RDP 9208: Credit Supply and Demand and the Australian Economy 1. Introduction
July 1992
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The role of financial intermediaries in the economy is of particular importance for two reasons – they hold a central position in the payments system, and provide credit to borrowers who find it difficult to obtain funds in open markets. Prior to the liberalisation of financial markets in the early 1980s, the central role of banks in issuing liquid liabilities that functioned as “money” ensured that bank deposits and currency had a reasonably close relationship with nominal expenditure. Financial liberalisation, however, undermined this role. New financial products have emerged which are close substitutes for money. In addition, banks have partly moved from their traditional deposit base to wholesale markets to finance their lending.[1] This has led some authors to suggest that credit may be a more useful indicator for policy than the monetary aggregates.[2]
While financial deregulation has undermined banks' position as providers of “money”, depository institutions continue to play an important role in the provision of credit to small borrowers. Small, heterogeneous commercial borrowers, without the reputations of larger companies, find it prohibitively expensive to borrow directly in open markets. Similarly, in the housing market purchases are primarily financed by household borrowing from intermediaries. In liberalised financial markets since the early 1980s, credit is likely to have become a better leading indicator of nominal spending. Unconstrained by official regulations, borrowing is more likely to be based on expectations about future returns and on the cost of borrowing influenced by monetary policy. A shift in monetary policy that reduces expected future income and wealth, while also increasing the cost of borrowing, affects current decisions about future spending by businesses and households. While causation is from monetary policy to unobservable expected future income, wealth, spending and prices, it should first be observable in reduced credit demand before, or at least contemporaneously with, the decline in actual spending. Lending may even have a causal impact on economic activity, if independent influences on credit supply imposed by financial intermediaries lead to rationing or “credit crunch” episodes in a liberalised financial environment.
In contrast to these predictions, a previous study based on data to 1987 by Bullock, Morris and Stevens (1989) found that total credit lagged nominal demand. One possible reason for this is that their sample period contained relatively few observations from the deregulated environment since 1984. As more observations are now available, it is possible to test the extent to which the earlier finding may need to be reconsidered.
In Section 2 factors influencing the supply of and demand for business credit are explained and tested on data from the early 1980s to the end of 1991. These provide an explanation for the behaviour of credit over this period, and demonstrate that rationing has not been important. Simple temporal ordering tests are then used to examine whether business credit has become a more useful leading indicator of investment since 1983. Section 3 re-examines the relationship between total credit and nominal GDP. The apparent importance of regulations (or their absence) in understanding the links between credit and the economy is discussed in Section 4. Section 5 concludes.