Political and Institutional Determinants of Credit Booms
| Published date | 01 October 2019 |
| Author | Vítor Castro,Rodrigo Martins |
| Date | 01 October 2019 |
| DOI | http://doi.org/10.1111/obes.12290 |
1144
©2019 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 85, 1 (2019) 0305–9049
doi: 10.1111/obes.12290
Political and Institutional Determinants of Credit
Booms*
V´
itor Castro†,‡ and Rodrigo Martins§,¶
†School of Business and Economics, Loughborough University, Loughborough,
Leicestershire, LE11 3TU, UK (e-mail: v.m.q.castro@lboro.ac.uk)
‡Economic Policies Research Unit (NIPE), University of Minho, Campus of Gualtar,
4710-057, Braga, Portugal
§Faculty of Economics, University of Coimbra, Av. Dias da Silva 165 3004-512, Coimbra,
Portugal (e-mail: rodrigom@fe.uc.pt)
¶Centre for Business and Economics Research (CeBER), Av. Dias da Silva 165 3004-512,
Coimbra, Portugal
Abstract
The literature that investigates credit booms has essentially focused on their economic
determinants. This paper explores the importance of political conditionings and central
bank independence and provides some striking findings on this matter. Estimating a fixed
effects logit model over a panel of developed and developing countries for the period
1975q1–2016q4, we find that credit booms are less likely when right-wing parties are in
office, especially in developing countries, and when there is political instability. However,
they have not proven to depend on the electoral cycle. More independent Central Banks
are also found to reduce the probability of credit booms. Moreover, they seem to be more
likely to occur and spread within a monetary union.
I. Introduction
The 2008/09 financial crisis renewed the interest of economists and politicians in under-
standing the role that credit surges play in the formation, dissemination, and intensification
of economic shocks. This event and the economic recession that followed reminded us,
once again, that sometimes the credit system is not merely a spreader of shocks that hit
the economy – as the traditional financial accelerator mechanism suggests – but it can be
the source of the shock. In the previous decades, most economies experienced moments
of rapid credit growth (or credit booms), some of them followed by financial crisis (Jord`a,
Schularick and Taylor, 2011).These events are far from being rare and since they have the
potential to both harm and benefit the economy, it is of great importance for policymakers
to better understand the forces behind them.
JEL Classification numbers: C25, D72, E32, E51.
*The authors thank the two anonymous referees for their helpful comments and suggestions.
Determinants of credit booms 1145
A significant body of research has tried to comprehend the economic determinants
of abnormal credit growth and has successfully identified some relevant macroeconomic
factors that are associated with the credit dynamics (Gourinchas, Valdes and Landerretche,
2001; Barajas, Dell’Ariccia and Levchenko, 2009; Arena et al., 2015; Dell’Ariccia et al.,
2016; Meng and Gonzalez, 2017; Avdjiev, Binder and Sousa, 2018). However, the strict
focus on economic determinants, neglecting other potential drivers, is a shortcoming found
in the literature. This paper contributes to the extant literature by establishing a theoretical
framework for the linkage between political and institutional factors and credit dynamics
and by empirically testing this connection. It investigates if an electoral cycle is present;
if government ideology and overall political instability alter the ability of an economy to
generate credit booms; and tackles the relationship between monetary policy and credit
booms in a new perspective by analyzing the role of Central Bank independence and
monetary unions. There are arguments to reasonably assume that all these aspects can
actually be relevant and contribute to a better understanding of credit booms – we return
to this subject in section III.
Regarding the economic factors, our results suggest that if policymakers want
to regulate credit surges they should pay close attention to the relative price of credit,
economic growth and economic openness and exert control over the liquidity in the
system. Results also show that some of the political and institutional factors are em-
pirically relevant and robust to changes in the definition of credit booms. Although no
evidence of an electoral cycle in credit booms is found, they have proven to be less likely
in the presence of some types of political instability (higher government turnover and
decreased government’s ability to stay in office) and when right-wing parties are in of-
fice, especially in developing countries. Regarding the institutional framework for mon-
etary authorities, we find that when a country’s monetary policy is in the hands of a
single regional monetary union this seems to constitute a big challenge for the mon-
etary authority: credit booms have proven to be more likely in those economies and
when the level of Central Bank independence is low. The economic conditionings and
central bank independence matter significantly for both industrial and developing
countries. However, the political factors seem to matter most for the group of develop-
ing countries.
The rest of the paper is organized as follows. Section II reviews the existing literature
on credit booms. Section III discusses the role of the political environment and of Cen-
tral bank independence. Section IV describes the data and methodology. The empirical
analysis and the discussion of the results are presented in section V. Finally, section VI
concludes.
II. Literature review
Banking crisis are often associated with excessive credit expansions (Jord`a et al., 2011).
As such, credit plays, not just the traditional positive role of supporting investment and
economic growth, but also exhibits, under certain conditions, a malignant effect on the
economy. What these conditions are and what drivescredit expansions have been important
topics of research in recent years. The literature has mainlytackled them from an empirical
©2019 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
1146 Bulletin
perspective1and identified some keyexplanatory factors (see Mendoza and Terrones, 2008,
2012; Dell’Ariccia et al., 2016).
First, credit booms have been consistently linked to sharp increases in capital inflows
triggered by periods of disinflation or by lowinterest rates in developed economies, factors
that consequently raise the supply of loanable funds (Gourinchas et al., 2001; Calder´on
and Kubota, 2012; Gourinchas and Obstfeld, 2012; Blanchard et al., 2017). These surges
are usually associated with a rapid build-up of leverage or to a higher ratio of private credit
to bank deposits, which, in turn, may lead to financial fragility (Borio and Disyatat, 2011;
Gourinchas and Obstfeld, 2012). In particular, rising inflows of foreign capital may lead
to excessive monetary and credit expansions (Sidaoui, Ramos-Francia and Cuadra, 2011),
increase the vulnerabilities associated with currency and maturity mismatches (Akyuz,
2009), and create distortions in asset prices (Agnello, Castro and Sousa, 2012a; Agnello
and Sousa, 2013). Some strong evidence of the role playedby capital inflows is particularly
found in housing market studies: S´a,Towbinand Wieladek(2014) repor t that capital inflows
shocks generate housing booms, while S´a and Wieladek(2015) show a positive connection
between these influxes and house price growth.
Second, productivity shocks are also identified as a phenomenon that can pressure
capital stock to increase at a higher rate than GDP, thus strongly raising the credit-
to-GDP ratio. In addition, a better economic environment can also promote the build-
up of credit (Mendoza and Terrones, 2008, 2012; Mimir, 2016; Meng and Gonzalez,
2017).
Finally, researchers point out that financial reforms associated with financial liberaliza-
tion, the reduction in banks’reser verequirements and increases in the provision of financial
services may also contribute to more liquidity and to abnormal lending growth.2In this
context, Agnello, Mallick and Sousa (2012b) show that the removal of policies towards
directed credit and excessively high reserve requirements and improvements in the securi-
ties market reduces inequality.As a result, middle class stagnant incomes press politicians
to expand credit and to ease housing affordability (Rajan, 2010).
In addition, some studies also suggest that some domestic differences may account
for the uneven incidence of booms across countries: expansionary monetary and fiscal
policies; less flexible exchange rate regimes; weak supervision of the banking system; and
debt composition (Elekdag and Wu, 2013; Arena et al., 2015; Dell’Ariccia et al., 2016;
Avdjiev et al., 2018).
III. The role of the political environment and of Central Bank independence
In this paper, we explore the importance of the political environment and central bank
independence in explaining the likelihood of credit booms. Although unexplored from the
econometric point of view, the relationship between politics and credit booms or financial
crises has been debated in the related literature. Forexample, McCarty, Poole and Rosenthal
1For some recent theoretical papers on the subject, see Boissay, Collard and Smets (2016) and Burnside, Eichen-
baum and Rebelo (2016).
2Mendozaand Terrones (2012) point that productivitysurges, financial reforms, and massive capital inflow episodes
appear before 20–50% of the peak of credit booms in industrial and emerging market economies.
©2019 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
To continue reading
Request your trial