RDP 2012-02: The Role of Credit Supply in the Australian Economy 1. Introduction

It has long been observed that economies are prone to cycles of boom and bust in credit markets. In Australia, since financial deregulation in the 1980s, there have been two major episodes of financial turmoil, first with the recession of the early 1990s and more recently with the global financial crisis.

These episodes have clearly illustrated that disruptions in credit markets can have significant consequences for the real economy. In Australia and abroad, the global financial crisis saw a sharp rise in risk premia in financial markets and heightened constraints upon the supply of credit (Figure 1). This increased the cost and difficulty of obtaining finance for firms and households to fund private investment and consumption.

The channels through which these credit market frictions can influence the real economy have been discussed at length from a theoretical perspective (see, for example, Pagan and Robinson (2011)). However, quantifying the real effects of credit frictions requires identification of exogenous shifts in credit supply, which can be difficult, particularly as credit demand can also shift. For example, in addition to disruptions in credit markets, the global financial crisis saw sharp falls in consumer and business confidence, and a much more cautious attitude to spending, exacerbated by a desire to repair highly geared balance sheets.^[1] This reduced the demand for credit, contributing to the sharp decline in real business credit in 2009, making it difficult to disentangle the effects of a tightening in credit supply (Figure 2).

The main contribution of our research is to identify the importance of credit supply shocks for business credit and GDP in Australia over the past three decades. We employ a structural vector autoregression (VAR) model of the Australian economy and identify credit supply shocks by means of a survey variable that captures the difficulty that firms report in obtaining finance. This series is from the ACCI-Westpac Survey of Industrial Trends, the longest, continuous running private-sector survey in Australia.^[2] While this survey variable has been previously interpreted as a gauge of credit supply (Lowe and Rohling 1993; Park 2011), it has not been used to identify credit supply shocks empirically.^[3]

Understanding the impact of credit supply shocks is important from the perspective of a central bank. The implications for output and policy may vary depending on whether credit developments are driven by supply or demand factors. For example, an increase in the equilibrium price of credit in the economy may reflect an increase in the demand for credit or a tightening in the supply of credit. In the first case, policymakers may respond by increasing the cash rate to contain aggregate demand pressures, whereas in the second case policymakers may decrease the cash rate to ease financial conditions in the economy. Alternatively, a decline in the equilibrium quantity of credit in the economy may reflect a decline in the demand for credit or a tightening in the supply of credit, both of which may require more accommodative policy settings.

In addition to examining whether credit frictions have real effects, we also consider other broad implications of credit frictions for the macroeconomy. We assess whether credit frictions play a role in the transmission of monetary policy (a so-called ‘credit channel’) and also whether shocks to the creditworthiness of borrowers (unrelated to monetary policy developments) can lead to a higher cost of borrowing and stricter loan terms.

The paper is organised as follows. The next section outlines the theoretical linkages between credit frictions and the macroeconomy. Section 3 considers possible measures of credit frictions, introduces the ACCI-Westpac survey variable, and briefly reviews the related empirical literature. Section 4 explains the structural VAR specification used to model the role of credit frictions in the Australian economy. Section 5 presents the results and Section 6 examines some robustness exercises. Conclusions are drawn in Section 7.

Footnotes

Senior officials at the Reserve Bank of Australia have delivered many speeches since the onset of the crisis discussing the implications of credit market disruptions for the real economy. For example, see Stevens (2009), Battellino (2009), Edey (2009) and Ellis (2009). [1]

See Australian Chamber of Commerce and Industry (2009). [2]

Suzuki (2004) uses the ACCI-Westpac variable in a structural VAR framework. However, the aim of Suzuki's paper is somewhat different, looking to test the role of a bank lending channel of monetary policy transmission in Australia, as opposed to identifying shifts in credit supply. The bank lending channel is generally predicated on monetary policy affecting the supply of free reserves, which is not the case under the ‘corridor’ system of monetary policy implementation adopted in Australia (see Baker and Jacobs (2010)). [3]