Episodes of rapid growth in international capital flows are associated with banking crises. For the typical country, a crisis is at least three times as likely following a period of rapidly accelerating capital inflows. These are the central findings of research by Julián Caballero, published in the March 2016 issue of the Economic Journal.
His study, which analyses data from 125 banking crises and 146 developed and developing countries, uses a novel technique to establish a causal link between periods of rapid growth in capital inflows and subsequent banking crises. The technique allows the author to establish a causal link beyond the effect of confounding factors that often take place simultaneously with rapid growth of capital inflows – such as expansion of credit in the domestic financial system.
The research also sheds light on what type of capital inflows are more likely to end up in a banking crisis. The author finds that surges in portfolio-equity and debt are the type of inflows associated with crises rather than flows of foreign direct investment.
What''s more, while the effect of debt is mainly channelled through excessive lending prior to the crisis, the effect of portfolio-equity flows is present even in the absence of excessive lending. This is important because traditional explanations of the link between capital flows and crises emphasise only the role of debt flows and lending. Channels related to portfolio-equity flows are less well understood in economic models.
The policy implications of these results are twofold:
• First, policy-makers concerned about financial stability should pay attention not only to credit aggregates, but also to the size and acceleration of capital inflows, as well as to their composition. If a country is facing a large and rapid increase in capital inflows – particularly of portfolio-equity – imposing speed limits on credit growth to curb overlending may be insufficient to prevent a crisis. Furthermore, equity-type flows may bypass the banking sector, reducing the effectiveness of banking supervision and indicators of credit growth.
• Second, imposing capital controls is not a satisfactory answer. Controls seem to be ineffective in reducing the volume of flows and may have the effect of encouraging them towards equity-like instruments.
The author comments:
''After the unprecedented easing of monetary policy in developed economies following the global financial crisis of 2008/09, investors flooded emerging economies with capital.''
''This put the challenges posed by large windfalls of international capital and their subsequent retrenchment high on the global policy agenda.''
''Although emerging economies seem to have survived this episode without crises, the unwinding of quantitative easing will bring further policy challenges.''
''Do Surges in International Capital Inflows Influence the Likelihood of Banking Crises?'' by Julián Caballero is published in the March 2016 issue of the Economic Journal.
Julián Caballero is at the Research Department of the Inter-American Development Bank.