The swift and strong rebound of capital inflows in emerging Asian economies after the onset of the global financial crisis in 2008 has added new impetus to the debate on how to reap the gains to be enjoyed from capital inflows, while minimizing the possible economic costs. One of the unfavourable side effects of “too much” capital flows is (real) exchange rate appreciation — a loss of a country's competitiveness — that could adversely affect the tradable production and export sectors. Real exchange rate appreciation occurs regardless of the nature of the exchange rate regime implemented in a country. Under a flexible regime, real appreciation occurs through an upturn in the nominal exchange rate, while under a fixed exchange rate regime appreciation comes mainly through a rise in non-tradable prices. Under an intermediate regime, real currency appreciation occurs through a mixture of these two processes.

Stronger currency appreciation has become evident in emerging Asian economies (see Figure 6.1) along with a strong rebound in capital inflows (see Chapter 2). Exporters in many countries have asked for government intervention to mitigate the pressures arising from currency appreciation. Many central banks in the region, including China and Taiwan, have begun to tighten capital control policies, while the others monitor closely the movement of capital flows. In Korea, Taiwan and Thailand central banks have also intervened extensively in foreign exchange markets, while local currency bonds were issued to mop up the liquidity arising from foreign exchange market intervention.

These issues lead to empirical questions concerning the relationship between real exchange rates and capital flows in emerging Asian countries, particularly how far and how fast (real) exchange rates will be adjusted in response to capital flows. While there is strong evidence to believe that particular types of capital flows behave differently, whether the composition of capital flows matters in determining the movements of (real) exchange rates is also another question of interest. In particular, does the impact of foreign direct investment (FDI) on real exchange rates differ from other forms of capital flows, especially portfolio and bank loan investments?