Source: World Development Indicators (World Bank), BIS, Chinn & Ito (2006), AREAER (IMF), and authors’ calculations using a VAR model. Green (red) bars represent the average level of a given characteristic for the group of countries where the credit response is relatively weaker (stronger). For instance, the average GDP per capita in countries with relatively weaker (stronger) credit response to capital inflows is USD 22,000 (USD 10,000). We only show characteristics for which the average responses are significantly different between the two groups of countries.
First, the impact of gross capital inflows on domestic credit is found to be higher in countries with more closed financial accounts in their balance of payments. Rather than a causal relationship, this finding reflects the fact that capital flow management measures are generally used in countries (usually emerging economies) where the procyclical effect of capital inflows on domestic credit is stronger. Such measures thus seek to mitigate this effect. In other words, the procyclicality could be even higher without the extra room provided by restrictions on financial openness. Through these measures, when financial inflows (outflows) significantly increase, domestic authorities can tighten (ease) monetary policy without fearing further capital inflows (outflows).
Second, domestic credit is found to be more responsive to capital inflows in countries that have adopted less flexible exchange rate regimes. Let us suppose that a country experiences large capital inflows. The more rigid the exchange rate arrangement, the more monetary authorities have to buy foreign currency to prevent excessive appreciation of their domestic currency. Yet, the unsterilised part of the foreign reserves accumulation leads to an increase in domestic liquidity and improves banks’ ability to provide credit. This result is thus explained by a reduction in policy autonomy.
Lastly, our findings suggest that a strong presence of foreign banks and high outstanding cross-border claims on the country strengthen the domestic credit response to capital inflows, but after a certain lag (six months). This finding is rather intuitive. Even if monetary policy is tightened in order to prevent the build-up of a credit boom, foreign affiliates of global banks are able to overcome the higher cost of liquidity in the host country, as they can keep on raising credit by getting funds from the head office in the home country.
Two important economic policy implications
First, in line with the classic Mundell’s trilemma, ceteris paribus, countries with more flexible exchange rate regimes need less countercyclical policies to mitigate the impact of capital inflows.
Second, our findings tend to confirm the emergence of a global financial cycle that influences significantly the developments in domestic financial cycles. This hypothesis is backed up by some recent studies (see Rey, 2013). Owing to the predominance of international credit and risk-taking channels, banks’ leverage and credit growth are driven by monetary conditions in core economies such as the United States.
The global financial cycle dampens the ability of domestic authorities in other open economies to set countercyclical monetary policies, even when exchange rates are flexible.