Must-read: Olivier Blanchard et al.: “Macro Effects of Capital Inflows: Capital Type Matters”

Olivier Blanchard et al.: Macro Effects of Capital Inflows: Capital Type Matters: “Some scholars view capital inflows as contractionary…

…but many policymakers view them as expansionary. Evidence supports the policymakers. This column introduces an analytic framework that knits together the two views. For a given policy rate, bond inflows lead to currency appreciation and are contractionary, while non-bond inflows lead to an appreciation but also to a decrease in the cost of borrowing, and thus may be expansionary….

How can we reconcile the models and reality? [Our] answer… relies on… allowing for both ‘bonds’ (the rate on which can be thought of as the policy rate) and ‘non-bonds’… which are imperfect substitutes…. Capital inflows may decrease the rate on non-bonds and reduce the cost of financial intermediation…. Capital inflows may in this case be expansionary even for a given policy rate. In emerging markets, with a relatively underdeveloped financial system, the effect of a reduction in the cost of financial intermediation may dominate, leading to a credit boom and an output increase despite the appreciation. In more advanced economies, the appreciation may dominate, and capital inflows (even into non-bonds) may be contractionary (e.g. the Swiss case)….

The appropriate policies vis-à-vis capital inflows depend very much on the nature of the inflows.

Sterilised foreign exchange (FX) market intervention, if done through bonds (as is usually the case), can fully offset the effects of bond inflows…. When, however, sterilised foreign exchange intervention is used in response to non-bond inflows… FX intervention… by reducing upward pressure on the currency… increases capital inflows, and thus increases the effects of inflows on credit and the financial system….

The policymaker may have several objectives in mind – with respect to credit growth (given the risk of financial crisis); the currency (given the risk of Dutch disease); and output (given nominal rigidities in the system). The issue is really one of matching the policy instrument (there are three) to deliver on the most important objectives, without too much cost in terms of the other objectives…. If the central bank is worried about both appreciation and unhealthy or excessive credit growth, FX intervention or capital controls are preferable to the use of the policy rate in response to an increase in bond inflows…. In response to non-bond inflows, our framework suggests that if the goal is to maintain exchange rate stability with minimum impact on the return to non-bonds, capital controls do the job best, followed by FX intervention, followed by a move in the policy rate….

[We] use global flows to all emerging market countries together with the VIX as instruments…. We find that, while bond inflows have a negative effect on economic activity, non-bond inflows have a significant and positive effect. We also find that non-bond inflows (excluding FDI) have a strong positive effect on credit…. FDI inflows, while they increase output, have a negative impact on credit, perhaps because some of the intermediation which would have taken place through banks is replaced by FDI financing…

January 2, 2016


Brad DeLong
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