On the real effects of net capital inflows: The experiences of developing countries

The literature on real exchange rate (RER) stresses the role that the monetization of large capital inflows has on the appreciation of the RER, but it overlooks the main determinants through which RER changes really come about during net capital inflow episodes; that is, adjustments in production and demand in tradable and nontradable sectors and sterilization policies. The purpose of the research presented in this dissertation is to fill this gap. Several conclusions emerge from this research. First, production and demand responses play an important role in real adjustments during episodes of net capital inflows: Increases in the share of nontradables are accompanied by RER appreciation during such episodes. In addition, evidence suggests that net resource transfer (NRT) is a better indicator of RER changes than net capital inflows. Second, central banks generally engage in sterilized intervention in response to large capital inflows, much more so than is suggested in the literature. Such intervention may seem quite natural in fixed exchange rate systems, but it is frequently present regardless of which exchange rate system prevails. The broad conclusion is that central banks counteract the real effects of the capital inflows; that is, they attempt to offset both the sharp appreciation of the RER and the shift of resources toward the production of nontradables. To do so, they seem to treat international reserves as a combined instrument and objective of monetary policy. Data analysis of ten Latin American countries and seven Asian countries supports these conclusions.;To further unveil the real effects of net capital inflows on developing countries, a critical survey of the empirical literature on the connections between foreign direct investment (FDI) and economic growth is presented. This survey reveals that, in spite of the belief of most economists that large volumes of foreign direct investment can have a significant and positive impact on the economic growth of the host economy, several of the few empirical studies that actually address the links between FDI and growth in developing countries fail to support this belief. Some of these studies, however, particularly those using macroeconomic data, present caveats in theoretical framework or methodology, or both, that are in some cases serious enough to undermine the soundness of their conclusions. On the other hand, recent empirical studies, some of which use industry and plant data, show a plausible basis for significant estimates of the connections between FDI and economic growth and the key nature of such connections. These studies offer promising avenues for future research.