Episodes of Large Capital Inflows and the Likelihood of Banking and Currency Crises and Sudden Stops

Abstract

JT03301984This paper provides an empirical investigation of the relationship between surges in capital inflows and the probability of subsequent banking, currency and balance-of-payment crises. Using a panel of developed and emerging economies from 1970 to 2007, it is shown that a large capital inflow episode increases substantially the probability of having a banking or a currency crisis in the two following years. The effect is especially large for the case of balance-of-payment crises. The paper also finds that the effect of large capital inflows is different depending on the type of flows characterising the episode. In particular, large capital inflows that are debt-driven significantly increase the probability of banking, currency and balance of payment crises, whereas if inflows are driven by equity portfolio investment or FDI there is a negligible effect. This means that structural reforms that modify the composition of capital flows towards a lower share of debt are likely to reduce the financial vulnerabilities to large capital inflows. At the same time, however, structural reforms may also increase the overall size of capital flows.JEL classification: E44; E51; F1; F34.

Can Reforms Promoting Growth Increase Financial Fragility?

“…However, results in column 2 suggest that the impact of capital flows on the likelihood of a twin crisis originates from portfolio debt flows, while FDIs and portfolio equity flows do not appear to affect the probability of a twin crisis taking place. This evidence is consistent with Furceri et al (2011), Ahrend, Goujard and Schwellnus (2012) and Ahrend and Goujard (2012a,b;2015) who find that portfolio, and more specifically portfolio debt flows, have a strong positive impact on the likelihood of financial crises.…”

“…The empirical literature is mixed regarding whether countries with a more liberalised capital account are more prone to crises. For instance, Furceri et al (2011) find that episodes of large capital inflows increase the probability of banking, currency and balance of payment crises (sudden stops episodes). On the other hand, Glick and Hutchinson (2006) find for a sample of emerging economies that countries with more liberalised capital accounts experience a lower likelihood of currency crises, but fail to uncover similar evidence on vulnerabilities to banking crises.…”

“…Foreign direct investment is more stable and less prone to reversals (Wei, 2002;Albuquerque, 2003), while there is a general consensus that portfolio flows, including portfolio bond flows and commercial bank loans, generate the greatest risks from financial openness. 2 For instance, Furceri et al (2011) find that large capital inflows that are debt driven significantly increase the probability of banking, currency, and balance of payments crises, whereas if inflows are driven by equity portfolio investments or FDI they have a negligible effect. Ahrend and Goujard (2012a;2015) further find that a bias in external liabilities towards debt strongly increases the risk of a systemic banking crisis.…”