Summary:
The 2008 global financial crisis underscores the risks of high macroeconomic leverage and highlights the classic credit-driven financial cycle theories of Kindleberger (1978) and Minsky (1977), fueling extensive theoretical and empirical research post-crisis (Eggertsson and Krugman, 2012; Schularick and Taylor, 2012). Concurrently, China witnessed a significant rise in its macro leverage ratio, drawing concentrated policy attention. In 2015, China embarked on a deleveraging policy, and in recent years, it has implemented a series of measures to curb the growth of leverage. However, stimulus policies due to the COVID-19 pandemic in 2020 have reignited concerns about macro leverage risks. Global liquidity stimulus policies increase macro leverage ratios, raising a critical, unresolved question about their impact on the global economy. The core of credit-driven financial cycle theory pertains to the excessive flow of credit from the financial sector to non-financial sectors, creating investment surpluses and asset bubbles. This illusory prosperity fails to generate real output, leading to defaults, asset crashes, and economic downturns through Fisher's (1933) debt-deflation mechanism. The theory predicts that credit supply-induced increases in the macro leverage ratio (credit stock/total output) result in reduced future output. Although the literature confirms a negative relationship between macro leverage and future total output, it fails to establish causality, making it unable to provide credible validation of debt-driven financial cycle theory. Understanding the dynamics of changes in leverage is crucial for devising precise macro leverage management policies. The key mechanism of debt-driven financial cycles is excessive credit supply, marking supply-side-driven leverage changes as particularly hazardous. Accurately identifying supply-side credit effects on future output is vital for optimal macro policy decisions. In this study, we manually collect a novel cross-country dataset (from the Bank Lending Survey), covering quarterly data for 42 countries from 1994 to 2019. We utilize bank lending standards to measure credit supply directly, retest credit cycle theory, and offer policy insights for emerging markets such as China. All of this work has important theoretical value and practical significance. First, using the standard two-stage least squares method, we assess how supply-driven sectoral leverage influences total output. We note that a 1% increase in private sector macro leverage due to relaxed credit standards leads to a 0.23%-0.43% decline in total output growth over the next year, with a 5-year average reduction of about 0.15%. Second, by differentiating between the corporate and household sectors, our results show that an increase in non-financial corporate leverage driven by credit supply reduces future total output growth, while household leverage affects economic growth positively in the short term but negatively in the long term. These findings persist even when cyclical factors in credit standards are considered. Third, our findings indicate that stimulative policies, such as the aggregate monetary policy, do not directly lead to sectoral leverage increases or negatively affect future total output growth, thus mitigating concerns about leverage changes due to countercyclical stimulus policies. Lastly, distinguishing between developed and emerging market economies, we observe that in emerging markets, a rapid increase in non-financial corporate sector leverage significantly and persistently dampens total output growth, indicating potential biases if macro leverage management policies in emerging markets directly draw from findings based on developed economy samples. We make three key contributions. First, we systematically compile Bank Lending Survey data from 42 countries, detailing information such as credit standards for effective use in academic and policy research and thereby enriching the literature on banking and credit. Second, we effectively address the prominent endogeneity issues in the credit cycle literature, providing more reliable validation of debt-driven financial cycle theory. Finally, our findings emphasize the need to maintain stable credit standards and supplies for economic stability, particularly alerting emerging economies to the risks of rapid leverage increases driven by corporate sector credit. In summary, our conclusions provide credible insights for leverage management policies, particularly in emerging market countries such as China.
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