This paper uses Granger causality tests to assess the linkages between
changes in the real exchange rate and net capital inflows using the example
of Western Balkan countries, which have suffered from low competitiveness and
external imbalances for many years. The real exchange rate is a measure of a
country?s price competitiveness, and the paper uses two concepts: relative
unit labour cost and relative inflation differential. The sample consists of
six Western Balkan countries for the period 1996-2012, relative to the
European Union (EU). The main finding is that changes in the net capital
flows precede changes in relative unit labour costs and not vice versa. Also,
there is evidence that net capital flows affect the inflation differential of
countries, although to a less discernible extent. This suggests that the
increasing divergence in the unit labour cost between the EU and Western
Balkan countries up to the global financial crisis was at least partly the
result of net capital inflows. The paper adds to the ongoing debate on
improving cost competitiveness through wage restrictions as the main vehicle
to avert the accumulation of current account imbalances. It shows the
importance of changes in the exchange rate regime, reform of the interaction
between the financial and the real sector, and financial supervision and
structural change.
Capital Inflows and the Real Exchange Rate: A Comparative Study of Asia and Latin America
