Fiscal Imbalances Capital Inflows And The Real Exchange Rate

This paper examines the links between fiscal policy, capital inflows, and the real exchange rate in Turkey since the late 1980s. After an overview of recent macroeconomic developments in Turkey, a vector autoregression model is estimated linking government spending, interest rate differentials, capital inflows, and the temporary component of the real exchange rate. Positive shocks to government spending and capital inflows lead to an appreciation of the temporary component of the real exchange rate, whereas positive shocks to the uncovered interest rate differential lead to a capital inflow and an appreciation of the temporary component of the real exchange rate. The findings highlight the role of fiscal adjustment in restoring macroeconomic stability.

This paper examines the links between fiscal policy, capital inflows, and the real exchange rate in Turkey since the late 1980s. After an overview of recent macroeconomic developments in Turkey, a vector autoregression model is estimated linking government spending, interest rate differentials, capital inflows, and the temporary component of the real exchange rate. Positive shocks to government spending and capital inflows lead to an appreciation of the temporary component of the real exchange rate, whereas positive shocks to the uncovered interest rate differential lead to a capital inflow and an appreciation of the temporary component of the real exchange rate. The findings highlight the role of fiscal adjustment in restoring macroeconomic stability.

This paper examines the links between capital inflows and the real exchange rate under pegged exchange rates. The analytical framework is described, and a near-VAR model linking capital inflows, interest rate differentials, government spending, money base velocity, and the temporary component of the real exchange rate (TCRER) is estimated for Korea, Mexico, the Philippines, and Thailand. TCRER movements are associated only weakly with shocks to capital flows. Negative shocks to U.S. interest rates lead to capital inflows in Asia and a TCRER appreciation in the Philippines and Thailand. Positive shocks to government spending have a small but statistically significant effect on the TCRER for Korea.

This paper argues that, in improving the efficient allocation of resources, financial sector development could dampen the appreciation effect of capital inflows. Using dynamic panel data techniques, the paper finds that the exchange rate appreciation effect of FDI inflows is indeed attenuated when financial and capital markets are larger and more active. The main implication of these results is that one of the main dangers associated with large capital inflows in emerging markets-the destabilization of macroeconomic management due to a sizeable appreciation of the real exchange rate-can be mitigated partly by developing a deep financial sector.

We review the literature on Dutch disease, and document that shocks that trigger foreign exchange inflows (such as natural resource booms, surges in foreign aid, remittances, or capital inflows) appreciate the real exchange rate, generate factor reallocation, and reduce manufacturing output and net exports. We also observe that real exchange rate misalignment due to overvaluation and higher volatility of the real exchange rate lower growth. Regarding the effect of undervaluation of the exchange rate on economic growth, the evidence is mixed and inconclusive. However, there is no evidence in the literature that Dutch disease reduces overall economic growth. Policy responses should aim at adequately managing the boom and the risks associated with it.

A number of emerging markets have experienced substantial real exchange rate appreciation in recent years, generating concerns about competitiveness and prompting policymakers to respond with a combination of mitigating policies. This paper shows that fiscal policy can play a role in alleviating these pressures. Using a sample of 28 emerging market economies over 1983-2011, we estimate a dynamic model of the real exchange rate and find that a permanent fiscal adjustment may reduce appreciation pressures over the long term. Furthermore, the composition of public spending matters, with reductions in current spending playing a key role. To illustrate the importance of these findings, the paper focuses on the case of Brazil. Our results suggest that maintaining fiscal discipline while increasing public investment in Brazil is likely to ease real appreciation pressures, highlighting the importance of tackling long-standing budget rigidities.

The dramatic growth of international capital flow has provided unprecedented opportunities and risks in emerging markets. This book is the result of a conference exploring this phenomenon, sponsored by the Federal Reserve Bank of Dallas. The issues explored include direct versus portfolio investment; exchange rates and economic growth; and optimal exchange rate policy for stabilizing inflation in developing countries. It concludes with a panel discussion on central bank coordination in the midst of exchange rate instability.

"This is a very timely book that brings the reader to the forefront of current research on macroeconomic policy issues in economies subject to sizable capital flows".--Guillermo A. Calvo, University of Maryland.