Foreign Capital Inflows and Real Exchange Rate: Korea, 1990s

This study attempts to discriminate between the two competing hypotheses about the causal direction between capital inflows and the real exchange rate in Korea in the 1990s. A notable observation during the period was that the current account deficits were accompanied by capital inflows. Hypothesis 1 states that the inflow of foreign capital Granger-causes the real exchange rate whereas Hypothesis 2 claims that the causal direction goes the other way. The results based on both the bivariate and four-variable vector autoregression models support the Hypothesis 1. That is, capital inflows caused the real exchange rate to appreciate, which led to the current account deficits. This implies that the timing and extent of domestic capital market liberalization are important issues for Korea and other highly indebted capital recipient countries.