Capital inflows - the good, the bad and the bubbly

Our Financial Stability Papers are designed to develop new insights into risk management, to promote risk reduction policies, to improve financial crisis management planning or to report on aspects of our systemic financial stability work.
Published on 26 October 2016

Financial Stability Paper No. 40
By Glenn Hoggarth, Carsten Jung and Dennis Reinhardt

Capital inflows come in all shapes and sizes. This paper highlights that equity flows, especially foreign direct investment, are the most stable forms of capital inflows. In contrast, debt inflows from banks particularly in foreign currency are most prone to booms and busts. These flows also seem most sensitive to external factors, especially changes in global risk, and also to changes in domestic credit growth. Although portfolio debt flows are somewhat more stable particularly to advanced countries, granular data highlight that (open-ended) emerging market mutual funds in foreign currency and aimed at retail investors are also prone to inflow ‘surges’ and ‘stops’. The share of external debt denominated in foreign currency is significantly higher in emerging market economies (EMEs) than in advanced countries. EMEs also usually have shallower and narrower financial markets. This suggests these countries are more prone to risks from capital inflow booms and busts.

Capital account openness is, in principle, beneficial to the economy. It allows investors to diversify their asset portfolios and debtors more alternative sources of borrowing. It should also increase the efficiency of resource allocation, competition in the domestic financial system, and facilitate the transfer of technology knowhow. But it may also act as a source of risk to domestic financial stability. So the policy objective should be to maintain stable capital flows in the context of an open capital account. Financial crises have often been associated with marked changes in global risk. We find evidence that macroprudential policy reduces the sensitivity of capital inflows to global volatility. Therefore, in addition to building up buffers against external shocks such measure may help to reduce systemic risks caused by marked changes in capital flows. The OECD has begun this year to review their Codes of Liberalisation of Capital Movements. We hope this paper can serve as background to that review.

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