Capital flows and credit booms in emerging market economies?

Private capital began flowing back to emerging market economies (EMEs) in 2002 and continued to mid-2006. In parallel, most of these countries also witnessed rapid growth in bank credit to the private sector (BCPS). This paper seeks to determine whether this strong credit expansion reflects financial deepening or excess liquidity. In the first case, this phenomenon forms part of an economic catch-up process. In the second, the main emphasis is on the potential weakness of domestic banking systems and increased macroeconomic vulnerabilities of the concerned countries. Capital inflows tend to exacerbate these risks, such that they often coincide with credit booms. Depending on the observation period and the sample of emerging countries, between 40% and 60% of credit booms took place at a time when capital inflows were high. However, the linkage between credit booms and banking and financial crises is weaker, insofar as only 6%-20% of credit booms lead to a crisis. To explore the role of capital inflows in the observed credit expansion in EMEs, this article presents an econometric analysis of a 27-country sample over the last four years. A two-stage approach is taken: first, countries that have experienced excessive growth in bank credit to the private sector are identifi ed; second, the causality relationship between capital inflows and bank credit in these countries is examined. The main findings suggest that of the 27 EMEs, which on the whole recorded strong capital inflows over the last four years, just nine experienced a credit boom. Moreover, there does not appear to be a clear-cut causality relationship between capital inflows and BCPS. It is therefore difficult to draw general conclusions as regards financial stability. In some countries, a combination of substantial capital infl ows and credit booms may generate risks of instability if the external financing causes profound macroeconomic and financial imbalances. In other countries, massive capital infl ows and rapid credit growth may be linked to a healthier process of financial deepening.