This presentation is part of: F20-1 International and Monetary Economics

Foreign Capital Inflow and Its Relationship with Current Account Imbalances

Ho-don Yan, Ph.D. and Cheng-lang Yang, Ph.D., candidate. Economics, Feng Chia University, 100, Wen Hwa Rd.,, Taichung, 407, Taiwan

The resurgence of capital mobility since the end of the 1980s has led to increased discussion over whether it is a curse or a blessing, in particular for emerging market economies, many of which were affected by currency crises during the last decade of the 20th century. Recently there has been a surge of research attempting to address the issue of foreign capital inflows cum current account imbalances. This approach is based on testing whether there is a different causal relationship in the current account imbalance and foreign capital inflows between developed and developing countries. Within these studies, different causality testing approaches are implemented for different country sets and time periods, and they commonly investigate the causal relationships of the current account and foreign capital inflows by using the net capital inflows, i.e. the financial account from the balance of payment account.

This paper attempts to further explore this causal relationship between current account imbalances and foreign capital inflows. We particularly distinguish our study from the extant research studies in two respects. The first is that we use the gross, instead of net, foreign capital inflows to investigate the causal relationship with the current account imbalance. Net foreign capital inflows are the difference between foreign and domestic residents’ international investment behavior. We reckon that it is more appropriate to use gross foreign capital inflows if we intend to know how foreign investors affect domestic current account imbalances. Second, the emerging market economies’ currency crises of the 1990s show that massive foreign capital inflows might not be all detrimental to the capital-receiving countries. It is broadly agreed that equity-like forms of capital inflows are usually stable and instrumental to the economic growth, while debt-like forms of foreign capitals are unstable and culpable to sudden stop. Therefore, it is worth examining whether these two types of foreign capital inflows will bring different causal relationship with current account.

Using the augmented Vector Autoregression (VAR) model to estimate and implement the Granger non-causality test, we find that for 7 developed countries, gross foreign capital inflows mostly show a negligible causal relationship with the current account, and if there exists causal relationship, it is current account causes the foreign capital inflows. For 7 emerging market economies, it always seems true that foreign capital inflows Granger-cause current account imbalances. By further investigating the two components of the foreign capital inflows, equity-like forms of foreign capitals and debt-like forms of foreign capitals, the results of the causal relationship with current account mostly remain the same although in emerging market countries, there is more evidence of debt-like forms of capital inflows Granger causes current account imbalance.

Our empirical results suggest that emerging market economies are more susceptible to the influence of foreign capital inflows and they should be cautious when liberalizing their capital account and measures to prudently manage large capital inflows are necessary.


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