Working Paper: CEPR ID: DP16510
Authors: Jos Luis Peydr; Andrea Fabiani; Martha Lpez Pieros; Paul Soto
Abstract: We study how capital controls and domestic macroprudential policy tame credit supply booms, respectively targeting foreign and domestic bank debt. For identification, we exploit the simultaneous introduction of capital controls on foreign exchange (FX) debt inflows and an increase of reserve requirements on domestic bank deposits in Colombia during a strong credit boom, as well as credit registry and bank balance sheet data. Our results suggest that first, an increase in the local monetary policy rate, raising the interest rate spread with the United States, allows more FX-indebted banks to carry trade cheap FX funds with more expensive peso lending, especially toward riskier, opaque firms. Capital controls tax FX debt and break the carry trade. Second, the increase in reserve requirements on domestic deposits directly reduces credit supply, and more so for riskier, opaque firms, rather than enhances the transmission of monetary rates on credit supply. Importantly, different banks finance credit in the boom with either domestic or foreign (FX) financing. Hence, capital controls and domestic macroprudential policy complementarily mitigate the boom and the associated risk-taking through two distinct channels.
Keywords: capital controls; macroprudential and monetary policy; carry trade; credit supply; risk taking
JEL Codes: E52; E58; F34; F38; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in the local monetary policy rate (E52) | interest rate spread with the United States (E43) |
| interest rate spread with the United States (E43) | fx-indebted banks engaging in carry trade (G15) |
| capital controls (F38) | tax on fx debt (F38) |
| tax on fx debt (F38) | break carry trade (F31) |
| increase in reserve requirements on domestic deposits (E52) | reduce credit supply (E51) |
| reduce credit supply (E51) | impact riskier firms more significantly (G32) |
| capital controls and reserve requirements (F38) | mitigate credit booms and associated risk-taking (F65) |
| banks finance credit booms (G21) | through either domestic or foreign fx financing (F30) |