BIS Working Papers. Credit and growth after financial crises. No 416. Monetary and Economic Department. by Előd Takáts and Christian Upper. - PDF

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BIS Working Papers No 416 Credit and growth after financial crises by Előd Takáts and Christian Upper Monetary and Economic Department July 213 JEL classification: G1; E32. Keywords: creditless recovery;

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BIS Working Papers No 416 Credit and growth after financial crises by Előd Takáts and Christian Upper Monetary and Economic Department July 213 JEL classification: G1; E32. Keywords: creditless recovery; financial crises; deleveraging; household debt; corporate debt. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). Bank for International Settlements 213. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN (print) ISBN (online) ii WP 416 Credit and growth after financial crises Credit and growth after financial crises Előd Takáts and Christian Upper 1 Abstract We find that declining bank credit to the private sector will not necessarily constrain the economic recovery after output has bottomed out following a financial crisis. To obtain this result, we examine data from 39 financial crises, which as the current one were preceded by credit booms. In these crises the change in bank credit, either in real terms or relative to GDP, consistently did not correlate with growth during the first two years of the recovery. In the third and fourth year, the correlation becomes statistically significant but remains small in economic terms. The lack of association between deleveraging and the speed of recovery does not seem to arise due to limited data. In fact, our data shows that increasing competitiveness, via exchange rate depreciations, is statistically and economically significantly associated with faster recoveries. Our results contradict the current consensus that private sector deleveraging is necessarily harmful for growth. JEL classification: G1; E32. Keywords: creditless recovery; financial crises; deleveraging; household debt; corporate debt. 1 The views expressed here are those of the authors and do not necessarily represent those of the Bank for International Settlements. We are grateful for comments from Claudio Borio, Mathias Drehmann, Madhusudan Mohanty, Philip Turner and from seminar participants at the BIS, the Deutsche Bundesbank, the Netherlands Bank, the Universitat Pompeu Fabra, the University of Lausanne and EPLF, and at the SUERF/Deutsche/Bundesbank/IMFS The ESRB at 1 conference for useful comments. We thank Jakub Demski, Emese Kuruc and Garry Tang for their excellent research assistance. All remaining errors are our own. WP 416 Credit and growth after financial crises iii There seems to be a consensus that declining levels of bank lending to the private sector will reduce economic growth in the coming years. For example, the Institute of International Finance (211) argues that private sector deleveraging will remain a major headwind to growth in the years ahead. But is this consensus right? Does lower level of bank lending after output has bottomed out necessarily slow down the post-crisis recovery even if credit grew to unprecedented levels in the pre-crisis period? Or could in such a situation deleveraging be neutral or even beneficial to economic recovery? We answer these questions by examining 39 financial crises preceded by strong private sector credit growth in emerging and advanced economies over the past three decades. In other words, we focus our attention on crises which are similar to the current crisis in advanced economies. Contrary to the prevailing consensus, we find that lower bank lending to the private sector does not necessarily slow down economic growth after a financial crisis. The results show no correlation between economic growth in the first two years of recovery and the extent of bank credit growth during this period. As time progresses, the correlation becomes statistically significant but remains negligible in economic terms. This is not because of limited data: the standard errors are small and we find two other variables, real exchange rates and public debt, which statistically significantly correlate with the recovery. Importantly, the real effective exchange rate also has a meaningfully strong impact in economic terms. Our result is very robust to various debt measures (real debt or debt-to-gdp ratio) and also to the inclusion of several control variables. Our main contribution to the creditless recovery literature is to document that if credit booms preceded the financial crisis then the relationship between economic recovery and bank lending to the private sector is different: recovery is not anymore negatively associated with deleveraging. In a sense, we confirm the results from Calvo et al (26) and Claessens et al (29) on the existence of creditless recoveries. However, we also show that recoveries from the financial crises which were preceded by strong private debt growth are different. While in general, as Abiad et al (211) and Bijsterbosch and Dahlhaus (211) document, creditless recoveries are slower than recoveries with credit growth, we show that this is not the case if we focus on financial crises which were preceded by credit booms. After these financial crises bank lending to the private sector becomes essentially uncorrelated with the speed of recovery. Our results therefore lie somewhere in between the creditless recovery literature and Bech et al (212) who find that private sector deleveraging after financial crises leads to stronger recoveries. We investigate 39 emerging and advanced economy financial crises over the last 3 years which were preceded by credit booms. Graph 1 shows the average financial crisis experience in terms of output and credit. Real GDP (blue line) increases before the outbreak of the crisis (in period ) and falls thereafter and eventually recovers. The drop in GDP associated with most crises drives up the average credit-to-gdp ratio (red line) for another quarter after the outbreak of the crisis, but the ratio drops eventually and deleveraging begins as Tang and Upper (21) showed. 2 On average, real GDP levels recover their peaks around 8 quarters after the onset of the crisis, while credit-to-gdp ratios remain well below their peaks for several years. Importantly, these averages mask substantial country specific 2 Data that decomposes changes in credit into repayments, new lending and write-downs is unfortunately not available for any of the crises in our sample. WP 416 Credit and growth after financial crises 1 heterogeneity in deleveraging and recovery profiles (see Appendix Table A1). This heterogeneity allows us examine the correlations between bank lending to the private sector and economic growth systematically in our empirical analysis. Deleveraging and recovery 1 Average debt and output eight quarters before and after the crisis Graph 1 Starting point = Total credit/gdp (rhs) Real GDP (lhs) 1 1 Simple average across countries where dates are indexed by quarters to their respective crisis dates. Sources: Datastream; IMF, International Financial Statistics, World Economic Outlook; national data; BIS calculations. In the empirical analysis, we consistently find no correlation between bank lending to the private sector and economic growth. Only at longer horizons does the correlation become statistically significant albeit economically negligible. To measure this correlation independently from the crisis related output loss, we focus on the time period after economic activity has troughed, ie reached its bottom after the slump in output that followed all the crises in our sample. For deleveraging, we use two debt measures: real credit and the credit-to-gdp ratio. For economic recovery, we focus on real economic growth after the crisis trough. In all cases, we control for the drop in economic activity between the pre-crisis peak and the postcrisis trough as well as for the changes in the real exchange rate and the public debt-to-gdp ratio during the recovery phase. (We discuss in detail how we arrived to use precisely these measures later.) We use several one, two, three and four year windows both for credit and growth. No correlation arises between bank lending to the private sector and economic growth in two years or less. Once considering longer-term economic growth, the deleveraging variable becomes statistically significant. However, the effect is very small in economic terms, accounting for only a small fraction of overall growth during the recovery window. While our main contribution is to document that deleveraging does not seem to affect the recovery after financial crises preceded by credit booms, we also explore two factors that are statistically significantly correlated with the speed of recovery: real exchange rates and public debt. First and more importantly, real exchange rate depreciations are correlated with not only statistically but also economically significantly faster growth: it seems that the price channel of external adjustment can give meaningful boost to economic recovery. Second, declining public debt ratios are associated with faster recoveries, ie fiscal consolidation is associated with stronger economic growth but the economic impact seems to be 2 WP 416 Credit and growth after financial crises small. Still, this result, similarly to Bech et al (212), casts doubt on the efficacy of additional, deficit increasing fiscal stimulus after financial crises. But our baseline estimates could be misspecified along a number of dimensions. In order to confirm the robustness of the results we therefore extend the analysis in several directions. First, we show that the exclusion of borderline financial crises does not affect the results. Second, we rerun the regressions for nominal debt as the measure of deleveraging, where the correlation becomes weakly statistically significant for shorter recovery windows and less statistically significant for longer windows but it remains insignificant in economic terms. Third, replacing by consumption and investment growth yields no correlation in any specification. We thus rule out that increases in public spending or net exports mechanically offset any drop in growth of domestic private expenditure brought about by deleveraging. Fourth, we consider non-overlapping windows for credit and growth to address endogeneity concerns. Again, the coefficients of interest remain insignificant. All of these robustness checks confirm the initial finding: in financial crises preceded by credit booms bank lending to the private sector and the speed of economic recovery is uncorrelated except over very long windows. We suspect that the results arise because of the low quality of debt accumulated during the massive credit growth prior to the financial crisis. While debt is normally good, ie positively correlated with economic growth, excessive and misallocated debt has a darker side. Bad debt, via debt overhang (as explained in Lamont (1995) and Philippon (29)), zombie firms (Caballero, Hoshi and Kashyap (28)) and excessive debt levels (as argued in Cecchetti, Mohanty and Zampolli (211) and Cecchetti and Kharroubi (212)) can all lower economic growth. This would suggest that while normally increasing credit improves economic performance bad debt is detrimental. In this framework, the lack of correlation between bank lending to the private sector and economic growth could mean that substantial amount of bad, ie low quality, debt could have accumulated during the pre-crisis credit boom. Of course, our results should be read with appropriate caveats. Though we devote more space later to discuss them, we feel important to highlight the potential limitations of this exercise. First, we report correlations, not causal relationships. We are not able to distinguish between the part of deleveraging that is due to supply constraints which presumably has a large impact on growth and the part that reflects lower demand for credit ie which may be the result of low growth. Second, the economies currently in crisis differ from our sample in many important aspects, which might make historical experiences not directly useful for policymakers. Our results seem to be relevant when thinking about policy challenges advanced economies face now, because they also saw massive private debt increases prior to their crisis. First, bank lending to the private sector does not seem to be a major determinant of the speed of economic recovery now that the crisis has troughed. Efforts to avoid deleveraging could be misleading and distract policy attention from areas which might matter for the recovery, such as structural reforms. Second, our results on public debt cast some doubt on the efficiency of prolonged fiscal stimulus in the recovery phase. Third, our results on real exchange rates suggest that structural reforms to boost competitiveness, via labour market reforms for instance, could be valuable. Such reform might be especially useful in euro area countries which do not have flexible exchange rates. Finally, the strong WP 416 Credit and growth after financial crises 3 impact of exchange rates on the recovery and the global nature of the current crisis highlight the potential risk of countries turning to zero-sum competitive devaluations. The rest of the paper is organized as follows. The second section introduces the database. The third one details the empirical analysis. The fourth performs a robustness tests. The fifth discusses the caveats and the final one concludes with policy implications. Data We focus on financial crises that were preceded by strong increases in credit. Our list of crises draws from Laeven and Valencia (28) and Drehmann, Borio and Tsatsaronis (211). We exclude crises that (i) happened before 197 or in very poor economies, (ii) took place in economies that were in the early stages of a transition from a centrally planned to a market economy, (iii) occurred in an environment of hyperinflation, or (iv) where deleveraging has not yet run its course (such as the United Kingdom and the United States after 27). For the remaining crises we only include those which followed an expansion in private sector debt/gdp for two or more consecutive years. Table A1 in the appendix provides an overview of the crises in our sample. We experimented with other measures for identifying credit booms, but they were not fully satisfactory for this study. For instance, Tang and Upper (21) use two measures of credit booms, namely that by Mendoza and Terrones (28) and by Borio and Drehmann (29). These two measures define a credit boom as an episode where the credit-to-gdp ratio or real credit, respectively, exceeds its long-term trend by a certain threshold. We decided not to use these approaches because the long term debt trend was negative in some cases, which would have led to identifying debt booms with contracting debt. Our private credit measure uses besides the standard domestic bank credit to the private sector (from the IMF IFS database) the claims of BIS reporting banks on the domestic nonbank financial sector (from the BIS consolidated banking statistics). 3 This definition excludes bonds and other debt securities other than those held by BIS reporters, loans by other financial institutions (eg insurance corporations), securitised credit (held by non-commercial banks), and trade credit. Thus, our dataset is not directly comparable to flow of funds data, which is not available for the vast majority of episodes in our sample. Nevertheless, this does not materially hinder our analysis as bank debt was by far the most dominant source of finance for both households and non-financial corporations in all the crises of our sample. Unfortunately, this kind of data might be less useful for analysing the current advanced economy financial crises where securitization was widespread This bank credit construction captures both lending by domestic bank and international banks to the domestic economy. Furthermore, it is widely available on a quarterly basis for our crises. The most recent BIS Banking Statistics series provide a more precise picture by combining locational and consolidated data, which might be useful for future studies on more recent crises. More recently, the BIS has published series on total credit for a large cross-section of countries. We do not use these series because they do not include most of the episodes in our sample. For details see Dembiermont et al (213). 4 WP 416 Credit and growth after financial crises We also use several standard control variables in the robustness tests. Real and nominal GDP figures, GDP deflator, consumption, gross fixed capital formation (investment), nominal and real effective exchange rates (the latter discounted by the consumer price index), current account balances, consumer price indices, population data, public debt and short term interest rates are obtained from the IMF IFS database. Trading partner growth is obtained from the IMF directions of trade database, and world economic growth from the IMF WEO (World Economic Outlook) database. Almost all of the countries in our sample experienced significant deleveraging after the financial crisis (Tang and Upper, 21)). On average, the ratio of private debt to GDP fell by eight percentage points two years after the crisis started. This compares to an increase of 38 percentage points in the two years before the crisis. That said, the deleveraging experience varies greatly across countries. At one extreme, the build-up in private sector debt paused for just one quarter when Argentina went through the Tequila crisis in early This contrasts with debt reductions in excess of 6 percentage points of GDP in many South East Asian economies in the late 199s and in Uruguay in the early 2s. The post-crisis deleveraging in Asia was particularly sharp because the post-crisis appreciation of local currencies pushed down the local currency value of foreign currency denominated debt. Empirical analysis In the empirical analysis, we focus on what happens pots-crisis after real GDP has reached its trough. We do this because financial crises tend to be associated with sharp drops in output, which often take place before any deleveraging gets under way. Furthermore, we control for crisis-related output losses from trough to peak. Intuitively, we allow for the possibility that deeper crises imply steeper rebounds to the extent that part of the output loss is not permanent. We also control for the change in real effective exchange rates and public debt, because these variables turn out to be consistently both economically and statistically significant in our preliminary analysis (detailed in the next subsection). The regression we run is formalized in equation (1): y cr y REER pd (1) trough g trough c trough trough g trough g trough i trough i peak i trough i trough i i where y denotes real GDP in natural logarithms, cr credit (we allow for two different measures: real credit in natural logarithms and the credit-to-gdp ratio in percentages), REER real effective exchange rates, and pd public debt (as percent of GDP);, and are model parameters and the error term; trough represents the time real GDP is lowest, peak the time real GDP was highest prior to the crisis; g and c denote the window taken for growth ( y) and change in credit ( cr), respectively. The subscript i denotes the individual crises. In the subsequent analysis, we augment the regression with additional controls to test the robustness of the results. We are content to report the results as correlations, because the regression cannot establish causality unfortunately. Furthermore, the size of the database limits econometric techniques and the number of control variables. WP 416 Credit and growth after financial crises 5 Baseline estimation T
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