• Capital inflows;
  • financial market development;
  • real exchange rate;
  • dynamic panel data models


We argue that, in improving the efficient allocation of resources, financial sector development should dampen the appreciation effect of capital inflows. Using dynamic panel data techniques, the paper finds that the exchange rate appreciation effect of FDI inflows is indeed attenuated when financial and capital markets are larger and more active. The main implication of these results is that one of the main dangers associated with large capital inflows in emerging markets—the destabilization of macroeconomic management due to a sizeable appreciation of the real exchange rate—can be mitigated partly by means of developing a deep financial sector. Copyright © 2010 John Wiley & Sons, Ltd.