Capital Inflows, Exchange Rate Flexibility, and Credit Booms

Abstract

The prospects of expansionary monetary policies in the advanced countries for the foreseeable future have renewed the debate over policy options to cope with large capital inflows that are, at least partly, driven by low interest rates in the financial centers. Historically, capital flow bonanzas have often fueled sharp credit expansions in advanced and emerging market economies alike. Focusing primarily on emerging markets, we analyze the impact of exchange rate flexibility on credit markets during periods of large capital inflows. We show that credit grows more rapidly and its composition tilts to foreign currency in economies with less flexible exchange rate regimes, and that these results are not explained entirely by the fact that the latter attract more capital inflows than economies with more flexible regimes. Our findings thus suggest countries with less flexible exchange rate regimes may stand to benefit the most from regulatory policies that reduce banks' incentives to tap external markets and to lend/borrow in foreign currency; these policies include marginal reserve requirements on foreign lending, currency-dependent liquidity requirements, and higher capital requirement and/or dynamic provisioning on foreign exchange loans.

Capital inflows, exchange rate regimes and credit dynamics in emerging market economies

“…The more rigid the exchange rate regime, the higher the level of dollarization. Also, the crisis tends to exacerbate the level of dollarization which is more consistent with previous studies (Tirpák and Rosenberg, 2008;Magud et al, 2011).…”

“…to the study by Magud et al (2011). They show that exchange rate regimes of the EMEs during large inflows episodes may have a significant impact on credit distribution and liability dollarization.…”

“…On the one hand, a high degree of external debt could deter 22 All results are depicted in Appendix, in Tables 9 and 10. 23 Large outflows and sudden stop episodes may cause the abandonment of a peg or a crawling peg 24 Results on GMM and country-specific cyclical components are not reported here for brevity, but are available upon request to the author.…”

“…The same is true for alternative specifications, including time and fixed effects as well as GLS estimations (Table 10). In order to account for possible endogeneity between ERR and capital flows, 23 we re-run the estimation process using GMM estimators. Moreover, we consider a country-specific cyclical component of capital flows for robustness purpose.…”

Are capital inflows expansionary or contractionary in the Philippines?

“…However, more recent empirical studies in the boom-bust literature, including Caballero (2014) and Magud et al (2014), tell another story. As capital flows to a country, it triggers a domestic credit boom.…”