Capital Inflows, Exchange Rate Flexibility and Credit Booms

• Author: Esteban R. Vesperoni,Carmen M. Reinhart,Nicolas E. Magud
• Published date: 01 August 2014
• DOI: http://doi.org/10.1111/rode.12093
• Date: 01 August 2014

Capital Inflows, Exchange Rate Flexibility and

Credit Booms

Nicolas E. Magud, Carmen M. Reinhart, and Esteban R. Vesperoni*

Abstract

Historically, capital flow bonanzas have often fueled sharp credit expansions in advanced and emerging

market economies alike. Focusing primarily on emerging markets, this paper analyzes the impact of

exchange rate flexibility on credit markets during periods of large capital inflows. It is shown that bank

credit is larger 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. The 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 require-

ment and/or dynamic provisioning on foreign exchange loans.

1. Introduction

Capital inflow bonanzas have become more frequent after restrictions to international

movements were relaxed worldwide over the last decades.1Capital flows to emerging

economies can finance investment and foster economic growth, as well as increase

welfare by facilitating consumption smoothing. However, inflows may also induce

excessive monetary and credit expansions, build vulnerabilities associated with cur-

rency mismatches, and distort asset prices.2Large inflows tend to be associated with

expansionary economic policies and behave procyclically.3These linkages between

surges in capital inflows and financial excess are not limited to emerging markets, as

the recent wave of crises in advanced economies attest.4

The prospects of expansionary monetary policies in advanced countries have

renewed the debate over policy options to cope with large capital inflows in emerging

economies. 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”).5Second, many 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

* Reinhart: Kennedy School of Government, Harvard University, 79 JFK Street, Cambridge, MA 02138,

USA Tel: +1-617-496-8643; E-mail: Carmen_Reinhart@harvard.edu. Magud, Vesperoni: International

Monetary Fund, 700 19th St., NW, Washington, DC 20431, USA. The authors thank seminar participants at

the IMF, the Central Bank of Chile and the Central Bank of Paraguay. They also thank Marco Arena, Bas

Bakker, Martin Evans, Herman Kamil, Martin Kaufman, Anton Korinek, Pritha Mitra, Marcelo Olaverria,

Jiri Podpiera, Catriona Purfield, Sergio Schmukler, Cyril Pouvelle, and Rodrigo Valdes for useful com-

ments and suggestions. All remaining errors are those of the authors. This paper represents only the

authors’ views and not those of the International Monetary Fund, its Executive Board, or its Management.

Review of Development Economics, 18(3), 415–430, 2014

DOI:10.1111/rode.12093

© 2014 John Wiley & Sons Ltd

another push factor owing to the higher perceived risk of many advanced economies,

unprecedented since World War II).6The 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 up

in this paper.

We show that during capital inflow bonanzas, domestic credit is larger and its com-

position tilts to foreign currency in economies with relatively inflexible exchange rate

regimes.7Studies on economic performance under different exchange regimes have

tended to focus on growth, inflation, fiscal policies, and current account adjustments

but have been relatively silent on the evolution of domestic credit. In a recent paper,

Mendoza and Terrones (2008) show that capital inflows increase before the peak in

credit booms, and that these latter have a higher frequency under less flexible

exchange rate regimes. We discuss and document why and how this relationship

between capital inflows, domestic credit, and exchange rate regimes works through

banking intermediation. The main analysis is based on a panel of 25 emerging

markets in Asia, Europe and Latin America. We identify periods of capital inflow

booms and document that episodes of relatively inflexible exchange rate regimes are

positively associated with the ratio of private credit to gross domestic product (GDP).

We also show that the share of foreign currency credit is positively associated with

less flexible exchange regimes. The share of foreign currency credit also increases

with larger capital inflows and interest rate differentials.

These developments in credit could potentially be exclusively explained if countries

with more rigid exchange rate arrangements tend to record larger capital inflows.

However, by analyzing the relationship of the ratio of capital flows to GDP and the

exchange rate regime, we do not find compelling evidence that this is the case.

2. Exchange Rate Arrangements and Credit: Basic Concepts

The collapse of several pegged exchange rate regimes during the 1990s led to the per-

ception that these arrangements were more prone to currency and financial crises

after sharp credit expansions.8In this context, in a study of the occurrence of twin

crises, Kaminsky and Reinhart (1999) show banking crises and currency crises in close

succession. Overall, evidence on the link between crises and alternative exchange rate

regimes is not clear-cut, but the literature suggests that the exchange regime may have

an impact on developments in financial markets and asset prices, through several

channels.9

The basic textbook prediction tells us that in an economy with a pure floating

exchange rate regime, capital inflows would appreciate the domestic currency with no

further effect on monetary aggregates. With a fixed exchange rate, however, the

central bank would be forced to intervene, accumulating international reserves so as

to maintain the peg. Part or all of this reserve accumulation can be (in principle)

offset through sterilization, a contraction in domestic credit affected through open

market sales of domestic bonds. In practice, sterilization is usually partial, as it is

costly (risk premiums on domestic bonds may be large in emerging economies) and

foreign exchange intervention is associated with expanding the monetary base. Con-

sequently, economies with less flexible exchange rate regimes are more likely to

experience credit expansions in the presence of large capital inflows, the main channel

being bank intermediation of these flows.

Montiel and Reinhart (2001) describe another channel through which exchange

regimes may affect financial markets. They argue that by extending implicit improp-

416 N. E. Magud, C. M. Reinhart, and E. R. Vesperoni

© 2014 John Wiley & Sons Ltd