Credit, financial crises and the real economy: Could credit-based indicators signal upcoming economic distress?

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School of Economics | Master's thesis
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PURPOSE OF THE STUDY This study examines the role of credit expansion in business cycles in two ways. First, it reviews literature to determine whether credit is found to have a role in economic fluctuations. Secondly, the study investigates empirically whether credit-based indicators could be used to predict upcoming economic downturns. The empirical study is based on the proposition presented by Borio (2006) that changes in the monetary and financial regimes over the last few decades have made economies more vulnerable to buildup of financial imbalances, which lead to financial and economic distress when unwound. For this purpose, the study constructs a signaling model in the spirit of Kaminsky and Reinhart (1999) and Borio and Lowe (2002). DATA The data in the empirical section of the study consists of quarterly series covering 18 industrialized countries between Q1 1970 and Q4 2008. Four key components form the core of the indicators: they include a credit-to-GDP ratio that is based on the nominal private sector credit and GDP series from the IMF International Financial Statistics (IFS) database and OECD. Asset prices are gauged via MSCI equity price indices from Datastream and property price indices from the Bank for International Settlements (BIS). Additionally, real private sector fixed investment to GDP series is constructed for 15 of the 18 countries based on OECD data. RESULTS The mainstream academic literature has relatively little to offer in terms of explaining the causes of business cycles. Research of financial crises and asset price boom-bust dynamics provides one explanation. Rapid credit growth coexisting with asset price increases creates financial imbalances that lead to widespread economic distress when they unwind. An empirical examination via a signaling model verifies that credit-based indicators capturing the buildup of imbalances would often have provided advance warnings of costly downturns between 1980 and 2008.
business cycles, credit expansion, financial imbalances, signaling approach