Optimal credit development regimes and impact of foreign capital flows

Abstract

We investigate optimal credit development and examine the role of foreign capital flows. We use data from 87 countries to estimate plausible econometric models. We find evidence of four existing credit development regimes. We show the existence of a growth-enhancing credit development regime where any credit allocation to the economy promotes economic growth. We also use disaggregated foreign capital flows to investigate the impact of these capital flows on credit development regimes. We find that the impact of foreign capital flows depends on the type of foreign capital flows, the credit development regime and the level of countries’ economic development. Portfolio debt inflows are mainly associated with a moderate credit development regime. However, portfolio equity inflows and other debt inflows are mainly associated with a high credit development regime. We argue that, in their credit allocation behavior, banks tend to strategically use portfolio debt inflows in a moderate credit development regime, and portfolio equity inflows and other debt inflows (not in portfolio debt) in a high credit development regime. Finally, we study credit development regimes around the start of financial crises. We find that the second credit development regime—which is strongly associated with economic growth—is not associated with future financial crises. We call this regime the optimal credit development regime. We also find that the third credit development regime—which still has a positive impact on economic growth—can lead to financial crises two years later. We call this regime the arbitrage credit development regime. These results provide a new perspective on credit development in an environment of international economic and financial integration.