Taming the "Capital Flows-Credit Nexus": A Sectoral Approach

Capital flows may lead to financial vulnerabilities by fueling domestic credit booms, the so-called “capital flows-credit growth nexus, of particular concern to emerging markets. This paper makes two important contributions to the understanding of this nexus: it adopts a sectoral approach to the relationship between cross-border capital flows and domestic credit growth and it studies how different macroprudential and financial policies affect that relationship in emerging market economies. Using novel datasets on both sectoral flows and policy measures, it finds that financial policy 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. While, in general, macroprudential and foreign currency-based measures are better suited to mitigate the impact of banking sector flows, capital controls appear to lessen the impact of flows to non-financial corporates and other financial corporates. Splitting by borrowing sectors, macroprudential lending standards and measures targeted at household credit weaken the impact of inflows on household credit, while the latter also strengthen the relationship between NFC flows and NFC credit, suggesting a potential shift in composition.