Capital Inflows, Exchange Rate Flexibility, and Credit Booms

IMF Working Papers, February 1, 2012

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Authors: Nicolas E Magud, Esteban Vesperoni, Carmen Reinhart
Date: February 1, 2012
Core question: How does exchange rate flexibility affect credit markets during periods of large capital inflows, with a primary focus on emerging markets?
Central finding: Bank credit grows more rapidly and its composition tilts to foreign currency in economies with less flexible exchange rate regimes. These outcomes are not fully explained by greater capital inflows into less flexible regimes.

Bank credit expansion:
- Bank credit grows more rapidly in economies with less flexible exchange rate regimes.
Currency composition of credit:
- Credit composition tilts toward foreign currency in economies with less flexible exchange rate regimes.
Causation versus correlation:
- The observed faster credit growth and greater foreign currency tilt in less flexible regimes are not explained entirely by those regimes attracting more capital inflows than more flexible regimes.

Regulatory policies that reduce banks' incentives to tap external markets and to lend/borrow in foreign currency are likely most beneficial for countries with less flexible exchange rate regimes. Suggested measures include:
- Marginal reserve requirements on foreign lending.
- Currency-dependent liquidity requirements.
- Higher capital requirement and/or dynamic provisioning on foreign exchange loans.

Motivation: Prospects of expansionary monetary policies in advanced countries and associated low interest rates in financial centers raise concerns about large capital inflows and resulting credit booms.
Historical relevance: Capital flow bonanzas have historically fueled sharp credit expansions in both advanced and emerging market economies.