Financial integration, institutional quality, and real exchange rates: evidence from emerging markets

In the literature, there is little consensus on the role of external capital account liberalisation in explaining country-level competitiveness. This chapter provides an overview of issues investigating the role of financial integration in helping preserve their external price competitiveness using real effective exchange rates, in the presence of greater trade openness and better institutional quality. Aggregate and regional analyses are conducted to explore why trade openness alone is not sufficient in improving their export competitiveness. Using data covering 35 developing and emerging economies over 40 years, the chapter investigates whether adverse currency fluctuations hamper external competitiveness due to relative price differences that can create currency overvaluation which might not be mitigated via one type of openness alone. The findings suggest that trade or financial openness alone does not aid export competitiveness, but countries that are more open on both fronts and have a higher level of development can benefit in terms of real depreciation. Considering aggregate capital flows namely FDI, Portfolio and other financial flows, the authors further show that aside from openness in terms of policies and activities, greater international financial integration with trade integration in the presence of better institutions can enhance external price competitiveness, enabling reduction in international transaction costs.