Current account and credit growth: The role of household credit and financial depth

Over the last decade, policy discussions have focused on the persistent widening global imbalances prior to the 2008 financial crisis and the rebalancing experiences that followed. 1 has intensified efforts to understand better the dynamics in the balance of current accounts (CA). Researchers began to pay more attention to the impact of financial variables on the CA balance as their views about financial stability changed. Financial and economic cycles don’t necessarily coincide 2. As a result, financial imbalances can grow unnoticed even in stable macroeconomic environments. A credit-driven demand boom may lead to a weaker CA if policymakers do not curb financial excess. Understanding the relationship between the CA balance and credit growth is crucial to designing policies that are aimed at achieving macroeconomic and economic stabilization.

King and Levine’s (1993) measure of financial development, the private credit to GDP ratio, is widely used. The impact of credit expansion on the CA can be determined by using measures of total bank lending to the private sector. The authorities can reduce the risks of rapid credit growth by intervening. Economic theory makes different predictions about the effects of business and household credit. In light of these differences in impact on the economy, policymakers can implement three targeted measures for different types of credit.
This study examines the effect of credit growth in total and household credit on the CA. Recent studies have shown that as financial depth increases, the positive impact of credit expansion on the economy diminishes. We investigate the relationship between credit growth and CA by using studies that support the “too many finance” hypothesis 4.
Financial deepening is a crucial part of economic development, and policymakers support increased access to credit by both households and firms. A growing body of literature, on the other hand, argues that rapid growth in credit threatens financial stability and increases the likelihood of a crisis 5. Credit growth can be a danger to financial and macroeconomic stability, especially when it is excessive.

In literature 6, the influence of the financial deepening level on the CA balance was discussed in more detail. Biggs, 2009 and Biggs, 2010, however, suggest that the impact on economic growth of the flow of credits is much greater than the effect of stocking credit. This finding encourages us to concentrate on the impact of credit growth on CA balance.
Understanding the relationship between the growth of credit and the CA balance is another important aspect. A household credit boom is likely to negatively impact the CA balance when the economy’s supply capacity is constant. A CA deficit may result from the use of loans for business investments due to the reliance on foreign funds and the use of imported inputs. A rise in the amount of business credit will also increase the economic productive capacity. This development may have a positive impact on the CA balance if it promotes exporting in sectors. Researchers and policymakers are still unsure of the effects that different credit types have on the CA balance.
To assess the impact of excess finances on the CA, we constructed a dataset between 1986 and 2015 for 43 countries. We can decompose the bank lending data into two categories: household credit and business credit. The ratio of private lending to GDP is used to measure financial excess. We look at the impact of credit growth in the private sector, as well as the total credit growth.

We control for other variables, using a standard empirical CA, that have been identified in the literature as determinants of CA balance. These include net foreign assets (net foreign assets), relative income, growth rate average, oil trade, fiscal balance, and demographics. The findings of our study on the determinants for CA balance are in line with previous work. In terms of the financial variables, we find that the CA balance deteriorates significantly when the total credit grows.
We find that when we examine the role of the credit components, an increase in household debt causes a statistically and economically significant decline in the CA. In contrast, an increase in business credit does not affect the CA. This finding, although the methods do not permit a direct comparison with Mian, Sufi, and Verner (2017), is in line with their findings, which document an asymmetry of the effects between household debt and business loans. Their results also support the “credit-supply hypothesis” 8, which calls for macroprudential regulation. This result confirms the relevance of our policy analysis, which indicates that measures to curb the growth in household credit are effective in improving the CA.

To concretize our findings, the CA deficits that were caused by credit expansion prior to the global financial crisis are reported. For this exercise, we use the estimated coefficients based on the level of financial depth. We note that the aggressive credit expansion during this period led to a significant amount of CA deficits. This exercise shows that the expansion of household credit played an important role in global imbalances prior to the crisis.
Our results are subjected to a series of robustness tests. When we take into account common factors and institutional measures of quality, our results are similar to those from the benchmark empirical model. By using different subsamples of the time series dimension, our estimates remain stable over time. In order to measure financial depth, we use stock market capitalization or the overall size of the system. When alternative financial depth measurements are used, we find that total and household credit growth also has a stronger impact at lower levels of depth.

This paper’s main contribution is the documentation of a strong, robust relationship between credit expansion and CA balance by using a large dataset. We demonstrate that a rise in total credit growth leads to a marked decline in CA balance. This result is largely due to household credit. Business loans have no significant impact on the CA balance. We also show that the total and household credit rates have a greater negative impact on the CA balance at lower levels of financial strength.
Two arguments can be used to summarize our findings in terms of their policy implications. Our results suggest that policies aimed at preventing excess nine could be effective at reducing external imbalances, particularly in the early stages. Our analysis also reveals a second lesson in terms of policy: the use of targeted measures to slow rapid credit growth. Our study shows that limiting the growth of household loans can improve the CA balance by controlling ten total credits.

The following section reviews the literature. The third section describes data and methodologies. The fourth section provides empirical evidence about the impact of total credit growth and different types of credit expansion on the CA balance. The fifth section discusses how financial depth affects our results. The sixth section includes a discussion of results, as well as additional robustness tests.