Going with the Flow: Benefits of Capital Inflows for Emerging Markets

IMF Blog, December 6, 2016

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Canonical URL: Going with the Flow: Benefits of Capital Inflows for Emerging Markets

Author: Deniz Igan
Date: December 6, 2016
Motivating metaphor: Michael Mussa likened capital account liberalization to fire (remarks at the IMF Economic Forum on October 2, 1998), useful but potentially destructive.
Research question: Do capital inflows enhance growth in emerging market economies, or are they chiefly a source of vulnerability?

Sample: 22 emerging market economies from 1998 to 2010.
Unit of observation: industry-level (micro) data.
Identification strategy: exploit differences across industries in their need for external financing to infer causal impacts of capital inflows on output and value added.
Distinctions made:
- Types of capital flows (debt vs. equity and other sub-components).
- Outcomes considered: industry growth and growth volatility.
- Role of domestic financial market performance and large shocks to global financial markets.

Heterogeneous effects by industry financing needs:
- Industries more dependent on external finance grow disproportionately faster in countries hosting more capital inflows.
Time variation:
- Positive association is observed in the pre-crisis period of 1998–2007.
- The inflows–growth relationships break down during the crisis period (within the 1998–2010 sample).
Composition of inflows matters:
- The positive association with industry growth is driven by debt, rather than equity, inflows.
- Reduction in output volatility is more pronounced for equity, rather than debt, inflows.
Financial system interactions:
- The inflows–growth nexus is stronger in countries with well-functioning banks.
Role of global shocks:
- Large shocks to the global financial system are disruptive and hinder emerging market firms’ ability to turn capital inflows into investment and output.

Consider composition of capital inflows when assessing costs and benefits:
- Debt inflows are more closely associated with higher industry growth; equity inflows are more associated with volatility reduction.
Strengthen domestic banking and financial systems:
- Well-functioning banks improve the ability to harness growth benefits from capital inflows.
Improve global financial system resilience:
- A well-functioning global financial system reduces the risk that large shocks will prevent inflows from translating into growth.
Implement “fire safety measures”:
- Appropriate safeguards and policies (the domestic analog of fire safety) can improve the trade-off associated with capital inflow surges.

Source: Going with the Flow: Benefits of Capital Inflows for Emerging Markets — Deniz Igan, December 6, 2016.