Credit cycles and the economy: introduction.

Davis, E. Philip

The recent boom and succeeding prolonged downturn have brought very much to the fore the role of the credit cycle--the expansion and contraction of access to credit over the course of the business cycle--in driving economic activity. The sizeable costs of allowing free rein to such credit cycles are still evident in many countries. This issue of the National Institute Economic Review brings together key analyses in this area, thus aiding understanding and the development of appropriate policies and policy frameworks.

Claudio Borio (Bank for International Settlements) begins the series of articles by highlighting the deeper forces that are widely considered to underlie the current conjuncture, namely financial liberalisation, credible anti-inflationary monetary frameworks and globalisation of the real side of the economy. These have given scope for powerful financial cycles which exceed in duration and amplitude those of the business cycle. Such financial cycles mean we now have some recessions--such as the current one but also that of the early 1990s--which are characterised by greater depth and very slow recoveries owing to the need for balance sheet adjustment. Borio contends that there are two key changes to economic behaviour to be addressed, first that macroeconomic developments are taking longer to unfold, owing to the length of the financial cycle, and second that stocks of assets and debt rather than flows now dominate economic trends, building up excessively in the boom and generating damaging overhangs in the bust.

In the short term, he suggests there is a need for policies to address the current level of debt, including bank regulation directed at decisively repairing banks' balance sheets as in the Nordic countries in the 1990s, use of fiscal policy to repair private balance sheets and being aware of the dangers for monetary and financial stability from holding interest rates too low for too long.

In the longer term, he advocates not only longer policy horizons but also policies to limit financial booms (such as macroprudential buffers and embedding asset prices within monetary policy frameworks). He highlights the dangers if these policies are not adopted, notably protectionism and currency wars as well as bouts of high inflation. The impact on growth of such an adverse outcome would be seismic.

Philip Lane (Trinity College, Dublin) focuses on an aspect of the recent boom and bust that amplifies the mechanisms Borio highlights, namely the impact of financial globalisation on credit dynamics. At a basic level, banks in such an environment have a choice on the asset side between domestic and international lending and securities, while on the liabilities side banks can supplement domestic retail and wholesale deposits with much greater cross-border supply so that, even for domestic banks, lending need not be constrained. In a globalised financial system, international capital flows become pervasive influences on the behaviour of banks and hence on credit dynamics, as well as on sovereign and bank-bond markets. Besides amplitude, the composition of capital inflows also matters for fragility, such as whether inflows finance real estate or productive investment and whether there is debt that retains risk at home or an element of equity that transfers risk to foreign holders. All of these issues arise most strongly in a single currency zone such as the Euro Area, within which there is less of a constraint on current account imbalances.

Research has shown a strong link from net debt flows to domestic credit expansion in a range of countries and periods. Whereas the traditional pattern has been a 'sudden stop' in such inflows during a currency crisis, private sector reactions in the Euro Area since 2008 have been partly offset by the common liquidity policies. Complex distributive questions arise when a crisis does occur that requires multilateral resolution, even before banking union. The policy prescription in the Euro Area differs from Borio in that given the common monetary policy, fiscal policy must bear the burden of mitigating credit driven booms and busts, possibly including fiscal revaluations (such as taxes on non-traded goods and services) in the boom, offset by the opposite policy in the downturn. Macroprudential policy must be effective in limiting foreign as well as domestic fund inflows.

Thorsten Beck (Tilburg University) focuses on another aspect of credit cycles and credit provision, lending to small and medium enterprises (SMEs). Such firms typically account for a sizeable proportion of value added and employment in both advanced and developing countries. Hence it is important to assess barriers to their growth. In this context, the key aspect of SMEs from the financial point of view is the extent to which they are constrained in supply of finance, and hence constrained in their ability to grow and develop. This in turn depends on numerous structural aspects of the economy and financial system, broadly summarised as institutional and financial development. Provision can be enhanced by appropriate policies, for example in respect of competition, credit guarantees, openness to foreign ownership and credit registries. Banking market structure may impact on SME financing although empirical results are ambiguous. All these structural and institutional factors influence SME access to finance as depicted by the 'access possibilities frontier'.

There are also conjunctural aspects of SME finance that link to the credit cycle. Linked to Lane's subject matter, Beck notes that in some Eastern European countries, SMEs were able to access cross-border foreign currency financing but lacked the financial sophistication to cope with it in terms of currency hedging. The key stylised fact is that owing to their reliance on bank finance, SMEs are typically more financially constrained in crises than other firms, and also more affected by restrictive monetary policies. Foreign banks are often those most likely to withdraw, implying a role for market structure in the impact of credit cycles on SMEs. Trade credit, which is a substitute for bank credit in the upturn, becomes a complement in the downturn. Regulation may worsen the amplitude of credit cycles for SMEs, given higher capital charges for SMEs and their variation over the credit cycle. These issues matter for economic growth more generally since, as mentioned above, SMEs account for a significant proportion of economic activity and hence any restraint on their growth over the cycle is likely to have wider macroeconomic implications.

In this context, Angus Armstrong, E. Philip Davis, Iana Liadze and Cinzia Rienzo (NIESR) look at SME lending in the UK empirically over the 2001-12 period to trace how the credit cycle has affected SMEs in the UK. In line with the pattern suggested by Borio, there was an excess of provision (as reflected in price and availability to firms of above average risk) in the boom of 2005-7. Since 2008, there has been a prolonged tightening, which has tended to worsen in terms of availability while margins have remained high. The credit crunch is worse for low and average risk firms, suggestive of a partial withdrawal of banks from SME lending as an asset class rather than only a response to risk. The authors find a link from macroeconomic uncertainty to the cycle of lending to SMEs, which is much more marked than for large firms. Further to the suggestion in Beck, capital adequacy of banks also has a negative relation to SME lending that is not present for larger firms.

A weakness of the Armstrong et al. paper is that there is no explicit identification of supply and demand influences on SMEs in the credit cycle. This is remedied in the final paper by Sarah Holton, Martina Lawless and Fergal McCann (Central Bank of Ireland). They exploit differences in firm quality and the long government bond (risk free) interest rate across Euro Area countries to enable the identification of local 'credit crunches'. Such crunches can in turn be explained by macroeconomic factors (economic growth and private sector leverage) and a residual indicative of restrictive lending practices driven by risk aversion, weak bank balance sheets and deleveraging of banks. Results confirm a fragmentation of the Euro Area economy, with Germany, Belgium and Finland having favourable SME conditions by most measures, whilst Ireland, Spain, Portugal, Italy and the Netherlands have the most stringent credit conditions facing SMEs.

Further investigation of underlying reasons for these differences in the credit cycle is clearly warranted--the Armstrong et al. work using conditional volatility as a proxy for uncertainty may show one relevant aspect which helps to explain these differences.

E. Philip Davis, National Institute of Economic and Social Research, e-mail: e_philip_davis@msn.com and pdavis@niesr.ac.uk