To spot when systemic risks are building, financial markets could use a new canary in the coal mine.
Forget credit-default-swap spreads, value-at-risk and other apparently reliable warning signs of system-wide financial crises. The metric to watch is a country’s total credit-to-GDP (gross domestic product) ratio, according to the Bank for International Settlements (BIS). When this ratio is high, it reflects an unhealthy gap between economic growth and the amount of credit provided to private non-financial businesses and households — part of the perfect recipe for a blowup.
A new study released last week by the BIS, the central bank of central banks, says a country’s total credit-to-GDP gap is “a valuable early warning indicator for systemic banking crises.”
The metric has its naysayers. But the BIS paper says previous studies examined only credit granted by banks, whereas the new measure includes credit from shadow bankers and foreign lenders. It goes beyond the provision of credit by domestic commercial banks, savings banks and credit unions to include “securitized credits held by the nonbank financial sector and cross-border lending,” according to the BIS.
To test the metric’s effectiveness, BIS used a new database of private-sector credit to produce a study that comprised 39 emerging market and advanced economies. It also included 33 instances of financial crisis since 1970.
According to the BIS, the total credit-to-GDP was a superior indicator to bank-credit-to GDP in most of the crises studied. For example, ahead of the 2008 financial crisis the bank credit gap in the United Kingdom did not signal a large credit build-up. But the total credit gap “clearly captured the run-up in credit from the early 2000s onwards. This reflects the part played by nonbank funding, e.g. via securitization, as the boom’s main driver,” the BIS says.Total credit also predicted a greater proportion of the 33 crises without setting off more false alarms than the bank credit measure.
So where in the world is the credit-to-GDP ratio out of whack? China, according to Susan Weerts, a consultant to Chinese companies. Writing on Seeking Alpha in March, Weerts cites Credit Suisse numbers that show the country’s credit-to-GDP ratio at 176 percent, up from less than 120 percent in 2006. Not only is the magnitude of the ratio worrying but also the deviation above the long-term trend, Weerts writes, and both indicate systemic risk is building.
Non-bank financial-sector lending is a big cause, as is shadow banking. According to Credit Suisse shadow banking in China has ballooned to 22.8 trillion renminbi, or 44 percent of GDP.
Whether used in reference to China or elsewhere, the credit-to-GDP metric has its flaws, notes the BIS. Thus China might not be going off the cliff just yet. One possible flaw in the metric: it may signal crises too early. “In several cases credit-to-GDP gaps issued warning signals four, five or even more years before a crisis,” according to the BIS. That could be a crucial flaw, since the credit-to-GDP ratio was adopted as a reference point under Basel III rules for guiding how and when banks ought to increase their capital buffers to head off a near-term market meltdown.
A second important weakness of the metric is that international exposures, which credit-to-GDP doesn’t count, can precipitate crises. In Germany, the BIS notes, “the recent crisis was fueled by losses stemming mainly from exposures in the United States and Ireland.”
As to whether regulators and central banks can use credit-to-GDP to ward off a financial crisis, economists are skeptical. “Macroeconomists have long recognized the unreliability of activity gap measures and the acute difficulties that [they] can cause in formulating economic stabilization policies,” says a 2011 paper from the Chicago Federal Reserve Bank. One of the principal problems is that data on private-sector credit and GDP for past periods are often revised, making the ratio an imprecise real-time indicator.
Yet the BIS insists that total credit-to-GDP gaps “are useful for identifying vulnerabilities and can help guide the deployment of macro prudential tools.”