Policy-makers and practitioners tend to see capital inflows to emerging market economies (EMEs) as expansionary, as they ease domestic financial conditions and boost credit and domestic demand. This, coupled with their volatility, implies that capital flows to EMEs are also a source of vulnerability capable of generating boom-bust cycles. Capital controls and macroprudential policies thus emerge as relevant policy tools to manage associated risks. However, the causal effect of capital inflows on EME macro-financial conditions is hard to pin down empirically and should be key to well-informed policy design.
International bank lending is an important component of capital flows, as emphasized by the growing literature on the role of global banks in transmitting financial conditions across borders. We assess the causal effect of international bank lending on key financial and real variables for a sample of 22 EMEs over 1990Q1-2018Q4, using BIS data. To identify causal effects, we rely on the intuitive observation that, as international bank lending is concentrated, lenders that account for high shares of lending to a given EME will affect aggregate international lending to this country and, through it, aggregate macroeconomic conditions.
We find that cross-border bank credit causes higher domestic activity in EMEs through looser financial conditions. Financial condition indices ease, nominal and real effective exchange rates appreciate, sovereign and corporate spreads narrow, domestic interest rates fall, and housing prices rise. As a result, economic activity as well as domestic credit growth also pick up. The effects are weaker for countries that have higher degrees of capital inflow controls. In other words, controls on capital inflows can help EMEs cushion the effects of international bank lending shocks (eg moderate a boom in financial conditions, or limit the growth of credit).
Banking flows to emerging market economies (EMEs) are a potential source of vulnerability capable of generating boom-bust cycles. The causal effect of such inflows on EME macro-financial conditions is hard to pin down empirically and should be key to well-informed policy design. We provide novel empirical evidence on the effects of cross-border bank lending on EMEs macro-financial conditions. We identify causal effects by leveraging the heterogeneity in the size distribution of bilateral cross-border bank lending to construct granular instrumental variables for aggregate cross-border bank lending to 22 EMEs. We find that cross-border bank credit causes higher domestic activity in EMEs through looser financial conditions. Financial condition indices ease, nominal and real effective exchange rates appreciate, sovereign and corporate spreads narrow, and domestic interest rates fall. At the same time, real domestic credit grows, real GDP expands, imports rise, and housing prices increase as well. Eects are weaker for countries with relatively higher levels of capital inflow controls, supporting the view that these policy measures can be effective in dampening the vulnerabilities associated with external funding shocks.
JEL Classification: E0, F0, F3
Keywords: granular instrumental variables; capital flows; emerging markets; cross-border claims; credit shocks; international banking; capital controls.