[Paper Review] Capital Flows and the Stabilizing Role of Macroprudential Policies in CESEE

Markus Eller, Niko Hauzenberger+3 more|arXiv (Cornell University)|Sep 10, 2020

Global Financial Crisis and Policies4 citations

TL;DR

This paper proposes a regime-switching factor-augmented vector autoregressive (FAVAR) model to assess the stabilizing role of macroprudential policies (MPPs) in Central, Eastern, and Southeastern Europe (CESEE) from 2000 to 2018. Using an intensity-adjusted MPP index, it finds that tighter MPPs effectively reduce private credit growth and gross capital inflows in most CESEE countries, particularly in low-interest-rate or post-GFC periods, but do not consistently shield against capital flow volatility.

ABSTRACT

In line with the recent policy discussion on the use of macroprudential measures to respond to cross-border risks arising from capital flows, this paper tries to quantify to what extent macroprudential policies (MPPs) have been able to stabilize capital flows in Central, Eastern and Southeastern Europe (CESEE) -- a region that experienced a substantial boom-bust cycle in capital flows amid the global financial crisis and where policymakers had been quite active in adopting MPPs already before that crisis. To study the dynamic responses of capital flows to MPP shocks, we propose a novel regime-switching factor-augmented vector autoregressive (FAVAR) model. It allows to capture potential structural breaks in the policy regime and to control -- besides domestic macroeconomic quantities -- for the impact of global factors such as the global financial cycle. Feeding into this model a novel intensity-adjusted macroprudential policy index, we find that tighter MPPs may be effective in containing domestic private sector credit growth and the volumes of gross capital inflows in a majority of the countries analyzed. However, they do not seem to generally shield CESEE countries from capital flow volatility.

Motivation & Objective

• To assess the effectiveness of macroprudential policies (MPPs) in stabilizing capital flows in CESEE countries amid global financial cycle fluctuations.
• To address the limited empirical evidence on MPPs' direct impact on cross-border capital flows, especially in emerging markets with high financial integration.
• To model dynamic responses of capital flows to MPP shocks while accounting for structural breaks and global financial cycle factors.
• To evaluate whether MPPs can mitigate capital flow volatility, particularly in the context of foreign-currency-denominated credit booms and banking sector dominance.
• To explore cross-country heterogeneity in MPP effectiveness, considering differences in policy design, financial cycles, and exchange rate regimes.

Proposed method

• Proposes a novel regime-switching factor-augmented vector autoregressive (FAVAR) model to capture structural breaks in policy regimes and time-varying responses.
• Incorporates global factors—particularly the global financial cycle—via a set of common factors extracted from a large dataset of international financial and macroeconomic variables.
• Employs an intensity-adjusted macroprudential policy index (from Eller et al., 2020b) to measure both the presence and degree of MPP implementation across 11 CESEE EU member states.
• Uses Bayesian estimation with 68% credible sets to identify and assess the dynamic responses of capital flows, credit growth, and volatility to a one-standard-deviation tightening shock in MPPs.
• Applies the model separately across sub-periods (pre-GFC, post-GFC, high/low interest rate regimes) to detect time-varying policy effectiveness.
• Analyzes responses of total gross capital inflows, bank flows, and other investment inflows, distinguishing between volume and volatility responses.

Experimental results

Research questions

• RQ1 To what extent do macroprudential policies reduce domestic private credit growth and gross capital inflows in CESEE countries?
• RQ2 How do the dynamic responses of capital flows to MPP shocks vary across different economic regimes (e.g., pre-GFC, post-GFC, high vs. low interest rate periods)?
• RQ3 Can macroprudential policies effectively reduce the volatility of capital flows in CESEE countries, particularly in the face of global financial cycle fluctuations?
• RQ4 Are there significant cross-country differences in the effectiveness of MPPs, and what factors might explain this heterogeneity?
• RQ5 How do global factors, such as the global financial cycle, interact with domestic MPPs in shaping capital flow dynamics?

Key findings

• Tighter macroprudential policies significantly reduce private sector credit growth in the majority of CESEE countries, with stronger and more immediate responses observed in low-interest-rate environments.
• MPPs are effective in curbing gross capital inflows, particularly in the post-global financial crisis period, where negative responses are both larger in magnitude and faster in transmission.
• The response of capital flow volatility to MPP tightening is mixed: in some cases, MPPs reduce volatility (especially for bank flows post-GFC), but in others, they do not provide consistent protection.
• The intensity-adjusted MPP index successfully captures the degree of policy implementation, enabling more nuanced estimation of policy effects than binary indicators.
• Averaged across models, 5 out of 11 countries show significant negative responses in credit growth to MPP shocks, while 7 out of 11 show significant negative responses in capital inflow volumes.
• Heterogeneity in responses suggests that factors such as policy composition, financial cycle phase, and exchange rate regime significantly influence MPP effectiveness, warranting further country-specific analysis.