Reserve requirements and capital flows in Latin America

The experience of a number of central banks in emerging economies indicates that capital flows can pose a dilemma. For example, raising policy rates can attract more capital inflows by raising deposit rates. It has been suggested, however, that raising reserve requirements instead of the policy rate can address this dilemma, as deposit rates will not necessarily increase, even if lending rates rise. To investigate this possibility, this paper examines how banks adjust loan and deposit rates in response to changes in reserve requirements. We use data on 97 banks from five Latin American countries over the period 2000–14. Our results indicate that higher reserve requirements are associated with lower deposit rates, whereas loan rates remain unchanged during normal times and increase during periods of large capital inflows. Reserve requirements may therefore be a way to mitigate the dilemma posed by capital inflows in some Latin American economies.