Taming the “Capital Flows-Credit Nexus”: A Sectoral Approach

Capital inflows may lead to financial vulnerabilities by fuelling domestic credit booms, the so-called “capital flows-credit growth nexus”, which is of particular importance for emerging market economies. This paper makes two important innovations in understanding this nexus: 1) it adopts a sectoral approach; and 2) it assesses the effectiveness of different financial policies (macroprudential and capital controls) in taming the nexus. Using novel datasets on sectoral capital flows and policies, the results show that some measures can mitigate domestic credit growth, not only directly, but also indirectly, through the reduction of the sensitivity of credit to capital inflows. Furthermore, the results underscore the importance of a granular sectoral approach in identifying the full range of connections between capital flows and credit growth, as well as the appropriate policy response. The findings offer support on the use of a broad policy toolkit in taming the capital inflows and credit growth nexus.