## 4. Domestic Credit and Capital Inflows: Selected Advanced Economics

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### Introduction and scope
- Capital inflows bonanzas have become more frequent after restrictions to international movements were relaxed worldwide over the last decades.
- Inflows can finance investment and consumption smoothing but may induce excessive monetary and credit expansions, currency mismatches, and asset price distortions.
- The paper shows that during capital inflow bonanzas, domestic credit grows more rapidly and its composition tilts to foreign currency in economies with relatively inflexible exchange rate regimes.
- Main sample: a panel of 25 emerging markets in Asia, Emerging Europe, and Latin America.

### Exchange rate arrangements and channels to credit
- Basic transmission channels:
  - With a fixed exchange rate, reserve accumulation from inflows expands the monetary base; sterilization is usually partial, so less flexible regimes are more likely to experience credit expansions via bank intermediation.
  - Credible pegs and implicit guarantees can increase incentives for banks to expand and for borrowers to take foreign-currency debt.
  - Pegs can reduce nominal exchange rate volatility and interest rate differentials, fostering liability dollarization and higher foreign-currency lending.
- Policy-relevant levers highlighted:
  - Marginal reserve requirements on foreign lending.
  - Currency-dependent liquidity requirements.
  - Debt-to-income and loan-to-value ratios.
  - Higher capital requirements and/or dynamic provisioning on FX loans.

### Data, coverage, and identification of booms
- Countries and regional coverage:
  - Asia: Indonesia, Korea, Malaysia, Philippines, Thailand (period 1990–1997).
  - Emerging Europe: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Slovak Republic, Serbia, Turkey (period 1999–2008).
  - Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay (period 1993–2002).
- Capital inflows booms identified regionally using two criteria (trend monotonic increase with structural trend change; or inflows exceed their long-term trend). Regional series were de-trended with an HP filter using λ = 100.
- Resulting panel: 25 cross-sections with 10 observations per cross-section in Latin America and Europe, and 8 observations in Asia. Maximum sample size: 240 annual observations.
- Exchange rate regime measured using the Reinhart and Rogoff de-facto (COARSE) classification (index increasing with more flexible regimes).
- Financial deepness from Beck, Demirgüç-Kunt and Levine measures; financial integration from Chinn and Ito index.

### Methodology: variables and econometrics
- Main dependent variables:
  - Domestic credit = ratio of banking system credit to the private sector to GDP at current prices.
  - Foreign currency credit = ratio of credit to the private sector in foreign currency to total credit to the private sector.
  - Capital flows = ratio of capital flows to GDP at current prices, both in U.S. dollars.
- Controls include macroeconomic factors (real GDP, real GDP growth, external debt/GDP, exports and imports/GDP, inflation, broad money/GDP, foreign-currency deposits/total deposits, real exchange rate), financial sector variables (interest rate differentials, capital inflows, banking leverage), and country and time fixed effects.
- Estimation strategy: pooled OLS, fixed effects (within) with time effects, GLS allowing for heteroskedasticity and autocorrelation, and instrumental variable specifications (lagged instruments) to address potential endogeneity.

### Main findings

- A. Domestic credit
  - Exchange rate flexibility is negatively associated with domestic credit: less flexible regimes are associated with higher credit to the private sector.
  - Point estimate interpretation (pooled): a 1-point increase in the exchange rate classification index (a 17 percent increase) increases the ratio of domestic credit to GDP by about 4¼ percentage points (a 10 percent increase in the average credit to GDP ratio in the sample, which stands at 40 percent).
  - Results robust across fixed effects, GLS, and IV estimations (exchange rate regime coefficient negative and statistically significant at the 1 percent level in reported specifications).
  - Other robust correlates of higher domestic credit: larger capital inflows and a larger depositor base (captured by broad money/GDP).

- B. Credit composition (share of foreign-currency lending)
  - Exchange rate flexibility is negatively associated with the share of credit in foreign currency: less flexible regimes are associated with a higher share of foreign-currency credit.
  - Point estimate interpretation (pooled): a 1-point increase in the exchange rate classification index increases the share of credit in foreign currency by about 14 percentage points (a 35 percent increase in the average share of foreign currency lending in the sample, which stands at 41 percent).
  - Capital inflows and the share of domestic deposits in foreign currency are positively associated with a higher share of foreign-currency lending.
  - Interest rate differentials are positively and significantly associated with FX lending.
  - Banking leverage (loan-to-deposit ratio) is positively associated with the share of FX lending.
  - Interaction effect: leverage*exchange rate regime has a negative coefficient — the positive relation between leverage and credit in foreign currency is stronger in countries with less flexible exchange rate regimes; the interaction reduces the leverage elasticity by more than a third in the pooled estimate.
  - Interpretation: in less flexible regimes banks reduce FX open position via more FX lending (shifting currency risk to borrowers) while increasing credit risk exposure to unhedged FX borrowers.

- C. Capital flows (volume)
  - No robust evidence that exchange rate flexibility affects the volume of capital flows to emerging economies: exchange rate regime variable not statistically significant in capital flows regressions across OLS, fixed effects, GLS, and IV specifications.
  - Larger capital inflows are associated with greater financial openness and integration, greater trade openness, and higher external debt stocks (all lagged in specifications to reduce endogeneity).
  - Implication: the exchange rate regime influences credit via transmission channels (composition and financial intermediation) rather than by systematically attracting larger volumes of capital inflows.

### Parallels with advanced economies
- Preliminary snapshot suggests parallels in advanced economies (e.g., euro area since the mid-1990s): capital inflows associated with credit expansions; lack of exchange rate flexibility may have played a role in domestic credit expansions in some European advanced economies.
- The paper notes this as an area worth exploring further.

### Policy implications and recommended macroprudential measures
- Main policy message: exchange rate flexibility can help curb the effects of capital inflows on domestic credit; where exchange rate flexibility is limited, carefully designed macro-prudential policies should be deployed to counteract the transmission.
- Recommended macro-prudential and regulatory measures (targeting banks’ external funding and incentives to lend/borrow in foreign currency):
  - Currency-dependent liquidity requirements, possibly combined with marginal reserve requirements on external wholesale financing. These reduce credit and reduce incentives to borrow in foreign currency by reducing interest rate differentials between domestic and foreign currency loans.
  - Increasing capital requirements for FX loans and/or introducing dynamic provisioning on FX loans (provisions rise as the share of FX loans increases). These internalize higher credit risk and help build buffers for reversals.
  - Tightening debt-to-income and loan-to-value ratios conditional on debt currency denomination to contain domestic credit directly; these may be more effective than traditional monetary tightening in some contexts.
- Because the exchange regime does not appear to strongly affect inflow volumes, less flexible regimes do not necessarily warrant broader capital controls solely to curb bank credit; rather, targeted macro-prudential measures addressing transmission channels are emphasized.
- Less flexible exchange regimes increase vulnerability to capital flow reversals because credit expansions are larger there; monitoring and policies to handle reversals and differential dynamics across regimes are needed.

*Source: IMF staff analysis in "Domestic Credit and Capital Inflows: Selected Advanced Economics" (content unit provided).*

### References .............................................................................................................

### References

### Tables
- 1. The Exchange Rate Regime and Domestic Credit ...........................................................14
- 2. The Exchange Rate Regime and Credit Composition ......................................................15
- 3.  The Exchange Rate Regime and Credit Composition: Transmision ................................16
- 4.  The Exchange Rate Regime and Capital Flows ...............................................................18
- 5. Summary of Main Results ................................................................................................19

### Figures
- 1. Exchange Rate Regime - Coarse Classification .................................................................7
- 2. Defining Regional Capital Flow Cycles ............................................................................9
- 3.  Exchange Rate Flexibility, Credit, and Capital Flows .................................................... 11

*Source: _wp1241 - References .............................................................................................................*

### 4. Domestic Credit and Capital Inflows: Selected Advanced Economics ............................19

### 4. Domestic Credit and Capital Inflows: Selected Advanced Economics

### Introduction and scope
- Capital inflows bonanzas have become more frequent after restrictions to international movements were relaxed worldwide over the last decades.
- Inflows can finance investment and consumption smoothing but may induce excessive monetary and credit expansions, currency mismatches, and asset price distortions.
- The paper shows that during capital inflow bonanzas, domestic credit grows more rapidly and its composition tilts to foreign currency in economies with relatively inflexible exchange rate regimes.
- Main sample: a panel of 25 emerging markets in Asia, Emerging Europe, and Latin America.

### Exchange rate arrangements and channels to credit
- Basic transmission channels outlined:
  - With a fixed exchange rate, reserve accumulation from inflows expands the monetary base; sterilization is usually partial, so less flexible regimes are more likely to experience credit expansions via bank intermediation.
  - Credible pegs and implicit guarantees can increase incentives for banks to expand and for borrowers to take foreign-currency debt.
  - Pegs can reduce nominal exchange rate volatility and interest rate differentials, fostering liability dollarization and higher foreign-currency lending.
- Policy levers highlighted as relevant given these channels: marginal reserve requirements on foreign lending, currency-dependent liquidity requirements, debt-to-income and loan-to-value ratios, higher capital requirements and/or dynamic provisioning on FX loans.

### Data, coverage, and identification of booms
- Countries and regional coverage:
  - Asia: Indonesia, Korea, Malaysia, Philippines, Thailand (period 1990–1997).
  - Emerging Europe: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Slovak Republic, Serbia, Turkey (period 1999–2008).
  - Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay (period 1993–2002).
- Capital inflows booms identified regionally using two criteria (trend monotonic increase with structural trend change; or inflows exceed their long-term trend). Regional series were de-trended with an HP filter using λ = 100.
- Resulting panel: 25 cross-sections with 10 observations per cross-section in Latin America and Europe, and 8 observations in Asia. Maximum sample size: 240 annual observations.
- Exchange rate regime measured using the Reinhart and Rogoff de-facto (COARSE) classification (index increasing with more flexible regimes). Financial deepness from Beck, Demirgüç-Kunt and Levine measures; financial integration from Chinn and Ito index.

### Methodology: variables and econometrics
- Main dependent variables:
  - Domestic credit = ratio of banking system credit to the private sector to GDP at current prices.
  - Foreign currency credit = ratio of credit to the private sector in foreign currency to total credit to the private sector.
  - Capital flows = ratio of capital flows to GDP at current prices, both in U.S. dollars.
- Controls include macroeconomic factors (real GDP, real GDP growth, external debt/GDP, exports and imports/GDP, inflation, broad money/GDP, foreign-currency deposits/total deposits, real exchange rate), financial sector variables (interest rate differentials, capital inflows, banking leverage), and country and time fixed effects.
- Estimation strategy: pooled OLS, fixed effects (within) with time effects, GLS allowing for heteroskedasticity and autocorrelation, and instrumental variable specifications (lagged instruments) to address potential endogeneity.

### Main findings

A. Domestic credit
- Exchange rate flexibility is negatively associated with domestic credit: less flexible regimes are associated with higher credit to the private sector.
- Point estimate interpretation (pooled): a 1-point increase in the exchange rate classification index (a 17 percent increase) increases the ratio of domestic credit to GDP by about 4¼ percentage points (a 10 percent increase in the average credit to GDP ratio in the sample, which stands at 40 percent).
- Results robust across fixed effects, GLS, and IV estimations (exchange rate regime coefficient negative and statistically significant at the 1 percent level in reported specifications).
- Other robust correlates of higher domestic credit: larger capital inflows and a larger depositor base (captured by broad money/GDP).

B. Credit composition (share of foreign-currency lending)
- Exchange rate flexibility is negatively associated with the share of credit in foreign currency: less flexible regimes are associated with a higher share of foreign-currency credit.
- Point estimate interpretation (pooled): a 1-point increase in the exchange rate classification index increases the share of credit in foreign currency by about 14 percentage points (a 35 percent increase in the average share of foreign currency lending in the sample, which stands at 41 percent).
- Capital inflows and the share of domestic deposits in foreign currency are positively associated with a higher share of foreign-currency lending.
- Interest rate differentials positively and significantly associated with FX lending.
- Banking leverage (loan-to-deposit ratio) is positively associated with the share of FX lending. Interaction effect: leverage*exchange rate regime has a negative coefficient — the positive relation between leverage and credit in foreign currency is stronger in countries with less flexible exchange rate regimes; the interaction reduces the leverage elasticity by more than a third in the pooled estimate. Interpretation: in less flexible regimes banks reduce FX open position via more FX lending (shifting currency risk to borrowers) while increasing credit risk exposure to unhedged FX borrowers.

C. Capital flows (volume)
- No robust evidence that exchange rate flexibility affects the volume of capital flows to emerging economies: exchange rate regime variable not statistically significant in capital flows regressions across OLS, fixed effects, GLS, and IV specifications.
- Larger capital inflows are associated with greater financial openness and integration, greater trade openness, and higher external debt stocks (all lagged in specifications to reduce endogeneity).
- Implication: the exchange rate regime influences credit via transmission channels (composition and financial intermediation) rather than by systematically attracting larger volumes of capital inflows.

### Parallels with advanced economies
- Preliminary snapshot suggests parallels in advanced economies (e.g., euro area since the mid-1990s): capital inflows associated with credit expansions; lack of exchange rate flexibility may have played a role in domestic credit expansions in some European advanced economies. The paper notes this as an area worth exploring further.

### Policy implications and recommended macroprudential measures
- Main policy message: exchange rate flexibility can help curb the effects of capital inflows on domestic credit; where exchange rate flexibility is limited, carefully designed macro-prudential policies should be deployed to counteract the transmission.
- Recommended macro-prudential and regulatory measures (targeting banks’ external funding and incentives to lend/borrow in foreign currency):
  - Currency-dependent liquidity requirements, possibly combined with marginal reserve requirements on external wholesale financing. These reduce credit and reduce incentives to borrow in foreign currency by reducing interest rate differentials between domestic and foreign currency loans.
  - Increasing capital requirements for FX loans and/or introducing dynamic provisioning on FX loans (provisions rise as the share of FX loans increases). These internalize higher credit risk and help build buffers for reversals.
  - Tightening debt-to-income and loan-to-value ratios conditional on debt currency denomination to contain domestic credit directly; these may be more effective than traditional monetary tightening in some contexts.
- Because the exchange regime does not appear to strongly affect inflow volumes, less flexible regimes do not necessarily warrant broader capital controls solely to curb bank credit; rather, targeted macro-prudential measures addressing transmission channels are emphasized.
- Less flexible exchange regimes increase vulnerability to capital flow reversals because credit expansions are larger there; monitoring and policies to handle reversals and differential dynamics across regimes are needed.

*Source: IMF staff analysis in "Domestic Credit and Capital Inflows: Selected Advanced Economics" (content unit provided).*

### REFERENCES

### _wp1241 - REFERENCES

### Macroprudential policy, capital inflows, and credit booms
- Ashvin A. and N. Malhar (2011), “Safeguarding Banks and Containing Property Booms: Cross-Country Evidence on Macroprudential Policies and Lessons from Hong Kong SAR,” IMF Working Paper 11/284 (Washington: International Monetary Fund).
- Lim, C.; F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid, T. Wezel, Torsten and X. Wu (2011), “Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences,” IMF Working Paper 11/238 (Washington: International Monetary Fund).
- Bakker, B. and A. Gulde (2010), “The Credit Boom in the EU New Member States: Bad Luck or Bad Policies?,” IMF Working Paper 10/130 (Washington: International Monetary Fund).
- Mendoza, E. and M. Terrones (2008), “An Anatomy of Credit Booms: Evidence from Macro Aggregates and Micro Data,” NBER Working Paper 14049.
- Terrier, G., R. Valdés, C. Tovar, J. Chan-Lau, C. Fernández-Valdovinos, M. García-Escribano, M. Tang, M. Vera Martin, and C. Walker (2011), “Policy Instruments To Lean Against The Wind In Latin America,” IMF Working Paper 11/159 (Washington: International Monetary Fund).
- Ostry, J., A. Ghosh, K. Habermeier, L. Laeven, M. Chamon, M. Qureshi, and A. Kokenyne (2011), “Managing Capital Inflows: What Tools to Use,” IMF Staff Discussion Note 11/06 (Washington: International Monetary Fund).
- 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 (Washington: International Monetary Fund).
- Magud, N., C. Reinhart, and K. Rogoff (2011), “Capital Controls: Myth and Reality—A Portfolio Balance Approach,” NBER Working Paper 16805.
- Cavallo, D. and J. Cottani (1997), “Argentina's Convertibility Plan and the IMF,” The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May), pp. 17–22.

### Exchange rate regimes, sterilization, and currency arrangements
- Calvo, G. (1991), “The Perils of Sterilization,” IMF Staff Papers, 38, Issue 4, December, 921–926
- Calvo, G., L. Leiderman, and C. Reinhart (1995), “Capital Inflows to Latin America with Reference to the Asian Experience,” in Sebastian Edwards, ed. Capital Controls, Exchange Rates and Monetary Policy in the World Economy, (Cambridge: Cambridge University Press, 1995), 339–382.
- Ghosh, A., A. Gulde, J. Ostry, and H. Wolf (2003), “Exchange Rate Regimes: Choices and Consequences” (Cambridge, Massachusetts: MIT Press).
- Ghosh, A., J. Ostry, and Ch. Tsangarides (2010), “Exchange Rate Regimes and the stability of the International Monetary System,” IMF Occasional Paper 270 (Washington: International Monetary Fund).
- Ilzetzki, I., C. M. Reinhart, and K. Rogoff (2010), “Exchange Rate Arrangements into the 21st Century: Will the Anchor Currency Hold?"
- Reinhart, C. and V. Reinhart (2004), “The Modern History of Exchange Rate Arrangements: A Reinterpretation,” Quarterly Journal of Economics 119(1):1–48, February.
- Reinhart, C., and K. Rogoff (2009), This Time It’s Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, September).

### Financial openness, dollarization, and foreign currency borrowing
- Chinn, M. and Hiro I. (2008), "A New Measure of Financial Openness," Journal of Comparative Policy Analysis, Volume 10, Issue 3, p. 309 – 322 (September).
- Ize, A. and E. Levy-Yeyati (2003), “Financial Dollarization,” Journal of International Economics, Vol. 59, pp. 323-347.
- Jeanne, O. (2003), “Why do Emerging Markets Borrow in Foreign Currency?,” IMF Working Paper 03/177 (Washington: International Monetary Fund).
- Rosenberg, C. and M. Tirpák (2008), “Determinants of Foreign Currency Borrowing in the New Member States of the EU”, IMF Working Paper 08/173 (Washington: International Monetary Fund).
- Bubula, A., and I. Ötker-Robe (2003), “Are Pegged and Intermediate Regimes More Crisis Prone?” IMF Working Paper 03/223 (Washington: International Monetary Fund).
- Magud, N., C. Reinhart, and K. Rogoff (2011), “Capital Controls: Myth and Reality—A Portfolio Balance Approach,” NBER Working Paper 16805.

### Capital flows, procyclicality, and historical perspectives
- Fernandez Arias, E. and P. Montiel (1996), “The Surge of Capital Inflows to Developing Countries: an analytical Overview,” The World Bank Economic Review, 10, Issue 1, January, 51–77.
- 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: Oxford University Press, 2001), 3–28.
- Kaminsky, G., C. Reinhart, and C. Végh (2004), “When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies,” NBER Working Paper 10780.
- Reinhart, C. and V. Reinhart (2008), “Capital Flow Bonanzas: An Encompassing View of the Past and Present,” NBER Working Paper 14321.
- Obstfeld, M. and P.O. Gourinchas (2011), “Stories of the Twentieth Century for the Twenty-First,” NBER Working Paper 17252.
- Brunnermeier, M. S. Nagel, and, L. Pedersen (2009), “Carry Trades and Currency Crashes,” in NBER Macroeconomics Annual 2008, 2009, 23, 313–347
- Pantin, G. and H. Shin (2011), “Carry Trades, Monetary Policy and Speculative Dynamics,” mimeo, Princeton University.

### Regional outlooks and IMF reports
- International Monetary Fund (2010), “Heating Up in the South, Cooler in the North,” Regional Economic Outlook, Western Hemisphere Department, Washington D.C., October.
- 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 (Washington: International Monetary Fund).

*Source: _wp1241 - REFERENCES*

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