Economic Policy Uncertainty and Bank Lending Costs
SONG Quanyun, LI Xiao, QIAN Long
School of Finance, Southwestern University of Finance and Economics; Research Institute of Economics and Management, Southwestern University of Finance and Economics; Nanjing Branch, The People's Bank of China
Summary:
Economic policy is important for the transformation and structural change of China's economy. However, the complexity of formulating specific economic policies and unpredictability during their implementation leads to economic policy uncertainty. Studies have shown that such uncertainty significantly affects economic development and corporate behavior. However, few studies have focused on the mechanisms by which economic policy uncertainty affects macroeconomic operation and corporate behaviors. China's financial system is characterized as bank-dominated, and bank credit is an important source of financing for microeconomic entities, which makes bank credit an important channel through which economic policy uncertainty can affect the real economy. This paper examines the effect of economic policy uncertainty on the cost of bank loans to firms, focusing on two main issues. First, we examine how banks adjust banks loan pricing in response to economic policy uncertainty. We not only pay attention to the average effect of economic policy uncertainty on bank loan costs to firms but also to the heterogeneous effects on different types of bank and firm. Second, we examine whether economic policy uncertainty affects firm loan costs through a deleterious effect on firm credit defaults. These two issues provide a better understanding not only of how economic policy uncertainty affects firm behavior and the macro-economy, but also of the importance of consistency and transparency of economic policy in maintaining financial stability. Using the indicator constructed by Baker et al. (2016) and representative bank loan data from 2010 to 2015, this paper empirically explores the impact of economic policy uncertainty on firm bank lending costs. Several findings are worth mentioning. First, we show that economic policy uncertainty has a significantly positive effect on firm bank loan costs, especially for loans issued by smaller banks. We explain this as follows. A bank's incentive to self-insure is stronger during periods of higher uncertainty, as greater uncertainty makes it difficult to form accurate expectations of future liquidity demand and the frequency and intensity of the implementation of future macroeconomic policy. Banks therefore tend to identify borrowers by increasing loan costs. Second, our heterogeneity analysis indicates that economic policy uncertainty has a greater effect on the bank lending costs of micro-enterprises and private enterprises. Third, we show that the default risk of bank loans decreases when economic policy uncertainty increases. This indicates that the increase in bank loan costs when economic policy uncertainty increases is not due to an increase in default risk. It is more likely that banks strengthen their self-insurance incentive and transfer their policy uncertainty risk to firms when policy uncertainty increases. Based on our empirical analysis, we put forward the following policy suggestions. First, amplitude and frequency should be taken into consideration when applying economic policies to regulate the economy, especially the potentially detrimental effect of policy adjustment on bank credit allocations. Second, the management and guidance of banking sector expectations needs strengthening to improve bank anticipation of government policy and thus encourage banks to better serve the real economy. Third, the government must consider the potential heterogeneous effects of economic policy adjustment on different types of firms and banks, to improve the pertinence and effectiveness of economic policies. Our study contributes to the literature in the following ways. First, it enriches the literature on the effect of economic policy uncertainty and provides a better understanding of how it affects macroeconomic fluctuations and firm behavior from a micro-perspective. Second, we find that increased economic policy uncertainty intensifies the distortion of credit allocation in China's banking sector, indicating that the amplitude and frequency of economic policies are important in improving the stability and efficiency of its banking system. Future research should comprehensively explore the influence of economic policy uncertainty on bank credit supply and micro credit demand.
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