Implications of Capital Flows for Domestic Credit Growth: Evidence from Panel Data Analysis

Following the 2007-2009 global crisis, high credit growth became an issue of concern with an emphasis on its relationship with capital flows. It is argued that large and volatile international capital flows lead to credit expansion, which in turn, may cause economic and financial instabilities when it reaches excessive levels, particularly in developing countries. This paper aims to investigate the association between credit growth and capital inflows in the context of developing countries by using panel data analysis. The methodology employed in the study offers a number advantages by allowing for heterogeneity and cross-sectional dependence in the panel, while also considering the endogeneity issue. The overall results of the study provides evidence for the impact of capital inflows, more particularly other capital inflows, on credit growth in the sample. This finding suggests a more direct relationship between capital inflows and credit creation as other inflows mostly comprise international banking and trade credits. It is not surprising given the fact that banking sector has a critical role in the financial systems of developing countries. The significance of international dimension for credit creation through other capital inflows and the intermediary role of the banking system should have monetary policy implications, in the macroprudential or more conventional fashion.