Economic Booms - Credit Overview

Credit Overview

A credit boom is driven by a rapid expansion of credit to the private sector accompanied by rising asset prices. Following the boom phase, these prices collapse and a credit crunch arises, with access to financing falling below levels typical of normal times. The unwinding of the boom phase brings a considerably reduction in investment and a fall in consumption, whereupon an economic recession may follow. Recession following the burst of the episode may be short-lived, with GDP growth resuming within a year. In the financial sector of the economy the recovery is slower and credit may remain depressed for several periods. Credit contracts more sharply than GDP and the cost of borrowing may remain higher than in normal times.

A boom–bust cycle is also associated with the existence of bubbles in the stock market that may lead to a period of accelerated investment and excessive borrowing. After the buildup there is a stock market crash which is often attributed to speculative behavior and Herd behavior on the part of investors. All these studies share the following findings. During the build up of the boom there is rapid expansion in credit to the private sector, GDP, consumption and investment also grow above their rates observed during tranquil times. The non-tradable sector of the economy, that is economic activities produced only for domestic consumption, experiences faster growth, and the real exchange rate appreciates. During the boom banks extended more credit to the non-tradable sector of the economy, and there is a surge of capital flows into the country. Capital inflows tend to be 4% above its long run trend in the year previous to the crisis; similarly the price of housing is 15% above its trend one year before the bust.

In developing countries credit tends to be denominated in foreign currency increasing the debt burden of borrowers during the bust phase. It has been argued that the currency mismatch of the non-tradable sector can amplify the effects of the decline in economic activity during the bust phase. The reason is that the non-tradable sector uses the value of its production, its physical capital or any other asset as a guarantee to access financing from a bank; however more often than not, the collateral put forth by firms is denominated in domestic currency while its liabilities to the bank are denominated in foreign currency, thus during the bust, production diminishes and the foreign currency value of its collateral plummets, and the firm maybe forced to default on its debt. This mechanism helps explain why banks' loan portfolio deteriorates heavily during a bust, opening the possibility of a banking or financial crisis.

Evidence over the past 40 years in developing and developed countries document several regularities observed during credit booms. First, the length of the boom phase ranges between 6 to 7 years, and the episodes are often observed in different countries around the same period and are not limited to a single region. GDP and consumption rise 2 to 4% above its trend, while investment rises 18%. Output in the non-tradable sector rises 6.5% and the real exchange rate appreciates roughly 9%. Also capital flows increase up to 3.5 percentage points with respect to GDP, and the current account as a share of GDP declines about 2.5 percentage points more than in normal times. Stock markets also thrive during the boom phase and equity and housing prices rise considerably, for example in the Financial crisis (2007-present) the Case–Shiller index, measuring the real price of housing in the US, shows that between early 2000 and August 2007 housing prices had a cumulative increase of 125% .

During the downswing of the cycle consumption and investment fall, output in the non-tradable sector declines, the real exchange rate depreciates and asset and housing prices fall below trend. Investment is the component of GDP that suffer the most pronounced swings during the bust; for example after the Argentinean crisis, investment to GDP ratio fell by 5.5 percentage points in Argentina and by 6.1 percentage points in Chile. The contraction in GDP tends to be short lived, however when the bust is accompanied with a financial crisis the effects can be much large; after the 1997 Asian financial crisis, GDP in Thailand, Indonesia and Philippines fell by more than 10%, in the aftermath of the Argentine crisis GDP collapsed by roughly 23%.

Even though not all episodes of rapid credit growth end up in a bust, when they do the adjustment tends to be very disruptive. For example, output and consumption fall 4% below trend, investment falls about 18%, the real exchange rates depreciates suddenly by an average of 4% within one year. Output in the non-tradable sector drops 3% below its pre-boom value. Other indicators of the bust phase include, a sharp deterioration of the quality of banks portfolio with a sudden increase in non-performing loans and rapid deleveraging by financial institutions. The latter implies that financial institutions try to rise capital and improve their capital adequacy in periods where capital is scarcer forcing them to liquidate assets through fire sales. In open economies, the external accounts adjusts sharply; in the 1994 economic crisis in Mexico the current account went from a deficit of 8 percent of GDP to zero within a year. The average adjustment is approximately a jump from a current account deficit of 2.5% of GDP to a surplus of 1.5% of GDP.

The adjustment in the current account reflects the consumption cost associated to the bust as well as the reallocation of resources that takes places after the bust. During the boom phase the heightened desire for investment and consumption tends to move resources into the growing non-tradable sector of the economy. Since the bust depresses the non-tradable sector, both labor and capital shift back towards the tradable sector. This reallocation can be costly, for example if the skills workers need to enter the tradable sector are different than those employed in no-tradable sector, which can produce longer unemployment spell and losses in total factor productivity.

The phrase "boom and bust" was applied to the United Kingdom in the early 1990s. The "boom" period had come in the second half of the 1980s, when the economy grew rapidly and unemployment fell from a record of nearly 3,300,000 in 1984 to 1,600,000 by the end of 1989. However, the Conservative government led by Margaret Thatcher (and then John Major from November 1990) increased interest rates to tackle rising inflation, and by the end of 1990 the economy was in recession and unemployment was creeping back upwards, turning the "boom" into a "bust". Britain had joined the European Exchange Rate Mechanism in October 1990 before leaving it on Black Wednesday in September 1992, when interest rates had briefly peaked at 15%. Britain's departure from the exchange rate mechanism enables interest rates to be reduced. Within a year, inflation was falling, but unemployment was now above 2,000,000 and rising. The recession in Britain was officially declared over in April 1993, by which time it had lasted for a record of nearly three years. This marked the end of that "boom and bust" era in the British economy. A strong economic recovery followed, with low unemployment and inflation, and it would be 16 years before the economy entered another recession.