By Deniz Igan, Deputy Chief of the Macro-Financial Division in the IMF’s Research Department
Michael Mussa, a former Chief Economist of the IMF, famously likened capital account liberalization to fire. In his comments at the IMF Economic Forum on October 2, 1998, he said: "Fire warms our homes, it cooks our food, our internal combustion engines," and continued: "No doubt, fire is very useful, and we are not going to give up its manifold benefits. On the other hand, fire can also burn you down and do a great deal of damage."
As the Asian crisis unfolded, most perspectives on capital flows unsurprisingly took them more as a curse than as a blessing. Such views were reinforced with the reversal of international capital flows that followed the Lehman Brothers bankruptcy and the association between how much a country suffered during the global financial crisis and its pre-crisis dependence on external financing. As international capital flows recovered, the policy discussion focused on the possible problems the surge in capital inflows could cause for emerging market economies and how policymakers can and should manage inflows.
New micro evidence to answer an age-old question
In our recent work, we take a step back and look at the other side of the coin: are capital inflows a blessing in that they enhance growth? An extensive literature has attempted to answer this question and found little conclusive evidence that capital inflows yield significant benefits. The lack of such evidence in studies based on aggregate macro data, however, likely reflects the fact that different types of capital flows have different effects on growth. Moreover, a range of important factors - such as the quality of institutions and the strength of financial frictions - are difficult to capture in cross-country regressions.
In our study, we use micro data at the industry level to fill in these gaps and provide some new evidence on the nexus between capital inflows and growth in emerging market economies. Specifically, we examine the association between capital inflows and industry growth in a sample of 22 emerging market economies from 1998 to 2010.
Not all industries and flows are created equal
Our empirical approach exploits the differences across industries in their need for external financing to distinguish any causal impact of capital inflows on output and value added. In principle, capital inflows have the potential to increase access to finance (quantity) and reduce interest rates (cost of borrowing), and hence we expect industries more dependent on external finance (e.g., chemical industry) to grow disproportionately faster than their counterparts (e.g., textile industry) if they are located in countries hosting more capital inflows.
We also go beyond the existing literature by shedding light on the potential tradeoffs associated with capital inflows by investigating their impact on both growth and growth volatility in industrial sectors. In addition, we break down the total capital inflows to sub-components and test whether there are varying effects across different forms of capital flows. And finally, we explore to what extent the performance of domestic financial markets shapes the real effects of foreign capital inflows and what happens when there are large shocks to financial markets.
Fire is useful, and so is fire safety
As expected, more external finance dependent industries in countries that host more capital inflows grow disproportionately faster. Interestingly, this is the case in the pre-crisis period of 1998-2007, and the positive association is driven by debt, rather than equity, inflows. We also observe a reduction in output volatility, but this association is more pronounced for equity, rather than debt, inflows. These relationships, however, break down during the crisis. This is likely because large shocks to the global financial system are disruptive and hurt the ability of emerging market firms to turn capital inflows to investment and output. In line with this observation, the inflows-growth nexus is stronger in countries with well-functioning banks.
The findings point to the need to take the composition of capital inflows into account when assessing their costs and benefits. They also hint at the importance of a well-functioning global financial system as well as the domestic banking system for emerging markets to harness the growth benefits of capital inflows. Getting the right "fire safety measures" in place can help improve the trade-off that may be associated with capital inflow surges.