Inflation targeting and capital flows: A tale of two cycles in developing countries

Abstract

Global factors have traditionally determined capital flows, but domestic policies also matter. Developing countries face the challenge of managing procyclical capital inflows that can destabilize their macroeconomic environment. Inflation targeting can help solve this problem by enhancing the credibility and predictability of monetary policy. In this paper, we explore how inflation targeting affects the cyclical behavior of capital inflows in developing countries. First, we complement the data on international capital flows from the IMF with locational and consolidated banking statistics from the BIS. Second, we address the self-selection associated with inflation targeting by using entropy balancing. We find that inflation targeting reduces the procyclicality of capital inflows in developing countries. Specifically, inflation-targeting countries receive more (less) capital inflows during recessions (booms) than non-targeting countries. Other investment debt from the private sector mainly drives this effect. Our results are robust to various sensitivity checks and alternative specifications and methodologies.