Sustainable regulation, stronger currencies: Evidence from capital flow dynamics

Abstract

Using a staggered Difference-in-Differences approach across 48 countries, we find that currencies with more stringent Environment, Social, and Governance (ESG) regulations yield higher returns. The increase in currency returns stems from growth in net capital flows, which is primarily driven by a significant reduction in capital outflows, especially of portfolio investment. While changes in the ESG regulatory environment introduce uncertainty to the economy, investors value the alleviation of information opacity and, more significantly, the mitigation of ESG-related risks. Our findings highlight the potential of ESG regulation as an effective policy tool to enhance financial stability and attract capital by reducing perceived risk and information asymmetry in the international currency markets. • Countries with more stringent ESG regulations have higher currency returns. • Currency return increases are associated with growth in net capital flows, which are driven by reduced capital outflows particularly of portfolio investments. • The observed dynamics are mainly driven through the mitigation of ESG-related risks, though multiple mechanisms play a role. • ESG regulation serves as an effective tool to restrain capital flight and enhance currency performance in the international FX market.