Capital flows and exchange rate volatility: experience of emerging economies

In the recent past, there has been a significant rise in the cross-border capital flows and a large chunk of it is being attracted by emerging economies. This poses an important question, whether the capital flows, especially foreign portfolio flows, are responsible for the increasing volatility of exchange rate in emerging economies. This study is an attempt to answer this question. To this end, we estimated a Panel Vector Autoregression model using quarterly data of ten emerging economies for the period 1997Q1–2017Q1. The evidence from impulse response indicates that exchange rate volatility significantly increases in response to the shocks in portfolio capital flows than to shocks in foreign direct inflows. The forecast error variance decomposition also suggests that shocks to foreign portfolio investment flows exert significant impact on the exchange rate volatility. The foreign portfolio flows are responsible for more than 7% of the variations in exchange rate volatility, while current account balance, stock prices and interest rate together explain only around 4% of the variations in exchange rate volatility.