Capital Flows and Domestic Responses

by Joseph Joyce

Capital Flows and Domestic Responses

The international impact of financial shocks became apparent during the global financial crisis. But how do financial flows affect economic conditions during non-crisis times? And are there ways to shelter the domestic economy from these flows? Some new evidence from the IMF seeks to answer these questions.

IMF economists Bertrand Gruss, Malhar Nabar and Marcos Poplawski-Ribeiro, in a chapter in the IMF’s latest World Economic Outlook entitled “Roads Less Traveled: Growth in Emerging Markets and Developing Economies in a Complicated External Environment,” examine the impact of external conditions on growthsince the 1970s in over 80 emerging market and developing economies. This issue is particularly important in light of the contribution to global growth—80%—by these economies since the financial crisis.

The authors construct measures for the countries in their sample to capture the following external conditions: external demand, as measured by domestic absorption in a country’s trading partners; external finance, based on capital flows to peer economies; and the terms of trade, constructed from commodity prices. The cross-correlation across these measures is low, indicating that they capture different sources of external variation. The country-specific measures often diverge from their global values, which the authors attribute to domestic factors.

The three measures are all economically and statistically significant in explaining the growth rate of GDP per capita over five-year windows in the countries under stud , contributing almost 2 percentage points to income per capita growth over the 40-year period. Their collective impact rose from about 1.7 percentage points to 2.3 percentage points over the entire period. External financial conditions in particular have become increasingly important over time. Their contribution to growth increased by about half of a percentage point between the 1995-2004 and 2004-1014 periods, and represented half of the contribution from external factors since 2005. The authors attribute the rise in part to the increased financial integration of capital markets.

How do local conditions affect the impact of external financial flows on the domestic economy? In general, a loosening of external financial conditions contributes to growth when they are channeled to “…financially constrained agents while maintaining relatively robust risk management and origination standards that minimize the pitfalls of excessive credit growth.” This will occur when there is financial development and a healthy pace of increase in domestic credit to accompany capital account openness.

How do policymakers in emerging market economies actually respond to capital flows? IMF economists Atish R. Ghosh, Jonathan D. Ostry and Mahvash Qureshi look at this issue in a recent IMF working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” Using a sample of 50 emerging market economies over the period of 2005 to 2013, they investigate whether these countries sought to restrain the impact of capital inflows on their countries. Their evidence indicates that central bankers did seek to check their impact by foreign exchange market intervention and setting higher policy rates. Moreover, macro prudential policies were strengthened and capital controls tightened in response to capital surges. On the other hand, capital flows were associated a pro-cyclical response in government expenditures, signaling that fiscal and monetary policymakers have different goals.

The authors leave open for future research the question of whether such measures decrease the probability of experiencing a subsequent financial crisis (see here). The existence of global financial cycles (see here) indicates that global financial markets have become increasingly dependent on conditions in the advanced economies, particularly the U.S., which may limit the efficacy of domestic measures. Political turmoil in the U.S. may be the factor that upends the recent historically low levels of VIX (see also here). If so, policymakers in the emerging markets will need to take more steps to shield their economies from the ensuing turbulence.