RDP 9208: Credit Supply and Demand and the Australian Economy 4. Credit and the Economy

The above findings suggest the leading indicator properties of business and total credit improved vis-a-vis both activity variables (investment and GDP) over the period in which financial markets have been fully liberalised. Prior to 1984 peaks and troughs in business and total credit always lagged behind peaks and troughs of the activity variable. A possible reason for this is that in regulated financial markets, which include the presence of deposit rate ceilings and foreign exchange controls, financial intermediaries cannot finance any demand for credit based on private sector plans for future expenditure. Instead, the bulk of lending is financed from “core” deposits. Banks are unable to bid directly for funds, and must depend upon growth in national saving to fund the demand for loans, once private sector holdings of financial assets other than deposits with financial intermediaries have been determined. Since saving is positively related to income, movements in GDP are more likely to precede movements in loans financed from deposits during periods affected by financial regulations. Credit is able to play a more important role in financing expenditure only when rising current income has in any case reduced liquidity constraints in the economy.

In liberalised financial markets liquidity constraints are greatly reduced. Lending is no longer constrained by national saving, as international capital flows can more easily adjust to ensure differences between national saving and investment are financed. In this environment credit is determined by the forward-looking supply and demand factors described in Section 2. Financial institutions are able to respond more quickly to loan demand, given market factors influencing supply. Credit is always available at a price. Financial intermediaries manage their liabilities, simply buying any additional deposits they need to finance lending in wholesale markets, either in the domestic economy or abroad.

The implications of this change in environment for the behaviour of credit in relation to the economy appear to be quite strong. Where business credit and investment had a two-way causal relationship over the full sample period, business credit has unambiguously led investment since deregulation. Eliminating observations from the regulated period also sees total credit providing some useful leading information about GDP. While GDP also leads credit, so that two-way causation is present, the speed of adjustment of total credit consequent upon prior movements in GDP and interest rates is increased.

It is still too early to conclude that these results will prove robust for future turning points in the economic cycle. Moreover, the presence of two-way causation suggests that any leading indicator properties of credit with respect to the overall level of activity will always need to be assessed in the light of other developments in the economy. Nevertheless, it is interesting to note that similar findings concerning the improved indicator qualities of credit have been found for the US economy. For example, Bernanke and Blinder (1988) found that credit had a much more reliable relationship with economic activity in the 1979 to 1985 period, compared to money, than during the 1974 to 1979 period, when money had a stronger relationship. More recently, O'Brien and Browne (1992), in an OECD study, showed that the leading indicator properties of credit in the United States greatly improved over the 1983Q1 to 1991Q2 period, compared to an earlier sample period of 1970Q1 to 1982Q4. Okina (1992) has shown that, in the case of Japan, broad definitions of credit have remained good leading indicators of inflation in the 1980s and early 1990s, compared to money supply variables which are now less useful for forecasting.