What Is the Relationship Between Exchange Rate Fluctuations and International Capital Flows?
Abnormal fluctuations in exchange rates are often closely linked to international capital flows, which can lead to unnecessary volatility in industrial production and macroeconomic development. Therefore, stabilizing exchange rates helps maintain economic and price stability.
Today, cross-border capital flows are not only large in scale but also facilitated through multiple channels, with minimal artificial barriers.
Since the late 1970s, industrialized countries have relaxed financial regulations, further facilitating international capital flows.
Under a floating exchange rate system, the most direct consequence of large-scale international capital flows is fluctuations in foreign exchange market prices. If a large amount of capital flows into Germany, the exchange rate of the Deutsche Mark will rise. Conversely, if capital flows out of the U.S., the dollar's exchange rate will inevitably decline. On the other hand, if investors expect a country's currency to appreciate, capital will naturally flow into that country.
The correlation between capital flows and foreign exchange market movements has a significant impact on a country's industrial structure and price levels. For example, when a country experiences significant capital outflows, leading to a depreciation of its currency—or when investors anticipate depreciation, triggering capital flight—the industrial structure and prices will inevitably shift in favor of trade-exposed sectors. From a trade perspective, a country's industries can be divided into two categories: tradable (e.g., manufacturing, where products can be exported or imported) and non-tradable (e.g., certain services that must be produced and consumed locally). When capital outflows cause currency depreciation, prices in tradable sectors rise. If wages in these sectors do not adjust proportionally, expanding production becomes more profitable, boosting exports. However, from a domestic industrial perspective, capital shifts from non-tradable to tradable sectors. If this becomes a long-term trend, the national economic balance may be disrupted. Hence, industrialized nations and central banks generally oppose prolonged deviations of their currency's exchange rate from what they perceive as equilibrium. This is one reason why central banks directly intervene when their currency is persistently weak or excessively strong.
Another critical economic impact of capital flows and exchange rate fluctuations is that large-scale capital outflows increase the cost of domestic capital formation, while excessive inflows may create unwanted inflationary pressures, undermining long-term investment. In the early 1980s, the U.S. implemented tight monetary policy alongside expansionary fiscal policy, attracting massive capital inflows and driving up the dollar's value. Meanwhile, the Federal Reserve (Fed) adopted a laissez-faire approach to the forex market in 1981–1982. In contrast, Western European nations, seeking to prevent capital flight amid declining European exchange rates, frequently intervened directly in forex markets and repeatedly urged the Fed to cooperate in stabilization efforts.
