Capital inflows and credit growth in emerging and developing economies: A dynamic panel data model

Abstract

Capital flows can dramatically affect domestic credit growth in a capital-recipient economy, particularly the emerging market and developing economies (EMDEs) which are highly vulnerable to capital flow variations. Despite the fact that many studies have been conducted to explore the macroeconomic impacts of domestic credit growth, the linkage between capital inflows and domestic credit growth is relatively scant. This study attempts to narrow this gap by investigating the impacts of capital inflows on domestic credit growth for a sample of 103 EMDEs from 1991-2015. The study makes several important contributions to the literature and policy debates. Firstly, it is the first study that documents the persistence of domestic credit growth in EMDEs. Secondly, to account for the dynamic relationship between capital inflows and domestic credit growth, the study adopts a dynamic panel data model estimated by using system generalized method of moments (SGMM) technique in order to address endogeneity issues caused by simultaneity and unobserved heterogeneity. Thirdly, the study provides a granular analysis of the impacts of capital inflows. Gross capital inflows significantly exert a positive influence on domestic credit growth in EMDEs; however, at the disaggregated level, only foreign direct investments (FDI) significantly and positively affect domestic credit growth whereas the other three types of capital inflows (i.e. portfolio equity, portfolio debt, and other investment) do not. Finally, the study derives major implications that are essential for macro-financial policy considerations in managing capital flows, particularly curtailing the impacts of capital inflow that may eventually cause rapid credit growth.