Capital-inflow bonanzas have become more frequent after restrictions to international movements were relaxed worldwide over the last decades.1 Capital flows to emerging economies can finance investment and foster economic growth. However, inflows may also induce sharp monetary and credit expansions, which build vulnerabilities associated with currency mismatches and distorted asset prices.2 These vulnerabilities are usually at the core of currency and financial crises, especially in the context of capital flow reversals.3
As in the past, spillovers from low international interest rates will likely have a significant impact in emerging economies. These spillovers may be stronger this time around, for two reasons.
- First, as advanced economies struggle with a massive public and private debt overhang, expansionary monetary policies may be in place for a longer period of time than in past ‘normal’ business cycles (a ‘push factor’).4
- Second, emerging markets have been conspicuously resilient during the financial crisis, increasing investors’ appetite for the asset class (possibly a ‘pull factor’ – although the relative attractiveness of emerging markets may also stem from another push factor owing to the higher perceived risk of advanced economies, unprecedented since WWII).5 The debate over the right policy mix to cope with capital flows has been and continues to be extensive. However, it has overlooked some dimensions of the role played by the exchange-rate regime, an issue we take in a recent paper (Magud et al 2011).
The exchange-rate regime could be an important element in credit expansions fuelled by capital inflows, for several reasons.
- First, the basic textbook prediction is that currency pegs limit the policy response to curve monetary expansions associated with large inflows.
- Second, by extending implicit improperly priced guarantees, fixed-exchange regimes may contribute to stronger credit growth than flexible ones. Montiel and Reinhart (2001) argue that deposit guarantees and a peg are perceived as a guarantee to foreign currency claims associated with capital inflows. The latter, in turn, increases the scope for banks’ expansion through external funds, which can potentially feed into domestic credit (ie, an increase in the banking system leverage ratio). Finally, in a different context, Backé and Wójcik (2007) develop a simple framework with an increasing trend in productivity growth in an emerging economy that pegs its domestic currency to a developed economy with constant productivity growth.6 The peg gives place to lower interest rates and higher domestic credit compared to the equilibrium with a flexible regime.
A credible fixed-exchange-rate regime may also place incentives for taking on debt in foreign currency. As for creditors, the increase in banks’ leverage – loan-to-deposit ratios – that large capital inflows usually bring about can place incentives to lend directly in foreign currency, as this would allow banks to avoid currency mismatches in their balance sheets. As for debtors – in credible (or temporarily credible) pegs – a small differential between interest rates in domestic and foreign currency may create incentives to borrow in the latter, as they would deflate a lower interest rate by expected domestic inflation or wage growth. These incentives have typically played a critical role during inflation stabilisation programmes, especially when they were coupled with policies allowing liability dollarisation.
Against this backdrop, in a recent paper we show that during capital inflows booms credit grows more rapidly and its composition tilts to foreign currency in economies with relatively inflexible exchange-rate regimes. We build a panel of 25 emerging markets – in Latin America, Europe, and Asia.7 We then define homogeneous periods of capital-inflow booms based on either changes in trend or positive cyclical deviations from trend – so that the observations in the panel are comparable. As a result, we identify capital-inflow bonanzas during 1990–97 in Asia, 1993–2002 in Latin America, and 1999–2008 in emerging Europe.
Panel regressions focus on three variables: domestic credit to the private sector (as a percentage of GDP), the share of foreign currency credit over the total, and the external financial and capital account (as a percentage of GDP). The main explanatory variable is the de facto exchange-rate regime in Reinhart and Rogoff (2004). For robustness, we used alternative variations of this classification (the ‘coarse’ and the ‘fine’ ones), as well as IMF’s AREARS, which for the more recent period yield similar results. Given the time-varying nature of exchange-rate regimes, using de facto arrangements have the advantage of drawing a distinction between what countries declare as their official de jure regime and their actual de facto practices, which may even capture to a certain degree the endogeneity of policies, shocks, and markets reactions.
As shown in Figure 1 and Table 1, we find that:8
- Domestic credit growth is higher in economies with less flexible exchange-rate regimes.
- The share of foreign currency credit is larger in economies with less flexible exchange regimes. Lack of exchange-rate flexibility exacerbates the effect of large capital inflows on the composition of domestic credit, increasing the share of foreign currency credit.
- There is no compelling evidence of a systematic relationship between the ratio of capital flows to GDP and the exchange-rate regime.
Figure 1. Exchange-rate flexibility vs domestic and foreign credit
Table 1. Factors affecting domestic and foreign credit
A digression: Advanced economies
While our analysis focuses on emerging markets, a snapshot of the advanced economies suggests that exchange-rate flexibility may also play a role on the magnitude of credit expansions. Comparable to the emerging market results, Figure 2 suggests that capital inflows may have also been associated with credit expansions in the Eurozone since the mid-1990s. Also, albeit with less significant inflows (in terms of GDP), countries with more flexible exchange regimes (such as the UK and US) do not show a positive association between inflows and domestic credit expansions. Of course, an important caveat to the differences in these correlations is that in the UK and the US (which are less bank dependent) much of the increased leverage in the decade prior to the crisis was not in the form of domestic bank credit but through securitised debt. Whether a broader definition of ‘credit’ blurs these differences between the Eurozone and the others remains to be seen, but the preliminary results from the emerging markets and the anecdotal evidence from the past decade for advanced economies suggest that this is a topic worthy of further analysis.
Figure 2. Capital flows and credit to the private sector
Our analysis contributes to the current debate on policies to manage large capital inflows in emerging economies. Specifically, our findings (see Table 1) suggest that exchange-rate flexibility may play a significant role in curbing the effects of capital inflows on domestic credit. From a policy perspective, relatively inflexible exchange-rate regimes may need to be ‘counteracted’ by carefully designed macroprudential policies that target banks’ external funding and incentives to lend/borrow in foreign currency. Such measures may include:
- Currency-dependent liquidity requirements – maybe even combining them with marginal reserve requirements on external wholesale financing. Both contain credit and reduce incentives to borrow in foreign currency by reducing the interest rate differential between loans in domestic and foreign currency.9
- Increasing capital requirement for foreign-exchange loans and/or introducing dynamic provisioning on foreign-exchange loans (ie provisions increase as the share of FX loan over the total increases). These would place incentives for banks to internalise the higher credit risk associated with potential borrowers’ currency mismatches. They would also facilitate the building of buffers to cope with capital flow reversals.
- Tightening debt-to-income and loan-to-value ratios (conditional on the debts’ currency denomination) would also contribute to contain domestic credit directly, and might be more effective than traditional monetary tightening – ie increasing domestic interest rates.
Backe, P and C Wojcik (2008), “Credit Booms, Monetary Integration, and the Neoclassical Synthesis,” Journal of Banking and Finance, 32:458-470.
Eyzaguirre, N, M Kaufman, S Phillips, and R Valdes (2011), “Managing Abundance to Avoid a Bust in Latin America”, IMF Staff Discussion Note 11/07, April.
Gosh. A, J Ostry, and Ch Tsangarides (2010), “Exchange Rate Regimes and the stability of the International Monetary System”, IMF Occasional Paper 270.
Magud, N, C Reinhart, and K Rogoff (2011), “Capital Controls: Myth and Reality – A Portfolio Balance Approach”, NBER Working Paper 16805.
Magud, Nicolas, Carmen M Reinhart, and Esteban R Vesperoni (2011), “Capital Inflows, Exchange Rate Flexibility, and Credit Booms”, NBER Working Paper 17670, December.
Montiel, P and C Reinhart (2001), “The Dynamics of Capital Movements to Emerging Economies During the 1990s”, in Stephany Griffith-Jones, Manuel Montes, and Anwar Nasution (eds.), Short-term Capital Flows and Economic Crises, Oxford University Press, 3-28.
Reinhart, C and V Reinhart (2008), “Capital Flow Bonanzas: An Encompassing View of the Past and Present”, in Jeffrey Frankel and Francesco Giavazzi (eds.), NBER International Seminar in Macroeconomics 2008, Chicago University Press, 1-54.
Reinhart, Carmen, and Kenneth Rogoff (2004), “The Modern History of Exchange Rate Arrangements: A Reinterpretation”, Quarterly Journal of Economics, 119:1-48.
1 See, for example, Reinhart and Reinhart (2008), and references therein.
2 See Magud, Reinhart, and Rogoff (2011) describing the four fears to capital inflows.
3 See Eyzaguirre et al (2011) for a recent debate on capital flows reversals.
4 For the importance of ‘push factors’ during capital inflows booms, see Calvo et al (1995).
5 Capital flow reversals were mild compared to previous inflows, and relatively short-lived.
6 This is particularly relevant in emerging Europe.
7 The countries in the sample are Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Slovak Republic, Serbia, Turkey, Indonesia, Korea, Malaysia, Philippines, and Thailand.
8 See the Magud et al 2011 for details. Notice that our empirical methodology is based on ex post information, ie, is backward-looking. An alternative approach could be to conduct event studies to capture market reactions on an ex ante basis. Event studies could focus on authorities’ announcements (signals), and analyze how forward-looking agents react to these announcements.
9 Notice that imposing reserve requirements across the board will not affect interest rate differentials.