Capital Flow Surges, Sudden Stops and Elevated Portfolio Inflow Volatility Shocks: What is the Nature of Their Interaction with GDP Growth and Credit?

Abstract

Evidence shows that capital flow surges shock increases credit growth and GDP growth in contrast to the contractionary effects induced by a capital flow sudden stops and a positive net portfolio flow volatility shock. A capital flow surges shock increases credit growth more than GDP growth. Furthermore, evidence shows that these shocks can amplify the impact of a negative shock on the economy. This was especially the case during the recession in 2009. Nonetheless, the contribution of various capital flow episodes has been very muted, and even negative in some instances post 2008, despite the surge in global liquidity associated with unconventional monetary policy interventions by various central banks. We find that capital flow surges episodes shocks explain a relatively large proportion of fluctuation in credit growth than capital flow sudden stops shocks. This could possibly be due to the fact that a large portion of domestic bank intermediated credit is domestically funded. The implication is that, even in periods of severe capital outflow episodes, there might be disruptions in domestic bank lending activity, but they might not result in a complete freeze or dysfunction in the banking sector activity. There is need for policy initiatives aimed at strengthening the ability of the financial system to withstand episodes of large global risk aversion and adverse capital flow episode shocks. In addition, to the extent that growth in credit extension is driven less by capital flows, these findings reinforce the case for the consideration of macro-prudential tools such as the loan-to-value and repayment-to-income ratios as part of the macroprudential policies toolkit.