Financial capital inflows and exchange rate instability: The case of Turkey

Abstract

In the beginning of financial liberalization policies, it is generally argued that capital inflows can provide the opportunities for developing countries to accelerate economic growth. Nowadays most of the economists emphasize the role of foreign capital in generating financial instability in domestic economies. From this point of view, the objective of this paper is basically to examine the effects of financial capital inflows on economic growth and exchange rate as an indicator of financial instability in Turkish Economy. Using VAR Model and quarterly data from 1992 to 2010, this study indicates that financial capital inflows is the major cause of the real exchange rate appreciation although promoting economic growth. The findings reveal that the real appreciation of the domestic money induced by the greater availability of foreign financing is a short-term phenomenon that, sooner or later, would have to be reversed because of "expectation of exchange rate depreciation"; and in the mean time, is hampering growth and creating a serious financial instability.