Policy makers and practitioners tend to view capital inflows into emerging market economies (EMEs) as expansionary, as they ease domestic financial conditions and stimulate credit and domestic demand. This, together 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 appear to be relevant political tools for managing the associated risks. However, the causal effect of capital inflows on the macro-financial conditions of EMEs is difficult to pin down empirically and should be the key to a well-informed policy design.
International bank lending is an important component of capital flows, as the growing literature on the role of global banks in transmitting financial conditions across borders highlights. We assess the causal effect of international bank lending on the main financial and real variables for a sample of 22 EMEs over the period 1990Q1-2018Q4, using data from the BIS. To identify causal effects, we rely on the intuitive observation that, as international bank lending is concentrated, lenders that account for a high share of lending to a given EME will affect aggregate international lending to that country and , through it, the aggregate macroeconomic conditions.
We find that cross-border bank lending leads to higher domestic activity in EMEs due to more flexible financial conditions. Financial condition indices are easing, nominal and real effective exchange rates appreciate, sovereign and corporate spreads narrow, domestic interest rates fall, and house prices rise. As a result, economic activity as well as domestic credit growth is also accelerating. The effects are smaller for countries with higher degrees of capital inflow controls. In other words, controlling capital inflows can help EMEs cushion the effects of shocks to international bank lending (eg, moderate a boom in financial conditions or limit credit growth).
Bank flows to emerging market economies (EMEs) are a potential source of vulnerability that can generate boom-bust cycles. The causal effect of such inflows on the macro-financial conditions of EMEs is difficult to pin down empirically and should be the key to a well-informed policy design. We provide new empirical evidence on the effects of cross-border bank lending on the macro-financial conditions of EMEs. We identify causal effects by taking advantage of the heterogeneity of the size distribution of bilateral cross-border bank loans to construct granular instrumental variables for cross-border bank loans aggregated to 22 EMEs. We find that cross-border bank lending leads to higher domestic activity in EMEs due to more flexible financial conditions. Financial condition indices are easing, nominal and real effective exchange rates appreciate, sovereign and corporate spreads narrow, and domestic interest rates fall. At the same time, real domestic credit rises, real GDP rises, imports rise, and house prices rise as well. The eects are smaller for countries with relatively higher levels of capital inflow controls, confirming the idea that these policy measures may be effective in mitigating vulnerabilities associated with external financing shocks.
JEL classification: E0, F0, F3
Keywords: granular instrumental variables; capital flows; Emerging Markets; cross-border complaints; credit shocks; international bank; capital controls.