the literature of the macroeconomic impacts of capital flows in capital-importing economies is ambiguous and sometimes even contradictory. The results in this study demonstrate that capital flows can potentially improve a country's welfare, if properly managed and synchronized with strengthening financial sector development and institutional arrangements. The volatility and potentially adverse effects of capital flows should not be seen as an argument for emerging countries to close their capital accounts. In addition, as countries have limited ability to stop the 'waves' of capital flows as shown in Chapter 4, the emphasis should instead be put on strengthening the policy and institutional framework to better manage capital inflows. The evidence in this thesis strongly suggests that countries should avoid fully liberalizing their capital accounts until the process of financial and institutional development has advanced to a considerable extent. Show more