Domestic currency appreciation and foreign capital inflows: What comes first? (Chile, 1977–1982)

• Published in: Journal of international money and finance 1988-12, Vol.7 (4), p.447-466
• Main Author: Morande, Felipe G
• Format: Article
• Language: English
• Subjects: Appreciation; Capital flow; Chile; Currencies; Economic models; External debt; Foreign exchange rates; Foreign investment; LDCs
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/0261-5606(88)90027-7

The purpose of this paper is to find (Granger) causality relations between the real exchange rate, the inflow of foreign capital, interest rate arbitrage, and the terms of trade, in a representative indebted, developing country Chilé. This is done for a time period in which Chile went from an unprecedented expansion (1977–1981) to a severe recession (1982). The paper confronts two competing hypotheses that purport to explain such behavior. Hypothesis one claims that causality went from the real exchange rate (affected by nominal exchange rate policy) to capital inflows, in what could be termed a current-account–deficit-induced demand for foreign funds. Hypothesis two posits a causality that ran the other way—from capital inflows to the real exchange rate—in which case the ‘exogenous’ inflows of foreign money implied a current account deficit. Special attention is paid to the role played by two other related factors, interest rate arbitrage and terms of trade variations. By applying innovation accounting techniques based on estimated vector autoregressions, support is found for the second of these hypotheses. Thus, the real issue—in Chile and in many other currently indebted Latin American countries—should be the timing and extent of the capital account liberalization process carried out during the period.