Effect of capital flows on financial stability in middle-income countries
| DOI | https://doi.org/10.1108/JFRC-08-2020-0081 |
| Published date | 03 August 2021 |
| Date | 03 August 2021 |
| Pages | 491-513 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Kolawole Ebire,Saif Ullah,Bosede Ngozi Adeleye,Muhammad Ibrahim Shah |
Effect of capital flows on
financial stability in
middle-income countries
Kolawole Ebire
Department of Economics, University of Abuja, Nigeria and
Department of Banking and Finance, Nasarawa State University, Keffi, Nigeria
Saif Ullah
SZABIST, Karachi, Pakistan
Bosede Ngozi Adeleye
Department of Economics and Development Studies, Covenant University,
Ota, Nigeria, and
Muhammad Ibrahim Shah
BRAC Institute of Governance and Development, BRAC University Dhaka,
Dhaka, Bangladesh
Abstract
Purpose –This study aims to examinethe effect of various forms of capital flows on financial stabilityin
middle-incomecountries from 2010 to 2017 using the World Bankeconomy classifications of 121 economies.
Design/methodology/approach –Panel spatialcorrelation consistent approach wasused in this study.
Findings –The findings provide convincing evidence that in middle-income countries, capital flows are
positive and significantpredictors of financial stability and that financial systems in advancedeconomies are
more stable than those of emergingand developing countries. However, outward foreign directinvestments
are shown to have the largestpotential for ensuring financial stability.
Originality/value –Globalization has fostered financial integration of nations, which is manifested in
capital flows from lower-income countries to middle-income and upper-income countries and vice versa.
These flows can lead to financial instability if not properly controlled. The authors show how the various
forms of capitalflows affect the financial stability in middle-income countries.
Keywords Capital flows, Financial stability, Foreign direct investment, Middle-income countries
Paper type Research paper
1. Introduction
Globalization has fostered financial integration of nations, which is manifested in capital
flows from lower-income countries to middle-income and upper-income countries and vice
versa. Capital flows have stirred various debates regarding its benefits and challenges.
Alfaro et al. (2005) argue that capitalflows facilitate efficient global allocation of savings by
channeling financial resources into their most productive use, which results in economic
growth and welfare around the globe. Those against(Dooley, 1998;Stiglitz, 2000) also argue
that capital flows create a higher risk of crises for developing countries (middle-income
JEL classification –E58 F20 F30 G01
Effect of
capital flows
491
Received29 August 2020
Revised24 January 2021
29March 2021
Accepted20 April 2021
Journalof Financial Regulation
andCompliance
Vol.29 No. 5, 2021
pp. 491-513
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-08-2020-0081
The current issue and full text archive of this journal is available on Emerald Insight at:
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counties). Therefore, the major objective of this study is to examine the effect of various
forms of capital flows on financialstability in middle-income countries.
According to Obadan (2004),capital flows include various kinds of financial transactions
(lending by governments and international organizations, bank lending, investment in
public or private bonds, investment in equities and direct investment in productive
ventures). Obiechina (2010) opined that the natureand source of capital flows determine its
impact. This study proxies capitalflows as inward foreign direct investment (FDI), outward
FDI, inward portfolio investment, outward portfolio investment and other capital flows
(which are net flows of short-term capital, a counterpart to valuation changes, exceptional
financing and net errors and omissions).
Financial stability is a precondition for a healthy economy (Kryvtsov et al., 2015) and
financial instability, and, on the other hand, can vitiate intermediation and disrupt
investment opportunities and growth. Dhal et al. (2011) posit that financial stability is
pursued within strong, sound and stableinstitutions, competitive and effective markets and
an efficient financial pricing perspective. This study, therefore, defines financial stability
based on the definition of World Bank Group (2020a), whichviews financial stability as the
absence of system-wide episodes in which the financial system fails to function (that is,
absence of crises). In other words, it is the resilience of financial systems to stress. A stable
financial system is capable of dissipatingfinancial imbalances that may arise endogenously
as a result of adverse and unforeseen circumstances. A stable financial system can absorb
shocks through self-corrective mechanisms, preventing adverse events from having a
disruptive effect on the financial systemor the economyat large. In the context of this work,
this study, therefore, proxies financial stability as domestic credit to the private sector. The
reason for this is because the banking sector plays a dominant role in the area of resource
mobilization and allocation,payment and settlement system and also serves as key player in
the money, credit, bond and forex market (Dhal et al., 2011). For robustness checks, bank’s
non-performing loans to gross loans (%) is used as the proxy for financialstability. We use
this variable becausethe crises which accompanied the 1997 East Asian financialinstability
and the 2008/2009 global financial crisiswere as a result of accumulation of non-performing
loans. Non-performing loans when left unsolved, can compound into financial instability
when such loans exceedbank capital in a relatively large number of banks.
This study also provides control of macroeconomic indicators on financial stability.
According to Baum et al. (2017), controlling for macroeconomic factors have a significant
effect on financial stability because of country-specificfinancial and macroeconomic
characteristics. The study argues that prior to the financial crisis, advanced economies
experience stable growthand low inflation in the presence of financial imbalances. The post-
global financial crisis era witnessed capital inflows that pose a systemic risk to both
macroeconomic and financial stability (Unsal, 2013). While Dhal et al. (2011) argue that
financial stability,growth and inflation could share a medium- to long-term relationshipand
enhance financial stability associated with higher growth accompanied by stable interest
rate. Baum et al. (2017) found that after controlling for macroeconomic factors, the effect of
capital flows on financial stability varies quite substantially across countries and
interestingly across the various types of flows. In light of the above, this study, therefore,
adopts inflation rateand GDP growth rate as control variables.
This paper contributes to the literature by examining the nexus between capital flows
and financial stability in middle-income countries. The interest in middle-income countries
stems from the fact that these countries are diverse in terms of size, population (constitute
about 75% of the world population) and market, and represent one-third of global GDP.
These statistics make this categoryof countries strategic and important for global financial
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