The relationship between credit and business cycles in Central America and the Dominican Republic

Financial crisis
Financial Economics

Since the beginning of the international financial crisis in 2007-2009 there has been a renewed interest on the linkages between financial markets and the real economy, as well as its implication towards the design of monetary policy.

From an empirical point of view, after the onset of the Great Recession in developed countries and important emerging economies, several studies collected empirical facts on the role of financial variables on the behavior of real aspects of the economy, in particular the importance of shocks in the credit markets. The main findings of this literature can be enumerated (Helbling, et. al. (2010), Zhu (2011), Busch (2012), Chen, et. al. (2012) and Claessensa, et. al. (2012)):

1. In business cycles frequencies (that is cycles between 6 to 32 quarters), credit market shocks are important as productivity innovations explaining macroeconomic fluctuations.
2. Financial cycles are often more pronounced than business cycles, with deeper and more intense downturns than recessions.
3. Recessions associated with financial disruptions tend to be longer and deeper than other recessions.
4. Output losses are larger when recessions are accompanied with credit crunches and house price busts.
5. Similar to how financial disruptions are associated with longer and deeper recessions, so are recoveries associated with credit and house price booms and associated with stronger output growth.

The study of credit-output relationship distinguishing types of frequency cycles has been also explored for the US and Euro area economies. Overall, both longer-run and business output cycles are correlated with assets prices, interest rates and credit. For Latin America, Gómez et. al. (2013) find that credit and activity cycles with duration between 1.25 to less 8 years are more volatile than medium size cycles (8 to 20 years) in Colombia, Chile and Peru.

Despite the evidence mentioned on the credit-output relationship, this is for a set of economies with sophisticated financial markets, meaning by this the existence of a greater variety of financial instruments through which companies can finance its investment expenditure.

Nevertheless, there is scarce evidence on the credit-output relationship for countries with less developed financial sectors. In a recent paper, we investigate the relationship between credit and output in this type of economies, using as a case of study the Central American countries and the Dominican Republic.

We address the empirics of the link between credit and real activity for the case of a group of developing countries with limited financial markets where bank credit is the main source of external finance for the private sector (Table 1). According to Shah, et. al. (2006) “…private debt markets are even smaller (than equity markets), and asset-backed securitization is at and incipient stage…

Credit to private sector in Central America

We compile information of credit to the private sector and the aggregate economic activity for Costa Rica, El Salvador, Honduras, Guatemala, Nicaragua and the Dominican Republic. The data is analyzed using simple statistical tools to identify stylized facts on the credit-activity relationship.

Annual Growth Rates in Central America

Overall, according to the information shown in Table 2, real loans tend to grow at higher average annual rates and display more volatility than economic activity, with the exception of El Salvador. Real loans grow at rates that double the growth of economic activity in Costa Rica, Guatemala and the Dominican Republic, nearly 1.3 times in the case of Honduras, and they are relatively equivalent in Nicaragua and El Salvador.

When we examine a common sample, 2007 -2012, the period including the international financial turmoil, excluding Guatemala and the Dominican Republic, there are no substantial changes in the behavior of observed series. In the case of Guatemala, real loans become more volatile relative to activity and the Dominican Republic shows the opposite behavior.

A closer look to the data, through the use of frequency domain techniques, bring several facts on what kind of relationship credit and output have in these economies.

Real loans and economic activity display different types of cycles, standing out those known as business cycles (1.5 to 8 years) and low frequency cycles. Also, there is evidence of a positive relationship between credit and real activity growth in frequencies associated to business cycles for all countries with the exception of Nicaragua, where the association is insignificant.

Another interesting finding is that, for Costa Rica and the Dominican Republic, the link between credit and output is very important in long lasting cycles (over 10 years), far from the type of cycles that monetary policy can influence with conventional instruments.

Finally, in terms of the lag-lead relationship, there is evidence suggesting that credit precedes economic activity business cycles frequencies in Costa Rica, El Salvador, Honduras, Nicaragua and the Dominican Republic. Excluding Nicaragua, this pattern is observed also in cycles lasting over 8 years for these mentioned economies. In case of Guatemala there is no evidence of statistical precedence of credit to economic activity.

1. Busch, U. (2012). “Credit Cycles and Business Cycles in Germany: A Comovement Analysis”. February. Social Science Research Network No. 2015976.

2. Chen, X., A. Kontonikas, A. Montagnoli. (2012). “Asset Prices, Credit and the Business Cycle”. Economics Letters, 117 (3), (857-861).

3. Claessens, S., M. Kose, M., M. Terrones (2011). “How do Business and Financial Cycles Interact?” CEPR Discussion Paper, No. DP8396.

4. Helbling, T., Huidrom, R., Kose, M. A., Otrok, C. (2010). “Do credit shocks matter? A global perspective”. European Economic Review. Elsevier, Vol. 55(3), pages (340-353), April

5. Gómez, J. E.; Ojeda, J.; F. Tenjo; H. Zárate (2013) “The Interdependece Between Credit and Real Business Cycles in Latin American Economies”. Borradores de Economia 768, Banco de la República de Colombia.

6. Shah, H.; A. Carvajal; G. Bannister; J. Chan-Lau; I. Guerra (2007). “Equity and Private Debt Markets in Central America, Panamá and the Dominican Republic”. IMF Working Paper WP/07/288.

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