Gross inflows of capital are a good leading indicator of credit booms, particularly those that end up in financial crisis. That is the central finding of research by César Calderón, Megumi Kubota, presented at the Royal Economic Society annual conference 2013.
Their study brings together two existing theories to explain the connection between gross inflows of capital and financial crises. The first suggests that huge inflows to the domestic economy may fuel activity in financial markets and – if not properly managed – lead to booms in credit and asset prices. The second suggests that credit expansion and overvalued asset prices are good predictors not only of the current financial crises but also of past ones.
The research shows the connection between gross capital inflows and financial crises using data for 71 countries between 1975 and 2010 available for each quarter rather than just annually and available for gross inflows rather than net inflows.
The researchers argue that not all types of inflows behave alike. Whereas foreign direct investment for the long term can have a stabilising effect, short-term private investment is the destablising factor and a good predictor of credit booms and consequently financial crises.
This study shows that surges in gross inflows are a good predictor of booms in credit markets – and, especially, those that end up in a systemic banking crisis (''bad credit booms'').
According to two strands of the literature: first, massive inflows to the domestic economy may fuel activity in financial markets and – if not properly managed – booms in credit and asset prices may arise. Second, credit expansion and overvalued asset prices have been good predictors not only of the current financial crises but also of past ones.
This research synthesises both strands of the literature and finds that surges of gross private capital inflows can help explain the incidence of subsequent credit booms and bad credit booms. When looking at their predictive power, the researchers argue that not all types of flows behave alike.
Gross private other investment (OI) inflows robustly predict the incidence of credit booms – while portfolio investment (PI) has no systematic link and FDI surges will at best mitigate the probability of credit booms. Consequently, gross private OI inflows are a good predictor of credit booms.
The paper evaluates the linkages between surges in gross private capital inflows and the incidence of booms in credit markets. In contrast to previous research papers in this literature: it examines gross inflows rather than net inflows; and it uses quarterly data for 71 countries from 1975q1 and 2010q4 instead of annual frequency.
The quarterly data can better capture the dynamic behaviour of capital flows and credit markets along the business cycle. Therefore, the evaluations are more precise about the impact on credit booms of (the overall amount and the different types of) financing flows coming from abroad.
Gross flows distinguish the impact on credit markets of investment inflows coming from foreign investors because net flows do not appropriately differentiate the behaviour of foreign investors from that of domestic ones since the mid-1990s. Consequently, it may provide misleading inference on the amount of capital supplied from abroad.
Finally, the researchers identify credit booms by following two competing methodologies. One focuses on excessive growth in real credit per capita (beyond regular cyclical fluctuations) and another focuses on disproportionate movements in the ratio of credit to GDP.
The views expressed in this paper are those of the authors, and do not necessarily reflect those of the World Bank or its Boards of Directors.