Capital Flows Liberalisation and Macroprudential Policie - 2022 - Economic Analy

Economic Analysis and Policy 73 (2022) 602–619
Contents lists available at ScienceDirect
Economic Analysis and Policy

journal homepage: www.elsevier.com/locate/eap
Analyses of Topical Policy Issues
Capital flows liberalisation and macroprudential policies: The

effects on credit cycles in emerging economies
∗
Tanja Kuzman a , Jelisaveta Lazarevic a , Milan Nedeljkovic a,b ,
a
FEFA, Metropolitan University, Bulevar Zorana Djindjica 44, Belgrade, 11070, Serbia
b
CESIfo, Poschinger Street 5, 81679 Munich, Germany
article info a b s t r a c t
Article history: This paper studies the conditionality in the relationship between capital flows liberali-
Received 4 March 2021 sation, macroprudential policies, and credit cycles in emerging market (EM) economies.
Received in revised form 14 December 2021 Using quarterly data for 16 EM economies, we document the effectiveness of broad
Accepted 14 December 2021
macroprudential measures in containing credit cycles in the EM economies. More impor-
Available online 23 December 2021
tantly and in line with theory, we find that the effect of liberalisation of capital inflows
JEL classification: on the excessive credit dynamics is conditional on the stance of the macroprudential
G28 regulation. When the macroprudential framework is tight, the liberalisation of capital
G38 inflows does not have a statistically significant effect on the excessive credit dynamics.
F6 In contrast, in economies with a lax macroprudential framework, the liberalisation of
F34
capital inflows may amplify credit expansion. The results provide a rationale to explain
Keywords: often conflicting findings in the earlier empirical literature.
Credit cycle © 2021 Economic Society of Australia, Queensland. Published by Elsevier B.V. All rights
Capital flows reserved.
Macroprudential policy
Financial liberalisation
Emerging markets
1. Introduction
Financial globalisation has strongly increased over the past three decades, driven by expanding trade and informational
globalisation while reinforcing the two processes. The liberalisation of capital flows was an integral part of this process,
yielding several benefits for emerging market (EM) economies. The liberalisation facilitates easier access to capital and
lowers the cost of capital (Makin and Robson, 2006), especially for smaller and more innovative firms, which are typically
more capital-constrained in EM economies (Forbes, 2007; Gupta and Yuan, 2009). Furthermore, stronger capital controls
are associated with greater reporting requirements for exporting and importing firms generating the ‘‘friction’’ in the form
of the higher cost of international trade transactions, which is alleviated through liberalisation (Wei and Zhang, 2007). The
free capital flows may have additional indirect positive effects on the economy — through facilitating financial market
development or enabling improvements in corporate governance and the institutional framework. The effects of these
‘‘collateral benefits’’ (Kose et al., 2009) take time to materialise and affect growth dynamics indirectly. In addition, the
liberalisation of domestic residents’ capital flows (capital outflows) improves the potential for cross-country risk-sharing
and expands the opportunities for diversification of assets held by the residents. By shifting the exposure from only
domestic sources of fluctuations, higher diversification helps smooth the fluctuations in consumption and investments of
domestic firms and households.
∗ Corresponding author at: FEFA, Metropolitan University, Bulevar Zorana Djindjica 44, Belgrade, 11070, Serbia.
E-mail addresses: tkuzman@fefa.edu.rs (T. Kuzman), jlazarevic@fefa.edu.rs (J. Lazarevic), mnedeljkovic@fefa.edu.rs (M. Nedeljkovic).
https://doi.org/10.1016/j.eap.2021.12.010
0313-5926/© 2021 Economic Society of Australia, Queensland. Published by Elsevier B.V. All rights reserved.
T. Kuzman, J. Lazarevic and M. Nedeljkovic Economic Analysis and Policy 73 (2022) 602–619
List of Abbreviations
AREAER Annual Report on Exchange Arrangements and Exchange Restrictions
ARIMA Autoregressive Integrated Moving Average
BIS Bank for International Settlements
CFM Capital Flow Management
DSTI Debt-Service-to-Income Ratio
EM Emerging Markets
FKRSU Database on the extent of financial liberalisation (Fernandez et al., 2015)
GDP Gross Domestic Product
HP Hodrick-Prescott
iMAPP IMF’s Integrated Macroprudential Policy
IMF International Monetary Fund
LSDV Least Square Dummy Variable
LTD Loan-to-Deposit Ratio
LTI Loan-to-Income Ratio
LTV Loan-to-Value Ratio
SIFI Systemically Important Financial Institutions
The liberalisation, however, imposes potential risks to the economy. Higher capital flows associated with the liberalisa-
tion can provide a channel through which external shocks are transmitted to the domestic economy (the other important
channel being the trade), amplifying local business cycle and local macroeconomic uncertainty (see, e.g., Mendoza,
2010). Moreover, free capital flows can potentially lead to faster than optimal credit expansion when the cheaper and
affordable capital leads to excessive risk-taking by domestic agents, especially in situations when the abundant capital
flows simultaneously lead to a strong increase in domestic asset prices (for an overview of the externalities view of capital
flows, please see, e.g., Erten et al., 2019). Excessive risk-taking can lead to higher boom and bust cycles in the economy
amplified by more volatile capital flows, themselves being prone to sudden reversals (Forbes and Warnock, 2012).
Over the past two decades, particularly from the onset of the global financial crisis, there has been a growing awareness
that macroprudential policies can significantly contribute to curbing excessive credit dynamics and mitigating the build-
up of the financial stability risks. Early literature (Crockett, 2000; Borio, 2003) highlighted the need to strengthen the
macroprudential orientation of the existing prudential frameworks, the view adopted by the majority of EM and developed
economies, although with different emphasis and timing before and after the global financial crisis. More recent theoretical
and empirical literature indeed documents the effectiveness of macroprudential policies in containing domestic credit
cycles (for theoretical evidence see, e.g., Farhi and Werning, 2016; Korinek and Sandri, 2016; Bianchi and Mendoza,
2018; for empirical evidence, please see Dell’Arccia et al., 2012; Claessens et al., 2012; Cerutti et al., 2017; Fendoglu,
2017). Moreover, in the environment of volatile capital flows and to safeguard financial stability, several EM economies
have either slowed the progress in financial liberalisation or imposed different capital controls. Although the distinction
between macroprudential measures and capital controls is not always clear in practice (see IMF, 2015), their underlying
nature and policy implications differ. The macroprudential policies often impose restrictions on the borrowing of domestic
agents (irrespective of the source of funding), while the capital controls essentially segment domestic and international
financial markets. In this way, the latter constrains the build-up of excessive risks associated with capital flows but,
simultaneously, may limit the scope for realisation of the growth benefits of capital flows. The question of optimality
between the progress in financial liberalisation, the use of macroprudential measures, and their effects on the credit
cycles remains open.
This paper contributes to the debate by empirically examining the conditionality in the relationship between capital
flows liberalisation, macroprudential policies, and credit cycles in EM economies. In particular, using quarterly data for
16 major EM economies over the 2000–2018 period, we explore the notion that the strength of association between
the liberalisation of capital flows and the extent of excessive credit expansion depends on the scope of macroprudential
measures implemented by local authorities. Our analysis distinguishes between the liberalisation of capital inflows and
capital outflows.
We document three stylised facts by exploiting both the time-series and the cross-country variation in the extent of
financial liberalisation and the tightness of macroprudential regulation. First, we confirm earlier results in the literature
on the general effectiveness of the macroprudential measures in containing credit cycles in the sample of EM economies.
Second and more importantly, we find that the effect of liberalisation of capital inflows on the excessive credit dynamics
is conditional on the intensity of the macroprudential regulation. When the macroprudential framework is tight, the
liberalisation of capital inflows does not have a statistically significant effect on the excessive credit dynamics. In contrast,
in economies with a lax macroprudential framework, the liberalisation of capital inflows may amplify credit expansion.
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Finally, we do not find a statistically significant effect of capital outflows liberalisation on credit dynamics. We confirm
that our results are not sensitive to alternative estimation methods, definitions of the dependent variable, or variations
in the control variable set.
Our empirical results are consistent with theoretical predictions in Korinek and Sandri (2016) and Mendoza and Rojas
(2019). Korinek and Sandri (2016) showed that in economies where overborrowing is driven by boom and bust in asset
prices, tighter macroprudential regulation is sufficient to alleviate the externality effects of capital flows and produce
constrained efficient equilibrium. They also showed that using both macroprudential policy and capital controls might
be desirable to circumvent financial fragilities if the exchange rate fluctuations, rather than asset prices, are the primary
source of externalities. In addition, Mendoza and Rojas (2019) showed that in the presence of non-negligible liability
dollarisation, the macroprudential policies might be more potent relative to the capital controls even when the exchange
rate fluctuations are the primary source of externalities. Our findings thus suggest that in the major EM economies, the
macroprudential policies may indeed be potent to mitigate the impact of capital flows liberalisation on the credit cycle.
2. Related literature
This paper is related to two different strands of the empirical literature. One (growing) strand of the literature studies
the effectiveness of macroprudential policies in curbing excessive credit expansion and house price inflation. The literature
is already large enough to be surveyed here, and we only focus on several key papers in this section. We point the
interested reader to several recent surveys (Araujo et al., 2020; Forbes, 2020; Galati and Moessner, 2018), which also
discuss other relevant aspects of macroprudential regulation, such as the effects on economic growth in the short and
medium run, the potential for dampening the impact of global shocks on the local economy, as well as the effects of
potential leakages in the regulation.
The evidence from the country-level panel data studies, like ours, generally points to the effectiveness of implemented
macroprudential measures in dampening excessive credit expansions and house price inflation. In one of the first
comprehensive empirical studies, Lim et al. (2011) showed that implementing different macroprudential measures
successfully reduced the procyclicality of credit and banking sector leverage in a large sample of countries over the
2000–2010 period. Dell’Arccia et al. (2012) confirmed that macroprudential policies contributed to the reduction in the
number of credit boom events and the intensity of the subsequent busts over the same period. Cerutti et al. (2017) find
that stronger macroprudential regulation is generally associated with lower credit growth in EM. Similarly, Fendoglu
(2017) and De Schryder and Opitz (2020) found that the overall tightening of macroprudential measures helps contain
credit cycles. In addition, Zhang and Zoli (2014) and Akinci and Olmstead-Rumsey (2018) illustrated that macroprudential
policies could impede credit and house price growth, thus contributing to greater stability of the overall financial markets.
The literature that studies the interplay between capital flows liberalisation and the level of macroprudential regulation,
however, is still in its infancy.
The second strand of the literature to which our paper is related focuses on the relation between the liberalisation of
capital flows and excessive credit expansions in the EM economies. We point the interested reader to the surveys in Kose
et al. (2009) and Erten et al. (2019) and provide a selective overview of this literature in the sequel. The voluminous
empirical literature generally does not provide a consensus view on the existence of the link. Hutchinson and Glick
(2001), using data for both developed and developing countries over the 1975–1996 period, find that the propensity
to banking and currency crises increases in the aftermath of financial liberalisation. Similarly, Reinhart and Reinhart
(2008) and Terrones and Mendoza (2008) showed that the likelihood of a banking crisis in EM economies is associated
with capital flow ‘‘surges’’ (excessive inflows). Ostry et al. (2011) report that in their sample of economies over the
1995–2008 period, half of the credit booms are associated with large capital inflows. Reinhart and Rogoff (2009) and
Gallagher (2012) similarly demonstrate the existence of a positive association between capital market liberalisation and
increased financial instability. On the other hand, many empirical studies do not find a significant relationship between
excessive credit expansions and the liberalisation of capital flows. Using data for developing countries over the 1975–
1997 period, Glick et al. (2006) identified the opposite mechanism to the extent that higher financial openness reduces
the probability of currency crises. Klein (2012) finds no effect of capital flows liberalisation on the aggregate and bank
credit growth dynamics over the 1995–2010 period. The absence of considering the conditionality of the liberalisation
effects can potentially explain the differences in the empirical results reported in the literature.
The limited number of empirical papers jointly studied the effects of financial liberalisation (capital controls) and
macroprudential policies on the credit cycle. Forbes et al. (2015) showed that tighter macroprudential measures can
reduce bank leverage and bank credit growth and that these measures are generally more effective, relative to capital
controls, in affecting macroeconomic outcomes. Frost et al. (2020) extended their results by showing greater effectiveness
of macroprudential policies relative to capital controls in preventing banking crises in the following three years. However,
the empirical framework in these papers does not allow for exploring the interplay and conditionality in the effects of
both types of measures. Fendoglu (2017) studied this relationship in the special case of portfolio capital flows and found
weak evidence that changes in macroprudential regulation may reduce the impact of the higher volume of portfolio flows
on the credit cycle in EM economies.
Our results contribute to the literature in at least two important ways. First, to our knowledge, this is the first study to
empirically analyse the conditionality in the relationship between capital flows liberalisation, macroprudential policies,
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and credit cycles in a common framework. Our main contribution is thus to provide evidence of the theoretical predictions
that in more advanced EM economies, tighter macroprudential regulation is sufficient to alleviate the externality effects of
capital flows on the credit cycle. In this way, we also provide a mechanism that can potentially explain often conflicting
findings in the earlier empirical literature. From a policy perspective, the result highlights the potential prioritisation
steps in sequencing policy measures to increase the resilience of the domestic financial system and exploit the benefits
of abundant global liquidity.
Second, our empirical framework is designed to address the limitations in the empirical literature, which studies the
effects of macroprudential regulation and capital flow liberalisation — definition of capital controls and macroprudential
regulation variables and potential endogeneity of policy variables. Our identification of the key forces of interest comes
from the variation in the level of macroprudential regulation and of the financial liberalisation across both countries and
time. Relative to studies that exploit only within a country change in the policy variables, where changes in regulations are
likely to be initiated in response to current local macroeconomic developments, the concerns about reverse causality in
our setting are much weaker. This is because our key variables of interest are defined as the states of tight macroprudential
regulation and high capital flows liberalisation and, as such, depend on the relative levels of implemented regulation at
each point in time. Since the levels are largely predetermined (as a result of policy decisions over the previous years), while
the relative changes in levels are driven by full cross-sectional information, the potential for reverse causality effects is
smaller. In addition, we also control for the possibility of unobserved confounding factors, which are both time and cross-
section varying by estimating specifications with interactive fixed effects, mitigating further the endogeneity concerns.
Finally, rather than focusing on the special case of portfolio flows (equity, bond, and money market), we consider broad
measures of capital flows liberalisation related to all types of flows other than the foreign direct investment.1 These
include cross-border bank, credit, and trade-related financial flows (such as guarantees, sureties, and financial backup
facilities) and flows in the derivatives, collective investment vehicles, and the real estate market. In this way, our results
provide a more general view of the effects of capital flows on the credit cycle. In addition, exploiting the Fernandez et al.
(2015) database on capital controls, we separately study the effects of liberalisation of capital inflows and capital outflows
on the credit dynamics.
The remainder of the paper is organised as follows. Section 3 discusses the data and empirical methodology. Section 4
presents the empirical results on the relationship between foreign exchange liberalisation, macroprudential policies, and
credit cycles in EM economies. Section 5 concludes.
3. Data and empirical methodology
3.1. Data
Our dataset includes balanced panel data for 16 EM economies — Brazil, Chile, China, Colombia, the Czech Republic,
Hungary, India, Indonesia, the Republic of Korea, Malaysia, Mexico, Poland, Russia, South Africa, Thailand, and Turkey.
The final sample reflects data availability of sufficiently long series for the key variables under consideration — the
credit dynamics and the measures of financial liberalisation and macroprudential policies. The sample is geographically
representative (dispersed) and spans countries from three major continents (and one from Africa). To assess the
high-frequency changes in the credit dynamics, the data was collected at a quarterly frequency over the 2000–2018
period.2
3.1.1. Credit data

The primary database for credit data is the Bank for International Settlements (BIS) quarterly statistics on credit to
the non-financial sector. We use ‘‘total credit’’ data, which includes financing of non-financial sectors from all sources,
including domestic banks, other domestic financial corporations, non-financial corporations, and non-residents. The
non-financial sector consists of non-financial corporations and households (including non-profit institutions serving
households). The total credit data thus allows for examining the build-up of excessive credit indebtedness beyond what
is channelled through the domestic banking system, which is particularly relevant in the financial liberalisation context.
The credit data for all countries is reported in the percentage of GDP.
In line with standard Basel accord practice (see, e.g., IMF, 2013; Fendoglu, 2017; De Schryder and Opitz, 2020), we
use the ‘‘credit gap’’ to assess the cyclical movements in credit and potential build-up of excessive credit expansion. The
credit gap is defined as the deviation of the actual credit-to-GDP ratio from its trend (long-run) value. Calculation of the
gap, therefore, requires estimation of the trend value of the credit to GDP ratio. Following Baba et al. (2020) and Galán
(2019), we use the one-sided recursive Hodrick–Prescott (HP) filter with λ = 25,000 for approximation of the trend value
1 We exclude the foreign direct investment flows from the analysis given their well-documented different effect (‘‘the good cholesterol’’) on the
credit cycles relative to other types of capital flows (see e.g., Albuquerque, 2003; Ostry et al., 2011).
2 Credit, macroeconomic, macroprudential, and financial liberalisation data are available for a longer, 1995–2018 period. However, the use of
macroprudential tools has become more prevalent from the early 2000s and we focus our analysis to this period. Nevertheless, the length of the
sample is still long enough to provide sufficient information about the economic relations of interest.
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Fig. 1. Key variables: Notes The top left chart shows the calculated cross-country average credit gap (solid line) and cross-country credit gap
interquartile range (shaded area). The credit gap is estimated as the deviation of credit-to-GDP ratio from its long-run (trend) value. The trend
is approximated using recursive one-sided HP filter. The top right chart shows the calculated cross-country average (solid line) and cross-country
interquartile range (shaded area) of the cumulative number of net tightening macroprudential measures (all measures excluding changes in the
reserve requirements). The bottom left (right) chart shows the calculated cross-country average (solid line) and cross-country interquartile range
(shaded area) of the presence of capital inflows (outflows) restrictions in nine categories of capital flows discussed in the main text. Sources for all
variables are discussed in the text and reported in Table 1.
in our baseline measurement of the credit gap.3 The choice of lambda reflects the empirical evidence on the duration
of financial cycles, which is larger relative to the real business cycles for which λ = 1600 is the common choice at a
quarterly frequency (Claessens et al., 2012; Drehmann and Tsatsaronis, 2014), but is generally lower than the 30 years
assumed in the BIS estimates Jordà et al. (2016). In calculating the trend, we use the credit data since the first quarter
of 1995 to initiate the filter. To examine the importance of using the HP filter for the trend estimation, we construct an
alternative measure of credit gap by approximating the trend using a cubic-trend time polynomial (following Garcia-Cicco
et al., 2010) and calculating the gap again as the deviation from the estimated trend.
The positive (negative) values of the estimated gap imply that the current level of credit is above (below) the stable
long-run level of credit. Fig. 1 (top left panel) plots the estimated cross-country average credit gap in our sample of EM
economies together with the interquartile range. The gap, on average, was strongly negative in the aftermath of the Asian
crisis and reverted to positive values for all EM economies after six years, reaching its peak at the beginning of the global
financial crisis. In line with Jordà et al. (2016), the duration of the credit cycle is longer relative to the real business cycles
and approximately 10 years in our sample
3 The standard two-sided HP filter has several weaknesses well-discussed in the literature (see, e.g., Cogley and Nason, 1995; Fukac and Pagan,
2010; Hamilton, 2018). The filter may produce spurious dynamic relations in part due to the use of artificially generated forecast values in estimation.
The obtained estimates of the trend (and therefore of the cyclical component) are also potentially sensitive to the length of the time series, the
choice of the smoothing parameter and the end point of the sample. We alleviate some of these concerns with the use of one-sided recursive filter.
In addition, in specification checks we use alternative measure of the trend as well as the credit growth as the dependent variable with no effect
on the obtained results.
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3.1.2. Macroprudential measures

The data on implemented macroprudential measures is from the IMF’s Integrated Macroprudential Policy (iMaPP)
database, originally constructed by Alam et al. (2019). The database is based on the IMF’s Macroprudential Policy Survey
and other available sources and provides information on the micro and macro-prudential measures implemented by each
country over the 2000–2018 period along 17 different types of measures: countercyclical capital buffer requirement;
capital conservation buffer requirements; general capital requirements; caps on leverage ratios; time-varying/dynamic
loan-loss provisioning; limits on the loan volumes or their growth rates; additional loan restrictions; limits on foreign
currency lending; levy/tax on financial institutions; liquidity measures; limits on net or gross open foreign exchange
positions and other currency mismatch regulations; capital or liquidity surcharges on systemically important financial
institutions (SIFI); reserve requirements; caps on loan-to-value (LTV) ratio; limits to the debt-service-to-income ratio
(DSTI) and the loan-to-income (LTI) ratio; limits to the loan-to-deposit (LTD) ratio and penalties for high LTD ratios; and
other measures. The LTV, DSTI, LTI, and LTD measures are focused directly on the borrowers, while other measures target
financial institutions. The dataset reports the number of tightening and easing actions within each calendar month for
each measure.
We construct an aggregate index of net cumulative macroprudential policy stance by summing all actions within
all categories within a quarter, excluding the reserve requirement policy given its dual character in EM economies as
(additional) monetary policy instrument. We use an aggregate index of macroprudential measures in estimations in line
with the fact that the potential excess credit growth in association with the financial liberalisation may arise due to
both the bank’s and the borrower’s behaviour. The higher values of the index imply the larger number of implemented
macroprudential measures.
Fig. 1 (top right panel) shows that, on average, the EM countries in our sample have increased their usage of
macroprudential measures over the 2000–2018 period. The average overall net usage of macroprudential instruments
is below one in 2000, and the cumulative number increases to above 26 in 2018, with an average annual increase in the
number of implemented net tightening measures being close to 2.5 from 2010. The developments reflect the stronger
emphasis of policymakers on preventing financial sector deficiencies, which were identified as the important drivers
behind the recent global financial crisis. There are also notable differences between the countries, where up to 25% of the
countries in our sample have implemented less than 5 net tightening of macro-prudential measures before 2016, whilst, at
the same time, several other countries implemented more than 20 measures over the same period. The observed country
heterogeneity and time variation in macroprudential stances contribute to more accurate identification of the effects on
credit cycles in the empirical analysis.
3.1.3. Financial liberalisation/capital restrictions data

The data on the extent of financial liberalisation is based on Fernandez et al. (2015) – FKRSU. The dataset is maintained
on professor Uribe’s website.4 The dataset is based on the IMF’s Annual Report on Exchange Arrangements and Exchange
Restrictions (AREAER) and provides annual data on the presence (absence) of capital flow restrictions for ten individual
categories of flows (assets): portfolio equity; portfolio bond; money market; collective investment; commercial credit;
financial credit; guarantees, sureties and financial backup facilities; derivatives; real estate; and direct investment. In line
with the IMF’s methodology, data on restrictions do not include the measures implemented with the macroprudential
aim [‘‘capital flow management’’ (CFM) measures in the IMF’s terminology], thereby allowing us to discriminate between
the two in our empirical analysis. Within each category, separate information on restrictions is provided for inflows and
outflows, as well as the joint score. The score for each category is obtained by averaging the assigned score for more
granular subcategories, 32 of which are provided in AREAER. For these granular subcategories, the authors assign a score
of 1 in the presence of a restriction and a 0 when there are no restrictions. The presence of restrictions is determined
based on the set of pre-defined rules for interpreting the information provided in AREAR (following Schindler, 2009); for
more detailed information, please see Fernandez et al. (2015).
The dataset expands on previously constructed Quinn (1997) and Schindler (2009) indices of capital restrictions, typical
benchmarks in the earlier empirical literature examining the effects of capital flow liberalisation. The FKRSU improves
upon the previous datasets by expanding the coverage of countries and the types of capital flows, as well as by lengthening
the available data over time (time dimension). Fernandez et al. (2015) also showed that capital restrictions are acyclical
(i.e., do not respond to the local business cycle) and have a relatively small standard deviation at annual frequencies.
We exclude restrictions on foreign direct investment given their different characteristics concerning the build-up of
credit fragilities and construct an index of capital restrictions, which is the average of total restrictions in nine remaining
categories. We construct separate indices for the liberalisation of capital inflows and capital outflows. Higher index values
indicate higher levels of capital restrictions within a given category. In our baseline estimates, following Zeev (2017), we
use the same index value for each quarter within the year. In additional specification checks, we interpolate the annual
values of indices to quarterly frequency using cubic splines. In line with Fernandez et al. (2015) and Zeev (2017), the
results are not sensitive to this choice. Fig. 1 lower panel shows time evolution of the average cross-country level of
restrictions together with the interquartile range. We can observe the general trend towards liberalisation among the EM
economies before the global financial crisis and tightening, in some economies transitory, capital controls since then. The
4 www.columbia.edu/~mu2166/fkrsu/.
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Table 1
Descriptive statistics.
Variables mean median st. dev p25 p75 Obs Sources
Dependent variables
Credit gap (based on HP filter) 0 0.09 6.12 −3.59 3.37 1088 BIS
Credit gap (based on cubic polynomial) 0 −0.08 5.67 −2.98 2.93 1088 BIS
Credit growth (year-on-year) 2.80 2.09 7.31 −1.77 7.06 1088 BIS
Underlying policy variables
Macroprudential policy index 9.57 5 11.85 1 14 1088 IMF, iMaPP
Controls on capital inflows index 0.49 0.5 0.28 0.27 0.69 1088 Fernandez et al. (2015)
Controls on capital outflows index 0.62 0.66 0.29 0.44 0.83 1088 Fernandez et al. (2015)
Control variables
Inflation (yoy): change −0.07 −0.03 1.59 −0.59 0.51 1088 IMF: IFS
GDP growth (yoy, 2 year average) 4.03 4.06 2.74 2.44 5.43 1088 IMF: IFS; Chang et al. (2015)
GDP growth (yoy) 4.03 4.26 3.67 2.2 6.01 1088 IMF: IFS ; Chang et al. (2015)
Real exchange rate (period end, log) 4.52 4.54 0.14 4.45 4.61 1088 BIS
Real exchange rate (period end, yoy) 0.37 0.67 8.08 −4.39 5.23 1088 BIS
Central bank policy rate (period end, change) 6.43 5.5 5.41 3.25 7.75 1088 BIS
Central bank policy rate (period average, change) 6.46 5.5 5.47 3.25 7.81 1088 BIS
Notes: The Table reports variables used in empirical analysis (column 1), their sample average (column 2), median (column 3), 25th quantile (column
4), 75th quantile (column 5), the number of observations (column 6) and data sources (column 7). The top panel reports summary statistics for
alternative measures of dependent variable. Credit gap is estimated as the deviation of credit-to-GDP ratio from its long-run (trend) value. The
trend is approximated using recursive one-sided HP filter (row 3) and cubic polynomial (row 4). The credit growth is computed as the year-on-year
change in the credit to GDP ratio. The middle panel reports summary statistics for data underlying construction of policy variables discussed in
Sections 3.1.1 and 3.1.2. Macroprudential policy index is the cumulative sum of within quarter net tightening policy actions in 16 categories discussed
in the main text. Controls on capital inflows (outflows) index is the average number of restrictions on foreign (domestic) resident capital flows in
nine categories discussed in the main text. The lower panel reports summary statistics for control variables. Yoy denotes taking the difference relative
to the corresponding quarter of the previous year. The change denotes taking the difference between the subsequent quarters. The two-year average
is computed as the rolling average of past eight quarters. The central bank policy rate is reported as the end of the quarter value (period end) and,
alternatively, as the within quarter average of monthly policy rates (period average). The data is for 2020Q1–2018Q4 period for 16 EM economies
outlined in the main text (N = 16, T = 64).
large width of the interquartile range suggests a significant degree of heterogeneity between the countries in the scope
and the pace of liberalisation. The data also shows that EM countries in our sample typically liberalised capital inflows
faster than the outflows.
3.1.4. Confounding factors

We include several control variables which may affect the credit dynamics through a variety of channels discussed in
the literature: monetary policy stance, aggregate demand conditions, balance sheet effects (Fendoglu, 2017; De Schryder
and Opitz, 2020; Nier et al., 2020). We use the central bank policy rate as a proxy for monetary policy stance. We use
the growth of quarterly year-on-year (y-o-y) inflation, quarterly year-on-year GDP growth, and average quarterly y-o-
y GDP growth as proxies for aggregate demand conditions. We use the real exchange rate as a proxy for the balance
sheet effects, which may be more significant in EM economies relative to developed economies. The real exchange rate is
defined such that higher values imply a real appreciation of the exchange rate. Data for macroeconomic variables which
display seasonality is seasonally adjusted using the X-13 ARIMA approach. The sources for all variables and the descriptive
statistics are reported in Table 1.
3.2. Econometric methodology
The estimates are based on the dynamic panel fixed-effect regressions. In particular, we estimate the following
specification:
yi, t = αi + µt + β MPPi, t −k + δ HLi, t −k + γ MPPi, t −k HLi, t −k + φ yi, t −1 + Π Xi, t −p + ui, t (1)
The dependent variable yit is the measure of a credit gap in country i at time t. We include country-fixed effects
αi and year-fixed effects µt to control for time-invariant, country-specific drivers of credit dynamics and global shocks,
respectively. The vector Xi,t −p includes time-varying covariates (policy rate, inflation, GDP growth, and real exchange
rate5 ), which may affect both credit dynamics and policy variables. The covariates enter the specification with a lag to
mitigate simultaneity concerns.
5 The asset price growth (of equity and/or house prices) is another potential confounding factor. However, the available data for these variables
at quarterly frequency for the EM economies was not sufficiently comprehensive to permit the variables to be included in the analysis. Nevertheless,
we control for this and potentially other omitted variables in regressions with interactive fixed effects.
608
Fig. 2. The macroprudential policy variable for example countries: Notes The charts show the accumulated number of net policy changes over the
sample (solid line) as well as the information underlying the construction of the dummy MPP variable for the state of the tight macroprudential
regulation. For each country, the variable takes value one over the periods which are shaded in the graph and zero otherwise. The y-axis displays
the accumulated number of net policy changes. The height of the shaded area does not have the interpretation and is shown for better visualisation..
The primary variables of interest in the specification (1) are the macroprudential regulation, MPP i,t −k, capital flows
liberalisation HLi,t −k, and their interaction term. Please recall from Section 3.1.2 that raw country-level macroprudential
data is in the form of an index of net cumulative macroprudential policy stance (sum across all policy dimensions) at a
given point in time. We define the macroprudential regulation variable MPP i,t −k as the dummy variable, which captures
the state of tight macro-prudential framework in country i, k quarters before the actual realisation of the credit gap. To take
into account the different pace of net tightening in macroprudential regulation across countries and over time, we follow
the approach similar to Zeev (2017) (in a different context) and define MPP i,t −k to take the value one if the country
i at time t-k ranks above the cross-sectional median in terms of the level (index) of macroprudential regulation and
zero otherwise. We use k lags distance to minimise simultaneity concerns and to allow for the fact that the effects of
changes in macroprudential regulation on credit dynamics are not immediate and tend to materialise over the horizon of
6–12 quarters (Forbes et al., 2015; Frost et al., 2020; De Schryder and Opitz, 2020). In addition, the construction of tight
macroprudential regulation state variable minimises the reverse causality concerns (that the macroprudential regulation
in country i is tightened in response to widening credit gap in country (i since the selection to the state of tight regulation
at each point in time t is determined by the level of macroprudential regulation in all countries at time t. Fig. 2 displays the
macroprudential index, for example, countries (Colombia and Mexico) together with MPP i,t −k variable. For each country,
the variable takes value one over the periods which are shaded in the graph and zero otherwise.
Our approach, however, shares a limitation with previous studies. The measures of macroprudential policy stance
based on the iMaPP database (or any other available source) capture the direction of the policy change (the policy is
tightened/eased/no change), but not the intensity of the change. This measurement error in the constructed macro-
prudential index may also spill over to our measure of the state of tight macro-prudential framework MPP i,t −k if the
measurement error affects the cross-country rankings at different points in time. Nevertheless, the measurement error
is likely to attenuate the effect of macroprudential policies on the credit cycle (Forbes, 2020); hence, the evidence of a
statistically significant effect would provide even stronger estimates in favour of the effectiveness of macroprudential
policies.
In the same way the macroprudential variable MPP i,t −k is constructed (relative to the cross-sectional median), we
define HLi,t −k as the state of high capital flow liberalisation (low capital controls) in country i, based on the level of the
capital restrictions index k quarters before the actual realisation of credit gap. We construct separate HLi,t −k measures for
capital inflows and capital outflows.
To capture nonlinear (conditional) effects, the specification (1) includes the interaction term MPP i,t −k HLi,t −k . The
coefficient γ next to the interaction term thus reports an additional effect of the tightness of the macroprudential
framework on the difference in the credit gap fluctuations between the economies with a higher and lower degree
of capital flow liberalisation, controlling for all other drivers of credit growth. In other words, the sum of coefficients
δ + γ provides an estimate of the effect of a higher degree of capital flow liberalisation on the credit cycle when the
macroprudential framework is tight.
Given the relatively large time-series dimension, we use the standard fixed effect estimator to estimate the parameters
of the baseline specification. The inclusion of country fixed effects controls for factors, such as legal origin, the initial
level of economic development, and social norms that may influence credit activity. In this way, some of the additional
endogeneity concerns are mitigated as the consistency of the fixed effect estimator allows for correlation with the
609
persistent component of the error term and requires that the policy variables are uncorrelated only with innovations
in the omitted time-varying factors and shocks to the dependent variable that enter the error term (Wooldridge, 2010).
In addition, year fixed effects account for global shocks that are common to all economies.
However, the standard fixed effect estimator is biased and inconsistent in the presence of the lagged dependent variable
when the time dimension of the panel is small. Even though the potential bias vanishes when the time dimension is
relatively long (for simulation evidence, see, e.g., Judson and Owen, 1999), as is the case in our sample, we provide an
additional specification check using the bias-corrected least square dummy variable (LSDV) estimator (Bun and Kiviet,
2003; Bruno, 2005). We use a higher-order approximation of the bias, of order O(N −1 T −1 ), and initialise the procedure
with a standard Blundell–Bond estimator.
Another potential concern is that the empirical specification may not include all relevant drivers of the credit dynamics
that may change both, over time and between the countries, which may also be correlated with the policy variables
(macroprudential regulation and capital flow liberalisation), such that the estimated parameters for these variables may
falsely capture some of the omitted variables’ effects on the credit dynamics. To mitigate these concerns while also
controlling for the dynamic character of the panel, we estimate another specification where we replace country-fixed
effects αi and year-fixed effects µt with the interactive fixed effects λi ft (Moon and Weidner, 2017):
yi, t = vi,t + β MPPi, t −k + δ HLi, t −k + γ MPPi, t −k HLi, t −k + φ yi, t −1 + Π Xi,t −p + ui, t
(2)
vi,t = λi ft
The interactive fixed effects capture all time and country varying unobserved factors, potentially correlated with the policy
variables, affecting the credit dynamics. The estimated parameters in the specification (2) are thus less likely to suffer from
the potentially omitted variable bias.
4. Results
4.1. Baseline specification
Table 2 presents the estimates of the baseline empirical specification, which uses the credit gap under the recursive
HP trend as the dependent variable. In line with the empirical evidence on the dynamic effectiveness of macroprudential
policies (Forbes et al., 2015; Frost et al., 2020; De Schryder and Opitz, 2020), we set k = 8 and, for consistency, maintain
the same time horizon for capital flows liberalisation measures. The standard errors are estimated using the Driscoll and
Kraay (1998) methodology, which controls for serial and spatial correlation in the error term, which can be expected in
a cross-country panel with financial data like ours.
We start the analysis by considering the constrained version of Eq. (1), which includes only the macroprudential
variable in the specification. The obtained results (Column 1 and 2) confirm the existing results on the effectiveness
of macroprudential policies (Lim et al., 2011; Cerutti et al., 2017; Fendoglu, 2017; De Schryder and Opitz, 2020) – tighter
macroprudential policy is associated with a lower positive credit gap. The effect is statistically significant and ranges
between −0.46% and −0.53% of GDP on average, at the quarterly frequency, depending on whether we include year effects
to the specification or not. After confirming that our approach can replicate the general results in the literature concerning
unconditional effects of macroprudential measures, we move to our primary question of interest – the conditionality in the
relationship between capital flows liberalisation, macroprudential policies, and credit cycles — and estimate the full
specification (1).
Columns 3 and 4 in Table 2 report the estimates of specification, which considers the liberalisation of capital inflows.
The results imply that liberalisation of capital inflows in economies with the loose prudential framework, on average,
amplifies the credit dynamics — the estimated coefficient for the HLi,t −k variable is positive and statistically significant
with or without controlling for potential time-varying factors, which can influence the credit dynamics in all economies
(the year effects).
However, the estimated coefficients for the interaction term are negative and statistically significant, indicating
significant differences in the relation between capital inflows liberalisation and the credit cycle depending on the state
of macroprudential regulation. The bottom row of Table 2 reports the sum of the estimated coefficient for HLi,t −k and
MPP i,t −k HLi,t −k variables. The estimated sum is close to zero and not statistically significant, implying that the liberalisation
of capital inflows does not significantly affect the excessive credit dynamics in economies with the tight macroprudential
framework. Finally, we find weak evidence that macroprudential measures are effective in the state of low capital
inflows liberalisation — the estimated coefficient for MPP i,t −k variable is negative but statistically significant only in
the specification without year effects. However, the macroprudential measures are effective in the state of high capital
inflows liberalisation, judged by the statistically significant negative estimate for the sum of the coefficients for two
macroprudential variables (MPP i,t −k and MPP i,t −k HLi,t −k ).
Our empirical results provide a new angle on the relationship between the liberalisation of capital flows and excessive
credit expansions in the EM economies and can potentially explain often conflicting findings in the earlier empirical
literature. We find that capital inflows liberalisation can heighten credit expansion in economies with a weak prudential
framework. This is consistent with, e.g., Hutchinson and Glick (2001), Reinhart and Reinhart (2008), and Terrones and
Mendoza (2008), who found the amplifying effect of credit flows on excessive risk-taking precisely over the periods
610
Table 2
Estimates of the baseline empirical specification.
Variable 1 2 3 4 5 6
Credit gap (lagged) 0.874*** 0.850*** 0.872*** 0.847*** 0.875*** 0.850***
(0.19) (0.022) (0.019) (0.022) (0.019) (0.023)
Inflation (yoy, lagged change) 0.067** 0.049* 0.066** 0.047 0.069** 0.048*
(0.033) (0.029) (0.033) (0.029) (0.033) (0.029)
GDP growth (yoy, 2 year average, lagged) 0.188*** 0.165*** 0.195*** 0.160*** 0.190*** 0.165***
(0.032) (0.027) (0.035) (0.031) (0.034) (0.029)
Real exchange rate (period end, log & lagged) 3.440*** 3.239*** 3.653*** 3.533*** 3.521*** 3.347***
(0.724) (0.788) (0.742) (0.804) (0.721) (0.829)
Policy rate (period end, lagged change) 0.024 −0.003 0.015 −0.026 0.017 −0.002
(0.02) (0.024) (0.019) (0.026) (0.020) (0.026)
MPP (lagged 8 periods) −0.533*** −0.463*** −0.325* −0.084 −0.504*** −0.449**
(−0.147) (0.160) (0.169) (0.170) (0.165) (0.175)
HL inflows (lagged 8 periods) 0.703** 1.083***
(0.347) (0.329)
MPP × HL inflows (lagged 8 periods) −0.812* −1.320***
(0.441) (0.445)
HL outflows (lagged 8 periods) 0.402 0.186
(0.305) (0.292)
MPP × HL outflows (lagged 8 periods) −0.350 −0.240
(0.351) (0.352)
Sum of coefficients for HL and MPP × HL −0.109 −0.237 0.052 −0.054
Wald test (p-value) 0.701 0.419 0.881 0.869
Sum of coefficients for MPP and MPP × HL −1.137*** −1.404*** −0.854** −0.689*
Wald test (p-value) 0.003 0.001 0.015 0.061
Year effects No Yes No Yes No Yes
Countries 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088
Notes: The Table shows estimated coefficients using standard fixed effect estimator with Driscoll and Kraay (1998) standard errors in parentheses.
Dependent variable in all regressions is the credit gap estimated as the deviation of credit-to-GDP ratio from its long-run (trend) value. The trend
value is estimated using HP filter. All regressions include country-fixed effects. MPP denotes dummy variable for the state of the tight macroprudential
regulation. HL inflows (outflows) denotes dummy variable for the state of high liberalisation of foreign (domestic) resident flows. The construction
of variables is discussed in the main text. Wald test (p-value) row in the Table reports the p-value for the test of the null hypothesis that the sum
of the two coefficients in the row above is equal to zero. Data sources for all regressors are reported in Table 1.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.
when macroprudential tools were uncommon and rarely used (i.e., the state of the loose macroprudential framework
was prevailing). On the other hand, the studies that use more recent data (e.g., Klein, 2012) often found limiting effects
of capital flows on the credit dynamics. This lack of evidence may reflect the mixing of countries with a tight and
lax macroprudential framework in the sample, biasing the results towards finding no effect, which we avoid with our
conditional analysis.
Our empirical results are also consistent with new theoretical literature that study different types of externalities
created by (volatile) capital flows and the role of macroprudential policies and capital controls in dampening these
processes. Korinek and Sandri (2016) showed that in economies where overborrowing is driven by a boom and bust cycle
in asset prices, tighter macroprudential regulation is sufficient to alleviate the externality effects of capital flows and
produce constrained efficient equilibrium. They also showed that using both macroprudential policy and capital controls
might be desirable to circumvent financial fragilities if the exchange rate fluctuations, rather than the asset prices, are
the primary source of externalities. Mendoza and Rojas (2019), in addition, showed that in the presence of non-negligible
liability dollarisation, macroprudential policies might be more potent relative to capital controls even when the exchange
rate fluctuations are the primary source of externalities. Our findings thus confirm empirically that macroprudential
policies may be sufficient to mitigate the impact of capital inflows liberalisation on the credit cycle.
The results for capital outflows liberalisation (Columns 5 and 6) differ to some extent relative to capital inflows. The
estimated coefficient for the HLi,t −k variable is positive but not statistically significant, suggesting no credit accelerating
effect from the liberalisation of domestic residents’ capital flows. The estimates also imply that macroprudential policy is
effective in constraining the credit cycle for both economies with high or low levels of liberalisation of capital outflows.
The obtained difference in estimated effects on the credit cycle between the liberalisation of capital inflows and outflows
may reflect the different character and volume of domestic resident flows in EM economies, which tend to be smaller in
magnitude as well as less impacting domestic asset prices and aggregate demand relative to foreign inflows.
Before proceeding to various specification checks, we explore the plausibility of the estimated coefficients for the
control variables. All variables have expected estimated signs: lagged increase in aggregate demand (captured by inflation
and average GDP growth) and real exchange rate appreciation is associated in a statistically significant manner with the
611
Table 3
Estimates with alternative measure of the dependent variable.
Variable\dependent variable Credit gap Credit gap Credit gap Credit Credit Credit
(cubic trend) (cubic trend) (cubic trend) growth growth growth
(0.028) (0.029) (0.029) (0.023) (0.022) (0.024)
Inflation (yoy, lagged change) 0.065*** 0.065*** 0.067*** 0.236*** 0.237*** 0.232***
(0.019) (0.020) (0.020) (0.053) (0.056) (0.057)
(0.037) (0.038) (0.037) (0.077) (0.080) (0.078)
(0.836) (0.834) (0.885) (0.957) (1.064) (0.957)
Policy rate (period end, lagged change) −0.035 −0.052* −0.038 −0.142 −0.179* −0.147
(0.025) (0.029) (0.028) (0.100) (0.101) (0.111)
MPP (lagged 8 periods) −0.416*** −0.253* −0.470*** −0.942*** −0.407 −1.022***
(0.130) (0.146) (0.150) (0.250) (0.340) (0.298)
HL inflows (lagged 8 periods) 0.818*** 1.554*
(0.255) (0.890)
MPP × HL inflows (lagged 8 periods) −0.754** −1.847*
(0.356) (1.11)
(0.307) (0.814)
MPP × HL outflows (lagged 8 periods) 0.037 0.121
(0.290) (1.138)
Sum of coefficients for HL and MPP × HL 0.064 0.282 −0.293 0.324
Wald test (p-value) 0.821 0.307 0.644 0.557
Sum of coefficients for MPP and MPP × HL −1.007*** −0.433 −2.254*** −0.901***
Wald test (p-value) 0.002 0.149 0.002 0.279
Year effects Yes Yes Yes Yes Yes Yes
Countries 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088
Dependent variable in Columns 1–3 is the credit gap estimated as the deviation of credit-to-GDP ratio from its long-run (trend) value. The trend value
is estimated using cubic time polynomial. Dependent variable in Columns 4–6 is the year-to-year credit growth. All regressions include country-fixed
effects. MPP denotes dummy variable for the state of the tight macroprudential regulation. HL inflows (outflows) denotes dummy variable for the
state of high liberalisation of foreign (domestic) resident flows. The construction of variables is discussed in the main text. Wald test (p-value) row
in the Table reports the p-value from the test of the null hypothesis that the sum of the two coefficients in the row above is equal to zero. Data
sources for all regressors are reported in Table 1.
positive credit gap over the subsequent period. The short-term policy rate change is associated with the decrease in
the gap, although the estimated coefficient is not statistically significant. We also confirm the previous findings on the
persistence in the credit gap and the need to use dynamic specification in the empirical analysis.
4.2. Specification checks
We evaluate the specifications presented from various perspectives. First, we consider the alternative measure of the
credit gap based on a cubic time polynomial estimate of the trend as the dependent variable. Table 3, Columns 1–3,
show that our results are not sensitive to the choice of the method for the trend approximation in the construction of
the credit gap.6 The estimated coefficients for the key variables of interest maintain their estimated signs and statistical
significance. The only difference is that we find stronger evidence that macroprudential measures are effective also in
the state of low capital inflows liberalisation as the estimated coefficient for MPP i,t −k variable is statistically significant in
both specifications. We estimate an additional set of regressions with the credit growth (year-on-year) as the dependent
variable (Table 3, Columns 4–6). The obtained results are very similar to those from the baseline specification.
Next, we consider alternative estimation methods. Table 4 presents the estimates using the alternative, bias-corrected
least square dummy variable (LSDV) estimator (Bun and Kiviet, 2003; Bruno, 2005). The standard errors are estimated
using clustered bootstrap with 500 repetitions. The obtained results are very similar to the baseline, in line with the large
time dimension of the sample, which minimises the extent of the potential bias in the standard fixed estimator.
Table 5 reports the estimates using the dynamic interactive fixed-effect estimator (Moon and Weidner, 2017). We
use a bias-corrected version of the estimator, which takes into account time and cross-sectional heteroscedasticity and
6 We only report the results from the regressions which include the year effects. The results from regressions without year effects are similar to
the benchmark estimates presented in Table 2.
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Table 4
Estimates using the alternative, bias-corrected least square dummy variable (LSDV) estimator.
Variable 1 2 3 4 5 6
(0.016) (0.018) (0.014) (0.018) (0.016) (0.019)
Inflation (yoy, lagged change) 0.065 0.048 0.063 0.049 0.067 0.049
(0.050) (0.051) (0.056) (0.057) (0.058) (0.057)
(0.039) (0.049) (0.043) (0.052) (0.049) (0.061)
(0.803) (0.794) (0.837) (0.872) (0.881) (0.923)
Policy rate (period end, lagged change) 0.025 −0.004 0.017 −0.028 0.018 −0.004
(0.027) (0.029) (0.023) (0.031) (0.030) (0.037)
MPP (lagged 8 periods) −0.461** −0.393* −0.267 −0.012 −0.424 −0.368*
(0.229) (0.232) (0.257) (0.274) (0.281) (0.221)
HL inflows (lagged 8 periods) 0.669* 1.130**
(0.399) (0.441)
MPP × HL inflows (lagged 8 periods) −0.766* −1.339**
(0.452) (0.564)
(0.438) (0.445)
MPP × HL outflows (lagged 8 periods) −0.432 −0.309
(0.526) (0.545)
Sum of coefficients for HL and MPP × HL −0.097 −0.209 −0.022 −0.058
Wald test (p-value) 0.832 0.653 0.898 0.959
Sum of coefficients for MPP and MPP × HL −1.033** −1.351*** −0.856 −0.677*
Wald test (p-value) 0.025 0.006 0.208 0.094
Year effects No Yes No Yes No Yes
Countries 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088
Notes: The Table shows estimated coefficients using bias-corrected least square dummy variable (LSDV) estimator with clustered bootstrap standard
errors in parentheses. Dependent variable in all regressions is the credit gap estimated as the deviation of credit-to-GDP ratio from its long-run
(trend) value. The trend value is estimated using recursive HP filter. All regressions include country-fixed effects. MPP denotes dummy variable
for the state of the tight macroprudential regulation. HL inflows (outflows) denotes dummy variable for the state of high liberalisation of foreign
(domestic) resident flows. The construction of variables is discussed in the main text. Wald test (p-value) row in the Table reports the p-value from
the test of the null hypothesis that the sum of the two coefficients in the row above is equal to zero. Data sources for all regressors are reported
in Table 1.
time-serial correlation in the error term. Since we include interactive effects, we do not report separate estimates with
and without year effects as we did in previous tables (the interactive effects now absorb the time effects). The obtained
results confirm earlier evidence on the conditionality in the relation between capital flows liberalisation, the tightness
of macroprudential regulation, and the credit dynamics as the estimated signs of the coefficients for the policy variables
and their statistical significance is unchanged relative to the baseline specification.
Further, we study the sensitivity of our baseline results to the horizon at which we estimate the relation between the
key variables and the credit gap. In line with the empirical evidence on the dynamic effectiveness of macroprudential
policies (Forbes et al., 2015; Frost et al., 2020; De Schryder and Opitz, 2020), we consider alternative lags of 1, 4,
and 12 quarters. For the sake of brevity, Table 6 reports only the results from the estimation of the full specification.
For comparison convenience, the first two columns repeat our baseline estimates, which use the lag of 8 quarters in
estimations. We find that the conditionality in the relation between macroprudential regulation, liberalisation of capital
inflows, and credit cycles is present at alternative horizons of 1 (column 3), 4 (column 5), and 12 quarters (column 7) as
the estimated coefficient for the liberalisation variable HL and the interaction term MPP x HL remain statistically significant
and with the same sign. The results from the Wald test of the sum of the two coefficients also confirm earlier findings. In
addition, we do not find statistically significant effects from the liberalisation of capital outflows on the credit dynamics
also at alternative time horizons (columns 4, 6, and 8). In the latter regressions, the coefficient for macroprudential
regulation is not statistically significant at shorter horizons, in line with earlier empirical evidence.
Next, we exploit alternative definitions of the macroprudential policy variable. We defined the macroprudential policy
variable as a dummy variable capturing how tight a country’s macroprudential policy is relative to the cross-sectional
median. By constructing the variable in this way, we minimise the reverse causality concerns (that the macroprudential
regulation in country i is tightened in response to widening credit gap in country (i) since the selection to the state of
tight regulation at each point in time t is determined by the level of macroprudential regulation in all countries at time
t. Table 7 presents the results from the sensitivity analysis when we use only time-series variation in the construction of
the macroprudential policy variable. Columns 1–4 display the results when MPP i,t −k is defined to take the value one if
613
Table 5
Estimates using the dynamic interactive fixed effect estimator.
Variable 1 2 3
Credit gap (lagged) 0.900*** 0.890*** 0.912***
(0.018) (0.018) (0.017)
Inflation (yoy, lagged change) 0.056 0.015 0.068**
(0.036) (0.029) (0.032)
GDP growth (yoy, 2 year average, lagged) 0.11*** 0.098*** 0.121***
(0.033) (0.034) (0.027)
Real exchange rate (period end, log & lagged) 0.899 2.508*** 1.01
(3.855) (0.706) (3.45)
Policy rate (period end, lagged change) −0.012 −0.039** −0.022*
(0.012) (0.019) (0.001)
MPP (lagged 8 periods) −0.541*** 0.084 −0.341**
(0.235) (0.173) (0.146)
HL inflows (lagged 8 periods) 0.913**
(0.338)
MPP × HL inflows (lagged 8 periods) −1.097***
(0.365)
HL outflows (lagged 8 periods) 0.442
(0.283)
MPP × HL outflows (lagged 8 periods) −0.265
(0.359)
Sum of coefficients for HL and MPP × HL −0.184 0.101
Wald test (p-value) 0.384 0.421
Sum of coefficients for MPP and MPP × HL −1.013*** −0.605***
Wald test (p-value) 0.001 0.007
Countries 16 16 16
Observations 1088 1088 1088
Notes: The Table shows estimated coefficients using bias-corrected interactive fixed effect estimator with standard errors robust to time and cross-
sectional heteroscedasticity and serial correlation in errors in parentheses. Dependent variable in all regressions is the credit gap estimated as the
deviation of credit-to-GDP ratio from its long-run (trend) value. The trend value is estimated using recursive HP filter. MPP denotes dummy variable
for the state of the tight macroprudential regulation. HL inflows (outflows) denotes dummy variable for the state of high liberalisation of foreign
(domestic) resident flows. The construction of variables is discussed in the main text. Wald test (p-value) row in the Table reports the p-value from
the test of the null hypothesis that the sum of the two coefficients in the row above is equal to zero. Data sources for all regressors are reported
in Table 1.
the cumulated index of net policy changes in country i at time t-k is above its five-year moving average, indicating tighter
policy stance relative to its trend (observed in Fig. 1). Columns 5–8 report the results when MPP i,t −k takes the value one
if the cumulated index of net policy changes in country i at time t-k is above its time-series average. The previously
estimated conditionality in the relationship between macroprudential regulation, liberalisation of capital inflows, and
credit cycles is also captured using alternative definitions of the macroprudential policy variable. We also repeated the
same sensitivity exercise with the capital liberalisation variable, defining the state of high liberalisation when the value
of the capital restrictions index in a given year is leading (is lower than) the index’s moving average value. The results
are fully in line with our baseline estimates and are available from the authors.
Finally, we confirm that the main results are not sensitive to the construction of control variables. Table 8 reports
estimates when we use alternative measures of control variables: lagged year-on-year GDP growth (columns 2 and 6);
lagged year-on-year change in the real exchange rate (columns 3 and 7); and lagged change in the policy rate (defined
as the period average, columns 4 and 8). For ease of comparison, columns 1 and 5 repeat the baseline results. The results
are qualitatively and often quantitatively very close to the baseline.
In summary, the results from various specification checks confirm that our results are not sensitive to an alternative
definition of the dependent variable, alternative estimation methods, alternative horizon at which the relationship
between the credit gap and the policy variables is estimated, alternative definitions of the macroprudential policy variable,
and high liberalisation variable or alternative definitions of the control variable set.
5. Concluding remarks
Unconventional monetary policies in advanced economies and volatile capital flows in and out of emerging markets
over the previous decade have posed significant challenges for safeguarding financial stability in these economies. While
the liberalisation of capital flows can provide multiple direct and indirect benefits (Kose et al., 2009) for the short-
term and the long-term growth of the economy, the liberalisation can generate new risks, including higher sensitivity
of the domestic economy to global shocks and higher vulnerability to financial crises, which together can exacerbate
614
Table 6
Estimates with macroprudential and liberalisation lags of 1, 4 and 12 quarters.
Variable 1 2 3 4 5 6 7 8
Credit gap (lagged) 0.847*** 0.850*** 0.848*** 0.845*** 0.848*** 0.848*** 0.846*** 0.846***
(0.021) (0.022) (0.021) (0.023) (0.022) (0.022) (0.022) (0.022)
Inflation (yoy, lagged change) 0.047** 0.048** 0.055** 0.047** 0.041 0.052** 0.051** 0.044*
(0.023) (0.024) (0.027) (0.023) (0.029) (0.024) (0.026) (0.023)
GDP growth (yoy, 2 year average, lagged) 0.160*** 0.165*** 0.141*** 0.150*** 0.138*** 0.154*** 0.173*** 0.179***
(0.031) (0.029) (0.023) (0.024) (0.027) (0.027) (0.028) (0.026)
Real exchange rate (period end, log & lagged) 3.533*** 3.347*** 4.038*** 3.676*** 3.816*** 3.561*** 3.372*** 3.695***
(0.920) (0.959) (0.911) (0.969) (0.912) (0.945) (0.905) (0.993)
Policy rate (period end, lagged change) −0.026 −0.002 0.001 0.014 −0.014 0.005 −0.012 0.011
(0.027) (0.026) (0.025) (0.027) (0.025) (0.024) (0.029) (0.026)
MPP (various lags) −0.084 −0.45*** 0.369** 0.011 0.208 −0.150 −0.215 −0.52***
(0.161) (0.170) (0.150) (0.165) (0.157) (0.151) (0.172) (0.157)
HL inflows (various lags) 1.083*** 1.015*** 1.029*** 0.554*
(0.298) (0.298) (0.326) (0.291)
MPP × HL inflows (various lags) −1.32*** −1.068*** −1.05*** −0.738*
(0.367) (0.291) (0.358) (0.446)
HL outflows (various lags) 0.186 −0.449 −0.309 −0.212
(0.268) (0.313) (0.376) (0.267)
MPP × HL outflows (various lags) −0.240 0.479 0.522 0.627
(0.298) (0.312) (0.438) (0.400)
Sum of coefficients for HL and MPP × HL −0.237 −0.054 −0.053 0.030 −0.023 −0.213 0.184 0.415
Wald test (p-value) 0.419 0.869 0.835 0.900 0.929 0.423 0.495 0.187
Sum of coefficients for MPP and MPP × HL −1.404*** −0.689* −0.699*** 0.490 −0.844*** 0.372 −0.953** 0.103
Wald test (p-value) 0.001 0.061 0.008 0.124 0.004 0.317 0.013 0.736
Year effects Yes Yes Yes Yes Yes Yes Yes Yes
Countries 16 16 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088 1088 1088
of variables is discussed in the main text. Column 1–2 repeat the baseline estimates when policy variables are lagged 8 quarters. Column 3–4 report
the estimates when policy variables are lagged 1 quarter. Column 5–6 (7–8) report the estimates when policy variables are lagged 4 (12) quarters.
Wald test (p-value) row in the Table reports the p-value for the test of the null hypothesis that the sum of the two coefficients in the row above
is equal to zero. Data sources for all regressors are reported in Table 1.
macroeconomic volatility. In particular, while the liberalisation can be beneficial in improving access to capital and
reducing the cost of capital for domestic agents, it can also potentially lead to faster than optimal credit expansion
when the cheaper and affordable capital leads to excessive risk-taking by domestic agents, especially in situations when
the abundant capital flows simultaneously lead to a strong increase in domestic asset prices. The more active use of
macroprudential policies in EM economies may reduce financial imbalances and tame the credit enhancing effects of
capital flows.
This paper empirically studied the conditionality in the relationship between capital flows liberalisation, macropru-
dential policies, and credit cycles in the sample of major EM economies. In particular, we explored the notion that the
strength of association between the liberalisation of capital flows and the extent of excessive credit expansion depends
on the scope of macroprudential measures implemented by local authorities.
Our findings confirmed earlier results in the literature on the general effectiveness of macroprudential measures in
containing credit cycles in the EM economies. What is more, we uncovered that the effect of liberalisation of capital
inflows on the excessive credit dynamics is conditional on the intensity of the macroprudential regulation. When the
macroprudential framework is tight, the liberalisation of capital inflows does not significantly affect the excessive credit
dynamics. In contrast, in economies with a lax macroprudential framework, the liberalisation of capital inflows may
amplify credit expansion. We also did not find a statistically significant effect of capital outflows liberalisation on the
credit dynamics.
Our results contribute to the literature in several ways. To our knowledge, this is the first study analysing empirically
the conditionality in the relationship between capital flows liberalisation, macroprudential policies, and credit cycles in
a common framework. Our main contribution is thus to provide evidence of the theoretical predictions that in more
advanced EM economies, tighter macroprudential regulation is sufficient to alleviate the externality effects of capital flows
on the credit cycle. In this way, we also provide a mechanism that can potentially explain often conflicting findings in the
earlier empirical literature. From a policy perspective, the result highlights the potential prioritisation steps in sequencing
615
Table 7
Estimates with alternative measures of macroprudential variable.
Variable 1 2 3 4 5 6 7 8
(0.018) (0.022) (0.018) (0.023) (0.019) (0.024) (0.018) (0.024)
Inflation (yoy, lagged change) 0.104** 0.077** 0.104** 0.075* 0.105** 0.078** 0.102** 0.074*
(0.041) (0.039) (0.041) (0.041) (0.041) (0.038) (0.041) (0.040)
GDP growth (yoy, 2 year average, lagged) 0.162*** 0.139*** 0.165*** 0.138*** 0.143*** 0.147*** 0.139*** 0.138***
(0.034) (0.030) (0.034) (0.028) (0.035) (0.028) (0.036) (0.027)
Real exchange rate (period end, log & lagged) 4.041*** 3.712*** 4.018*** 3.725*** 3.869*** 3.455*** 3.881*** 3.594***
(0.762) (0.878) (0.761) (0.920) (0.716) (0.819) (0.765) (0.918)
Policy rate (period end, lagged change) 0.046 0.028 0.047 0.034 0.017 0.018 0.014 0.017
(0.030) (0.031) (0.031) (0.032) (0.025) (0.029) (0.027) (0.030)
MPP (different definitions) 0.010 0.128 −0.136 0.007 −0.281 −0.052 −0.333* −0.102
(0.181) (0.235) (0.163) (0.206) (0.192) (0.255) (0.174) (0.240)
HL inflows 0.720** 0.660** 0.745** 0.745**
(0.309) (0.318) (0.342) (0.339)
MPP × HL inflows −0.623** −0.566* −0.741* −0.848**
(0.308) (0.344) (0.384) (0.396)
HL outflows 0.498 0.341 0.701* 0.568
(0.365) (0.400) (0.420) (0.428)
MPP × HL outflows −0.317 −0.423 −0.840 −1.068*
(0.347) (0.382) (0.560) (0.594)
Sum of coefficients for HL and MPP × HL 0.097 0.094 0.181 −0.082 0.004 −0.103 −0.139 −0.50
Wald test (p-value) 0.697 0.706 0.513 0.703 0.986 0.673 0.692 0.179
Sum of coefficients for MPP and MPP × HL −0.613** −0.438 −0.453 −0.416 −1.022*** −0.90** −1.173** −1.170*
Wald test (p-value) 0.024 0.179 0.209 0.333 0.003 0.032 0.037 0.085
Year effects No Yes No Yes No Yes No Yes
Countries 16 16 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088 1088 1088
of variables is discussed in the main text. Column 1–4 report the estimates when the macroprudential variable is defined to take the value one
if the cumulated index of net policy changes in country i at time t-k is above its five-year moving average. Columns 5–8 report the results when
MPP i,t −k takes the value one if the cumulated index of net policy changes in country i at time t-k is above its time series average. Wald test (p-value)
row in the Table reports the p-value for the test of the null hypothesis that the sum of the two coefficients in the row above is equal to zero. Data
sources for all regressors are reported in Table 1.
policy measures to increase the resilience of the domestic financial system and exploit the benefits of abundant global
liquidity.
The policy implications of our results come with a caveat and should not be interpreted in a normative way. We only
explored one dimension of the risks – the excessive credit fluctuations – associated with capital flows liberalisation and
the role of macroprudential regulation in taming the risks. Higher capital flows associated with liberalisation can provide
a channel through which external shocks are transmitted to the domestic economy, amplifying in this way local business
cycles and local macroeconomic uncertainty. Higher financial openness that fuels domestic debt expansion in ‘‘normal’’
times can lead to a stronger decline in real output and exports following negative shocks, which decrease global aggregate
demand and shift investors’ sentiment. Analogously, positive global shocks may accelerate domestic inflation or appreciate
the real exchange rate of financially open economies more strongly, thereby weakening their macroeconomic stability and
international price competitiveness. Analysing these risks and the role of macroprudential policy in mitigating them is
beyond this paper and provides a new avenue for research. Early empirical work (Bergant et al., 2020) documents the
effectiveness of macroprudential policy in dampening the effects of global shocks on GDP growth in EM economies. More
work is warranted to obtain a comprehensive view of the relationship between macroprudential measures, liberalisation of
capital flows, and macroeconomic outcomes. In addition, studying the effects of different types of capital flow liberalisation
approaches – activist versus capital account liberalisation – and particular types of macroprudential measures (instead of
using an aggregate measure as was done in this paper) provides fruitful avenues to explore in future research.
Acknowledgements
The authors would like to thank the Editor, the anonymous referee, Marco Alfano, Peter Backus, Luca Gelsomini, Gavin
Rae, Christian Saborowski, and seminar participants at the SES 2020 meeting for their comments and suggestions. Any
remaining errors are our own.
616
Table 8
Estimates with alternative measures of control variables.
Variable 1 2 3 4 5 6 7 8
(0.021) (0.021) (0.022) (0.022) (0.022) (0.022) (0.022) (0.022)
Inflation (yoy, lagged change) 0.047** 0.055* 0.045* 0.047 0.048** 0.055* 0.047* 0.048
(0.023) (0.032) (0.027) (0.029) (0.024) (0.031) (0.027) (0.029)
(0.031) (0.029) (0.031) (0.029) (0.030) (0.029)
(0.920) (0.869) (0.799) (0.959) (0.862) (0.826)
Policy rate (period end, lagged change) −0.026 −0.032 −0.046** −0.002 −0.008 −0.025
(0.027) (0.026) (0.022) (0.026) (0.026) (0.021)
MPP (lagged 8 periods) −0.084 0.009 −0.198 −0.087 −0.449*** −0.348** −0.461*** −0.449**
(0.161) (0.160) (0.169) (0.171) (0.170) (0.168) (0.179) (0.175)
HL inflows (lagged 8 periods) 1.083*** 1.099*** 0.861*** 1.073***
(0.298) (0.326) (0.329) (0.327)
MPP × HL inflows (lagged 8 periods) −1.320*** −1.363*** −1.054** −1.304***
(0.367) (0.439) (0.472) (0.446)
GDP growth (yoy, lagged) 0.062*** 0.065***
(0.022) (0.023)
Real exchange rate (period end, yoy, lagged) 0.033*** 0.035***
(0.009) (0.009)
Policy rate (period average, lagged change) −0.023 0.001
(0.026) (0.026)
HL outflows (lagged 8 periods) 0.186 0.174 0.259 0.178
(0.268) (0.288) (0.277) (0.291)
MPP × HL outflows (lagged 8 periods) −0.240 −0.461 −0.317 −0.232
(0.298) (0.347) (0.373) (0.351)
Sum of coefficients for HL and MPP × HL −0.237 −0.264 −0.193 −0.231 −0.054 −0.287 −0.058 −0.054
Wald test (p-value) 0.419 0.349 0.520 0.431 0.869 0.388 0.874 0.868
Sum of coefficients for MPP and MPP × HL −1.404*** −1.354*** −1.252*** −1.391*** −0.689* −0.809** −0.748** −0.681*
Wald test (p-value) 0.001 0.001 0.004 0.001 0.061 0.029 0.043 0.062
Year effects Yes Yes Yes Yes Yes Yes Yes Yes
Countries 16 16 16 16 16 16 16 16
Observations 1088 1088 1088 1088 1088 1088 1088 1088
regulation. HL inflows (outflows) denotes dummy variable for the state of high liberalisation of foreign (domestic) resident flows. The construction of
variables is discussed in the main text. Columns 1–4 report the estimates for capital inflows regressions, column 5–8 for capital outflows regressions.
Column 1 (5) repeats the baseline estimates. Column 2 (6) reports the estimates when using alternative definition of GDP growth in covariates.
Column 3 (7) reports the estimates when using alternative definition of the real exchange rate in covariates. Column 4 (8) reports the estimates
when using alternative definition of the central bank policy rates in covariates. Wald test (p-value) row in the Table reports the p-value for the test
of the null hypothesis that the sum of the two coefficients in the row above is equal to zero. Data sources for all regressors are reported in Table 1.
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Economic Analysis and Policy 73 (2022) 602–619

Contents lists available at ScienceDirect

Economic Analysis and Policy

Analyses of Topical Policy Issues

Capital flows liberalisation and macroprudential policies: The

3. Data and empirical methodology

3.1.1. Credit data

3.1.2. Macroprudential measures

3.1.3. Financial liberalisation/capital restrictions data

3.1.4. Confounding factors

3.2. Econometric methodology

yi, t = αi + µt + β MPPi, t −k + δ HLi, t −k + γ MPPi, t −k HLi, t −k + φ yi, t −1 + Π Xi, t −p + ui, t (1)

4.1. Baseline specification

4.2. Specification checks

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