ECONOMETRIC ANALYSIS OF THE RISKS OF EXCESSIVE CREDIT GROWTH IN THE EMERGING MARKET COUNTRIES WITH DIFFERENT DEGREES OF LIBERALIZATION OF CAPITAL FLOWS

from January 18, 2018, to January 17, 2022. The project's focus is on the economic analysis of the risks associated with excessive credit growth in emerging market countries with varying degrees of capital flow liberalization. The liberalization of capital and current transactions can help countries realize the benefits of capital flows and facilitate long-run economic growth. However, this process also imposes potential risks to the economy, including higher sensitivity to global shocks and higher vulnerability to excessive credit expansion. The International Monetary Fund's Institutional View on Liberalization and Management of Capital Flows (2012) identifies these risks as key concerns. The project focuses on the second identified risk component, the vulnerability to excessive credit expansion. Using a global sample of emerging market economies over the 1996-2018 period, the project designs a suitable econometric framework to address the following questions: Does the extent of excessive credit expansion differ between emerging market countries with different degrees of capital flow liberalization? Does the strength of association between capital flow liberalization and excessive credit expansion depend on the scope of prudential measures implemented by local authorities? The existing literature provides no consensus view on the relation between capital flow liberalization and excessive credit expansions in emerging market economies. Theoretically, liberalization of capital flows reduces the aggregate borrowing constraint, improving the availability and access to capital and reducing the cost of capital for domestic agents. However, if cheaper and affordable capital leads to excessive risk-taking by domestic agents, this can result in faster than optimal credit expansion. Econometric evidence from emerging markets' past experience suggests that the risk of excessive credit expansion is limited in economies that have built and maintained a sound prudential framework. The project's analysis focuses on the importance of prudential regulation for the strength of association between excessive credit expansions and liberalization of capital flows in Serbia. Using a sample of emerging market economies over the past 19 years (2000-2018 period), econometric evidence indicates that the overall effect of capital flow liberalization on excessive credit dynamics is conditional on the intensity of prudential regulation. When the prudential framework is strong, liberalization does not have a significant effect on excessive credit dynamics. In contrast, in economies with weak prudential frameworks, liberalization may amplify credit expansion. The project's findings suggest that the risk of excessive credit expansion is limited in economies that have built and maintained a sound prudential framework. This implies that the full liberalization of capital flows is not an appropriate policy goal for all countries at all times. The appropriate degree of liberalization depends on a country's specific circumstances, primarily on whether it has reached certain thresholds with respect to macro-economic fundamentals and the efficiency of financial regulation and supervision.