Summary:
The Central Financial Work Conference of 2023 proposes that efforts should be made to promote high-level financial opening-up, ensure financial and economic national security, and accelerate the construction of a financial power. In recent years, cross-border capital flows have become more frequent, and there is an obvious global financial cycle. Simultaneously, the relationship between cross-border capital flows and credit fluctuations in various countries has become closer. Historical experiences indicate that credit booms often precede financial disturbances like banking crises. In fact, exchange rates are crucial in linking cross-border capital flows, domestic credit cycles, and banking crises. Classical international finance theories suggest that under free capital flows, a floating exchange rate regime can stabilize external shocks and ensure the independence of central bank monetary policies. Under the background of global financial cycles, scholars have engaged in hot discussions about whether floating exchange rate regimes act as stabilizers and how China should choose its exchange rate regime and pursue high-quality financial opening-up. However, they have not yet reached a consensus. Therefore, it is necessary to explore the relationship among cross-border capital flows, domestic credit cycles, and banking crises under different exchange rate regimes. It could not only enhance international financial theories and provide empirical guidance for the reform of the RMB exchange rate regime, but also could act as a key element in promoting the process of high-quality financial opening-up and ensuring no systemic risks arise. This paper collects domestic credit and cross-border capital flow data from 28 emerging market economies, sourced from the International Monetary Fund and the Bank for International Settlements. The paper divides credit booms and busts, constructs a Probit regression model to study the empirical relationship between cross-border capital inflows and domestic credit booms or busts, and focuses on whether a floating exchange rate regime can act as a stabilizer. We find that non-direct investment debt inflows, especially cross-border bank loan inflows, exhibit a pro-cyclical relationship with domestic credit. Compared to fixed exchange rate regimes, the pro-cyclical relationship between cross-border bank loan inflows and domestic credit weakens in countries with floating exchange rate regimes, indicating that floating exchange rates play a stabilizing role. However, the pro-cyclical relationship between bond inflows and domestic credit strengthens under floating exchange rate regimes. Further analysis indicates that floating exchange rates can stabilize “good booms” that do not trigger banking crises but cannot suppress “bad booms” that end with banking crises. Thus, floating exchange rate regimes need to be coordinated with other policies, such as tight macroprudential policies, to effectively curb the occurrence of banking crises. This paper makes the following contributions: First, unlike existing studies that consider how capital inflows affect credit growth or analyze how capital inflows affect credit cycles from the perspective of debt structures, this paper analyzes the relationship among cross-border capital inflows, domestic credit cycles, and banking crises within a unified framework. More importantly, this paper studies the relationship among these three elements from the perspective of exchange rate regimes, investigating whether floating exchange rate regimes can act as stabilizers. Second, existing research rarely explores the relationship between different types of capital inflows and domestic credit fluctuations according to debt types and borrowing sectors. Avdjiev et al. (2021) found that domestic credit cycles are related to the type of external debt and borrowing sectors but did not further explore whether credit booms triggered by different types and sectors have different impacts on banking crises, and also did not investigate the role of floating exchange rate regimes. This paper finds that the stabilizing role of floating exchange rate regimes depends on the type and borrowing sectors. Third, existing literature has not explored the role of exchange rate regimes in stabilizing different types of credit booms and in preventing crises. This paper finds that floating exchange rate regimes can only stabilize “good booms” but cannot stabilize “bad booms” that lead to crises. Cooperation with other policies (such as macroprudential policies) is needed to better play the stabilizing role, indicating that floating exchange rate regimes are not a “one-size-fits-all” solution. Based on these conclusions, this paper has the following policy implications: First, emerging market economies should closely monitor and avoid large-scale cross-border bank loan flows. Second, in the process of promoting financial opening-up and maintaining financial stability, each department should effectively guard against exchange rate risks and choose reasonable external financing methods. When increasing domestic non-banking sector financing through the international bond market, the cost of managing exchange rate risks for the non-banking sector should be reduced through improving financial infrastructure. Third, emerging market economies need to strike a balance in the choice of exchange rate regimes while promoting financial opening-up and maintaining financial stability. Crawling peg regimes and managed floating regimes may be better choices. Fourth, exchange rate regimes themselves have limited effectiveness in preventing systemic financial risks. While maintaining a dual fluctuation of exchange rates, regulators should strengthen macroprudential supervision of the banking sector.
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