RDP 9208: Credit Supply and Demand and the Australian Economy 5. Conclusions

This paper has sought to examine the role of credit in the economy, taking account of new theories that emphasise the potential importance of informational problems that financial intermediaries need to overcome when operating in liberalised markets. These information problems may result in loan rationing, which would impart a causal relation between credit and subsequent developments in economic activity. However, such credit rationing effects were found to be absent when supply and demand functions were estimated for business loans over the period of financial liberalisation in Australia. Risks concerning the solvency of corporate clients appear to have been reflected in normal variations in the risk premia component of lending rates over the business cycle, rather than by rationing as such.

The estimated business loan supply and demand equations highlight the influence of forward-looking variables. Demand was influenced by investment expectations, inflation expectations and the earnings-to-equity-price ratio. Supply was affected by corporate net worth, cyclical risk premia, and bank share price behaviour. All of these variables are influenced by expectations about future activity. Furthermore, business and total credit were both shown to be influenced by the loan rate, which is a key aspect of the monetary policy transmission mechanism. Over the period of liberalised financial markets all of these factors should impart some leading indicator (though not necessarily “causal”) role to the behaviour of business and total credit.

This was confirmed with formal tests which analyse the temporal ordering of variables. Business credit has been an unambiguous leading indicator of investment since 1984, whereas two-way causation is present if data from the regulated era are included. The leading indicator properties of total credit vis-a-vis GDP also improved somewhat. If data from the regulated period were included in the tests, total credit was found to have no leading indicator role for GDP. For the period 1984 Q1 to 1991 Q4, however, total credit has a two-way relationship with GDP. There is information in current GDP growth useful for forecasting future credit growth, but at times credit may also have some information useful for forecasting GDP.

It seems likely that the role of credit as an indicator in an economy with liberalised financial markets may be different to its role in a regulated environment. When regulations are binding, banks are more dependent on their “core” deposits to finance their lending. “Core” deposits are accumulated in large part through saving from income, making it likely that GDP will have a tendency to lead credit. In liberalised markets the relative importance of core deposits in financing lending is greatly reduced, as financial institutions are able to manage their liabilities, essentially buying in wholesale markets at home or abroad any deposits needed to finance lending. Hence, to the extent that credit is determined by forward-looking variables, it is now somewhat more likely to provide leading information about the economic cycle than in the past.

However, experience suggests that the leading indicator properties of credit will nevertheless always need to be assessed with caution, taking due account of other relevant developments in the economy.