The Cleveland Federal Reserve has just held a conference on Financial Stability, something that this blog has covered a lot of recently. Quite a number of the presentations look interesting, but one in particular caught my attention. The paper was titled ‘Equilibrium Credit: The reference point for macroprudential supervisors’, by Daniel Buncic and Martin Melecky (henceforth B&M). As the title suggests, the focus of the paper was on the concept of equilibrium credit, the notion of some level of credit that is sustainable on a long term basis. This can be measured by the credit-to-gdp ratio and is part of the indicators that macroprudential supervisors will examine (see here). The research of B&M, however, highlights the shortcomings of this indicator as a measure of equilibrium credit that could result in ill-timed policy decisions.
The context of credit-to-gdp ratio
B&M begin by discussing the problems related to estimating this ratio with the Hodrick-Prescott (HP) filter. This is a purely statistical measure, but it suffers from measurement problems related to the ‘end-point’ of the series. Hence, it is questionable whether macroprudential policy such as counter-cyclical capital buffers should be initiated from such a calculation.
More of a concern is the assumption within this indicator that there is a unit elasticity relationship between credit and GDP. In other words, a one percent increase in GDP results in a one percent increase in the demand for credit. B&M show this to be an incorrect assumption, bringing the use of the credit-to-gpd ratio as a measure of equilibrium credit into question.
Beginning with the Quantity Theory of Money (Friedman, 1956), B&M set out a relationship between credit, credit velocity, GDP and the price level – that credit and it’s velocity depend on the amount of transactions (proxied by GDP) and the price level (here they use the GDP deflator). Furthermore, they articulate the determinants of credit velocity as the real domestic interest rate (rr), the lending-deposit spread (sprd) and the alternative cost of borrowing in another currency (acb). This enables them to define the following relationship between the credit-to-gdp ratio and credit demand:
The left hand side of this equation is referred to as the ‘unrestricted’ version of the credit-to-gdp ratio – if both beta coefficients, or elasticities were 1, it would represent the credit-to-gdp ratio. The right hand side is a time varying measure of disequilibrium credit. Therefore, the above identity says that credit in excess of transaction demand is provided to satisfy the speculative demand for credit.
This framework allowed B&M to address three important questions:
- Can we assume that the coefficients on GDP and the deflator are unity across countries, which implies policymakers could indeed focus on the credit-to-gdp ratio?
- If these coefficients are not 1, are they the same across countries, or do they differ?
- If there is cross-country heterogeneity across these parameters, can these differences be explained by economic, financial and institutional development?
How they did it
To examine the possible equilibrium relationships, B&M use an Autoregressive Distributed Lag (ARDL) model and combine this with an error correction model (ECM) to distinguish between short and long run dynamics.
They also conduct a second stage analysis, examining the cross country variation in three main areas: the country specific coefficient on GDP, the coefficient on the price level, and the country specific speed of adjustment of short term movements to the long run equilibrium.
B&M found many interesting results. On a general level, they found that credit responds negatively to increasing lending-to-borrowing spreads, the real interest rate, as well as the alternative cost of borrowing in foreign currency. Referring to point 1 above, they find strong statistical evidence that the coefficient on the GDP variable is significantly different from 1, bringing the assumption of a unity elasticity into question. Moreover, they find these coefficients to be different across countries.
Intriguing results are also found in relation to the determinants of cross country differences. Private credit to gdp ratio has a positive impact on the income elasticity of credit, the coefficient on GDP. This suggests that a country’s financial depth will play a role in its sensitivity to changing credit needs. Regarding the speed of adjustment of credit towards its long run equilibrium, this parameter increases with the number of branches per person, suggesting that greater access to financial services helps credit move towards its long run level. Other factors, such as use of capital markets, central bank independence and the experience of financial crisis, also played a role in determining the cross country differences of equilibrium credit.
The main result from this important work suggests that the use of the credit-to-gdp ratio to determine equilibrium credit is inappropriate. As an indicator, the credit-to-gdp ratio provides a simple view on equilibrium credit, but this may be misleading. As an indicator, it contains a possibly flawed assumption that a one percent increase in GDP leads to a one percent increase in credit. With this assumption questioned by this research, important cross country differences were also found. Importantly, this suggests that these country specific factors need to be considered when policymakers try to assess an economy’s equilibrium credit.
With so much at stake with these macroprudential and monetary policy decisions, this type of academic work is very helpful indeed.