Foreign Capital Inflows and the Current Account Imbalance: Which Causality Direction?

The ongoing financial globalization has instigated growing concerns on the issue of benefits and costs from free international capital mobility. Past experiences in the emerging market countries indicate that foreign capital inflows could cause persistent current account deficits and lead to currency crises. This paper empirically demonstrates that foreign capital inflows and current account imbalances interact in different ways between developed countries and emerging market countries. Using the Granger non-causality test, we find that foreign capital inflows Granger-cause the current account in the cases of emerging market countries, while a causal relation is negligently detected in the cases of developed countries. Indeed, distinct from developed countries, the current accounts of emerging market countries are susceptible to the influence of foreign capital inflows. Given the relatively immature financial markets, emerging market countries should be cautious while embracing financial globalization and prudent measures to manage large capital inflows are necessary.