Capital flow volatility and financial fragility: Cross-country evidence and policy lessons

The complex nature of international capital flows remains a central topic in academic debate. Despite extensive research, the relationship between capital inflows and financial system vulnerabilities remains complex and influenced by both global, regional and domestic factors that necessitate nuanced approaches when considering such relationships. This paper contributes to the ongoing debate by shedding light on the buildup of financial vulnerabilities stemming from capital inflows. Using a panel dataset covering 128 advanced and emerging economies and employing two-stage GMM estimation techniques, the paper examines the channels through which cross-border capital inflows contribute to financial vulnerability build-up. Our findings suggest that capital inflows, namely portfolio and cross-border bank inflows, remain a key driver of credit expansion and positively influence the risk-taking behaviour of commercial banks. Importantly, the underlying drivers of these flows are also critical in explaining such vulnerabilities. By using regional flows as an instrument for capital flows, we emphasise the role of regional and pull factors, while the distinction between natural-level and gap-driven inflows in the paper highlights important policy implications for economies exposed to external shocks. Finally, we find that capital flow control measures play a mitigating role in vulnerability build-up associated with external financing.