Large capital inflows usually have an important impact on macroeconomic conditions – and in particular, on fluctuations in domestic credit (Mendoza and Terrones 2012). Capital inflow booms can finance investment and economic growth, and can also bolster the deepening of what are often shallow financial sectors. Banking sector credit usually expands and stimulates consumption. The volatility associated with these cycles may pose significant macroeconomic challenges. Reversals in capital inflows could potentially result in credit busts and asset price deflation, with devastating effects on the macroeconomy. Notably, the recent fluctuations in global risk aversion triggered by the Federal Reserve ‘tapering’ talk in 2013 are a reminder of the likelihood of reversals in large capital inflows. Consequently, these events strengthen the need for a proper debate over the policy framework and the corresponding policy mix needed to deal with large fluctuations in international capital flows. In a recent paper we tackle some of these issues (Magud and Vesperoni 2014).
We look at how economies with different degrees of exchange rate flexibility behave during capital inflows reversals for 179 countries during 1969-2012. We find that the buffering role played by exchange rate flexibility during credit cycles looks like a ticket to purgatory with no entrance to paradise. In effect, our results suggest that exchange rate flexibility helps to contain banking credit growth compared to more rigid exchange rates during capital inflow booms. So flexibility is better, but not without credit cycles. The fall in credit growth in economies with more flexible exchange rate regimes (which is more modest than in fixed regimes) suggests that flexibility cannot fully shield the economy during the reversal. Furthermore, we observe what we dub as a recovery puzzle: credit growth in more flexible exchange rate regimes remains tepid well after the capital flow reversal takes place. Stylised facts on macroeconomic dynamics and credit are described below, followed by policy implications.
Capital inflow reversals are characterised by:
- A collapse in economic activity and sharp adjustments in the current account. As capital flows reverse, the current account adjusts, forcing the accommodation of domestic absorption.
Figure 1. Macroeconomic Variables
Sources: authors’ calculations.
- Investment falls strongly during reversals. Five years after a reversal, investment is still lower in terms of GDP than in the year of the reversal. Investment dynamics are apparently not much affected by the exchange rate regime in a country during capital inflow reversals.
- Private consumption remains fairly stable during the boom, before collapsing. As capital inflows retrench, consumption falls sharply, consistent with the reduction in external financing. This effect is particularly strong in more rigid exchange rate regimes. This appears consistent with consumption being mostly financed by bank credit, unlike investment, which is typically financed by a mix of banking and non-banking credit.
Real growth in banking credit to the private-sector collapses during capital inflow reversals. Consistent with Magud et al. (2011, 2014), banking credit accelerates during capital inflow booms. During the reversal stage of the cycle, however, real credit growth markedly slows down. Also, after capital flow reversal episodes end, real credit growth stabilises at a rate substantially lower than that of the boom phase.
The dynamics of banking sector credit show significant contrasts in economies with different exchange rate regimes. In particular:
- Credit growth is consistently higher in fixed regimes, but less so during reversals. Hence, even if only partially, flexible exchange rate regimes show more resilience during reversals as external financing dries up.
- Therefore, containing credit growth during the boom is the key policy challenge for fixed regimes.
- Supporting credit recovery seems to be a policy challenge for flexible regimes after reversals. The slow recovery in credit growth for several years after the reversal raises questions. Why it is so difficult for banks to resume lending in a system that was characterised by a more contained pick-up in credit during the boom years? We dub this as the (credit) recovery puzzle.
- Fixed regimes are exposed to sharp adjustments in non-deposit funding. The loan-to-deposit ratio (LTD) can be thought of as a proxy for banking sector external funding, as it reflects the share of total banking sector credit in excess of deposits. The sharp increase in LTDs in economies under fixed regimes suggests that capital inflows help finance the expansion of the lending portfolio through leverage. However, banks are forced to retrench this financing once these flows disappear – in fact, LTDs fall below the level attained at the initial stages of the capital inflow cycle. In contrast, in more flexible exchange rate regimes, this ratio – although higher throughout – is fairly stable over the capital flows cycle.
- The credit impulse is more procyclical in economies under fixed exchange rate regimes. Using the change in credit to GDP as a proxy for credit impulse – or a measure of acceleration – we observe that following a positive impulse during the boom phase, a strongly negative impulse is observed as capital flows reverse, particularly for fixed regimes.
Figure 2. Banking sector credit
Sources: authors’ calculations.
We have also run some regressions to verify this. Panel estimation shows that, after controlling for real GDP growth (economic activity), the real growth rate of broad money (monetary expansion), the financial account to GDP ratio (external financing), the credit to GDP ratio (credit deepness), and the real exchange rate (appreciation pressures), more flexible exchange rates depict lower rates of credit growth. Furthermore, cross-section estimation shows that exchange rate flexibility results in a smoother reversal in credit growth when external financing cycles enter into reversal mode.
In Magud, Reinhart, and Vesperoni (2014), we argued that flexible exchange rate regimes could be complemented by macro-prudential policies to smooth credit cycles during capital flow booms. By looking at reversals, we can add more granularity to this policy implication:
- On the one hand, measures aimed at containing excessive credit growth – such as debt-to-income, debt service-to-income, and loan-to-value ratios, or reserve requirements – seem to be particularly relevant in the context of less flexible exchange rate regimes, as credit tends to grow faster than in more flexible exchange rate arrangements.
- On the other hand, exchange rate flexibility can keep credit growth at bay to some degree during bonanzas. Hence, flexibility could be best complemented by measures like capital surcharges or countercyclical provisions during the credit expansion phase. By building buffers, these macro-prudential instruments can help deal with the recovery puzzle experienced by flexible exchange rate regimes during reversals.
The importance of understanding the dynamics of capital flow cycles and the optimal policies to deal with them could not be timelier. Expansionary monetary policies in advanced countries have likely had a significant impact on emerging economies. This has been strong this time around because advanced economies have maintained exceptionally expansionary monetary policies – including unconventional measures embedded in the multiple quantitative and credit easing initiatives – for a longer period of time than in past ‘normal’ business cycles. And given that the withdrawal of these unconventional monetary policies has started recently, discussing the appropriate policy responses in the context of external financing cycles in emerging markets becomes critical.
Authors' note: The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.
Magud N, C Reinhart, and E Vesperoni (2014), “Capital Inflows, Exchange Rate Flexibility, and Credit Booms,” forthcoming in Review of Development Economics (IMF Working Paper 12/41). Revised version of the 2011 NBER Working Paper 17670 (Massachusetts: National Bureau of Economic Research).
Magud, N and E Vesperoni (2014), “Exchange Rate Flexibility and Credit during Capital Inflow Reversals: Purgatory …not Paradise,” IMF Working Paper 14/61, April (Washington: International Monetary Fund).
Mendoza, E and M Terrones (2012), “An Anatomy of Credit Booms and their Demise,” NBER Working Paper 18379 (Massachusetts: National Bureau of Economic Research).