BRUEGEL

POLICY CONTRIBUTION
ISSUE 2013/03 FEBRUARY 2013

CAN EUROPE RECOVER WITHOUT CREDIT?

ZSOLT DARVAS

Highlights Data from 135 countries covering five decades suggests that creditless recoveries, in which the stock of real credit does not return to the pre-crisis level for three years after the GDP trough, are not rare and are characterised by remarkable real GDP growth rates: 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries. However, the implications of these historical episodes for the current European situation are limited, for two main reasons: First, creditless recoveries are much less common in high-income countries, than in low-income countries which are financially undeveloped. European economies heavily depend on bank loans and research suggests that loan supply played a major role in the recent weak credit performance of Europe. There are reasons to believe that, despite various efforts, normal lending has not yet been restored. Limited loan supply could be disruptive for the European economic recovery and there has been only a minor substitution of bank loans with debt securities. Second, creditless recoveries were associated with significant real exchange rate depreciation, which has hardly occurred so far in most of Europe. This stylised fact suggests that it might be difficult to re-establish economic growth in the absence of sizeable real exchange rate depreciation, if credit growth does not return. Zsolt Darvas (zsolt.darvas@bruegel.org) is a Research Fellow at Bruegel. Thanks are due to Hannah Lichtenberg and Li Savelin for research assistance, and to Bruegel colleagues for comments. The first version of this Policy Contribution was prepared as a background paper for Gill, Indermit, Martin Raiser and others (2012) Golden growth: Restoring the lustre of European economic model, World Bank.

Telephone +32 2 227 4210 info@bruegel.org www.bruegel.org

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CAN EUROPE RECOVER WITHOUT CREDIT?

ZSOLT DARVAS, FEBRUARY 2013
1 INTRODUCTION Access to finance is a crucial prerequisite for growth. Beyond using existing cash balances, retaining profits and raising new equity, options that are typically limited during a recession, borrowing can provide funds for day-to-day financial operations and long-term investment. In continental Europe, borrowing from banks is the dominant source of debt financing for nonfinancial corporations, and there has been little change in this during the past decade (Figure 1). In contrast, the share of debt securities is much higher in the United States and the issuance of debt securities overcompensated for the drop in bank credit from 2008 to 20111. Developments in the United Kingdom are in between the euro area and the US in these regards, while in other EU countries, bank loans tend to dominate even more than in the euro area. Credit growth has not yet resumed in most European countries, and credit is even declining in nominal terms in a number of countries. The declines in real terms are more significant. Clearly,
A. Euro area ( billions)
10,000 9,000 8,000 7,000 6,000 5,000 800 4,000 3,000 2,000 600 4,000 400 200 0 2,000 0 6,000 1,800

economic growth and credit growth are simultaneous and it is not just that credit can drive the economy, but the reverse causality also exists. Economic growth can increase both credit demand (households and corporations are more willing to consume and invest when the economic outlook improves) and credit supply (economic growth improves bank balance sheets and thereby their ability to supply credit). Yet there is abundant academic research concluding that limitations in credit supply have played a major role in credit developments recently, and such supply constraints could hinder credit expansion even if higher credit demand returns. Given the prominent role of credit in the European economy and the limited substitution of bank loans with debt securities, one should be concerned about the consequences for economic growth. However, while economic theory predicts a close association between credit supply and the business cycle, recent empirical literature has pointed out that there were a number of economic recoveries without credit growth, which are called creditless recoveries. Calvo, Izquierdo and Talvi (2006a, b) were among the first to observe this
C. United States ($ billions)
14,000 12,000 10,000

Figure 1: Debt liabilities of non-nancial corporations, 1999Q1-2012Q3

B. United Kingdom ( billions)
1,600 1,400 1,200 1,000 8,000

Debt securities Loans

Debt securities Loans

Debt securities Loans

1. Since the debt securities market is accessible for large firms only, total debt liabilities of small and medium-sized enterprises (SMEs) might not have increased, even in the US.

1,000

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003 Q1-2004 Q1-2005 Q1-2006 Q1-2007 Q1-2008 Q1-2009 Q1-2010 Q1-2011 Q1-2012

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003 Q1-2004 Q1-2005 Q1-2006 Q1-2007 Q1-2008 Q1-2009 Q1-2010 Q1-2011 Q1-2012

Source: Bruegel based on OECD 'Non-consolidated financial balance sheets by economic sector'. Note: quarterly balance sheet data. Debt securities correspond to 'Securities other than shares, excluding financial derivatives'.

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003 Q1-2004 Q1-2005 Q1-2006 Q1-2007 Q1-2008 Q1-2009 Q1-2010 Q1-2011 Q1-2012

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phenomenon by studying a sample of emerging market economies after systemic sudden stops. They dubbed such developments Phoenix miracles and showed that such recoveries are common, even though investment, a key driver of growth in normal times, remains weak in creditless recoveries. Subsequent research, such as Claesens, Kose and Terrones (2009a,b), International Monetary Fund (2009), Abiad, Dell'Ariccia and Li (2011), Bijsterbosch and Dahlhaus (2011), and Coricelli and Roland (2011), has looked at various other aspects of creditless (and also with-credit) recoveries. These studies have concluded that creditless recoveries are not rare events (they account for about every fifth recovery), but growth is about a third lower (ie 4.5 percent per year on average during the first three years of the recovery, as calculated by Abiad, Dell'Ariccia and Li, 2011) than in recoveries with credit (when average growth was found to be 6.3 percent per year). Creditless recoveries are typically preceded by banking crises and sizeable output falls. Industries that are more reliant on external finance grow disproportionately less during creditless recoveries. Several papers also conclude that impaired financial intermediation and limited credit supply are the major reasons behind sluggish credit growth during creditless recoveries. Given this cautiously optimistic literature on the existence of creditless recoveries, it is relevant to ask if European economies could also expect to grow without credit in the coming years. This question also has a bearing on the current debate on the targets and implementation speed of the Basel III requirements, since new capital, liquidity and leverage rules will likely impact on the ability of banks to supply credit to the economy. The goal of this Policy Contribution is to shed light on some less researched aspects of creditless recoveries: the role of exchange rate changes and financial development. After establishing some stylised facts using a sample of 135 countries and almost five decades of data, we assess the potential for creditless recoveries in Europe. 2 CREDITLESS RECOVERIES IN A HISTORICAL PERSPECTIVE: A NEW LOOK In our view, real exchange rate developments could play a major role in understanding creditless recoveries, yet the literature has not paid sufficient attention to this issue. While dummy variables indicating the existence of a currency crisis were included in some papers, this indicator does not capture the magnitude and persistence of exchange rate changes. In addition, exchange rates also changed in those cases that are not classified as currency crises. For example, Figure 2 shows that all four true miracles identified by Abiad, Dell'Ariccia and Li (2011), ie cases with exceptional high economic growth without cumulative real credit growth three years after the trough, were characterised by very

Figure 2: Examples of credit-less recoveries, the four true miracles (year of trough = 100)
Argentina
250 225 200 175 150 125 100 250 225 200 175 150 125 100 140 130 120 110 100 90 80 70 60 75 98 00 02 04 06 75 50 80 82 84 86 50 60 92 94 96 98 60 80 82 84 86 88 80

Chile
140 130 120 110 100 90 80 70 60 80 160 140 120 100

Mexico
160 140 120 100 170 160 150 140 130 120 110 80 100 90

Uruguay
170 160 150 140 130 120 110 100 90

Real GDP

Real credit

REER

Sources: Bruegel; see data appendix. Note: real credit is credit to the private sector deflated using the consumer price index. REER = real effective exchange rate, which was calculated against 145 trading partners for Argentina, Mexico and Uruguay and against 99 trading partners for Chile using trade weights and consumer prices.

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2. Abiad, Dell'Ariccia and Li (2011) mention, incidentally, that creditless recoveries are more common in countries with less developed financial markets. 3. We have checked 178 countries and the main bottleneck was the availability of credit data. 4. The filter developed by Hodrick and Prescott (1997) is a statistical method for decomposing a time series into trend and cyclical components. It is based on the assumption that the trend component is smooth and the smoothness can be set by altering a parameter. One problem with the filter is end-of-sample instability: when new observations are added, the estimated trend and cyclical components for the last few observations of the previous sample can change significantly. 5. As emphasised by Abiad, Dell'Ariccia and Li (2011), the IFS credit data has shortcomings: it does not include credit extended by non-bank financial intermediaries, and also does not include borrowing from abroad. But this is the only source with sufficient time and country coverage. 6. Note that the Argentine and the Chilean episodes shown in Figure 2 just marginally pass this criterion. 7. The level of a countrys development has a major bearing on growth drivers, see eg Veugelers (2011), justifying the focus on highand middle-income countries when we wish to draw lessons for EU countries. Considering GDP per capita at PPP in 2013, as projected by the IMF October 2012 World Economic Outlook, Italy, Greece, Spain and Portugal and all twelve member states that joined the EU in 2004 and 2007 would belong to the middle income

large falls in the real exchange rate close to the GDP trough. In addition to bringing the real exchange rate into the analysis, we also include trade openness and financial development. Trade openness may have a bearing on the impact of the exchange rate on the economy, while financial development may directly impact the incidence of creditless recoveries. For example, economies in their financial infancy might not be much impacted by the availability or the lack of credit, but credit constraints could be disruptive when companies rely heavily on credit2. Sample Our sample includes annual data from 1960 for 135 countries for which data on output, credit and real effective exchange rate (REER) are available3. We have excluded the period of the recent global crisis from the sample to search for recoveries (ie do not consider troughs during 2007-2012), but we use GDP data up to 2017 from the October 2012 forecast of the IMF in order to reduce the end-of-sample problem of the Hodrick-Prescott filter4. We have excluded transition countries (up to the mid-1990s) and Middle Eastern oil exporting countries, since the transition was characterised by enormous structural changes and the economies of oil exporters substantially differ from the economies of EU countries. Definitions of business cycle trough and creditless recoveries Similarly to Braun and Larrain (2005), Abiad, Dell'Ariccia and Li (2011) and Bijsterbosch and Dahlhaus (2011), we define the trough of the business cycle as the lowest point of the cyclical component of real GDP identified by the Hodrick-Prescott filter with smoothing parameter 6.25, which is the suggestion of Ravn and Uhlig (2002) for annual data. We only consider those troughs for which the lowest point of the cyclical component is below zero by more than its stan-

dard deviation. The recovery period is defined as the first three years following the trough. We required at least four years between subsequent troughs. The recovery is defined as creditless when the level of real credit stock (Claims on private sector, IFS line 32D5, deflated with the consumer price index) for three years after the trough is lower than in the year of trough6. The two main tables (page 5) Table 1 on the next page shows some main characteristics of both creditless and with-credit recoveries. We report median values of the various indicators, because there are a number of outliers in our sample. Table 2 reports test statistics checking the significance of the difference between the median values of the indicators for creditless and with-credit recoveries. In addition to total, we report statistics for three income groups based on GDP per capita relative to the US in the trough year: below 10 percent, between 10 and 60 percent, and above 60 percent and hereafter call these groups low-income, middle-income and highincome, respectively. Currently, EU countries would belong to the middle- and high-income groups and therefore we focus on these groups7. Incidence of creditless recoveries There are 428 recoveries in our sample of which 82 are creditless, ie about every fifth recovery. The incidence of creditless recoveries is highest in low-income countries (25.3 percent) and lowest in high-income countries (12.8 percent)8. In highincome countries, there were only 12 cases of creditless recoveries, the most recent in 1993, as indicated in Table A1 of the Appendix9. Growth Table 1 confirms the results from the literature that economic growth tends to be remarkable during the first three years of creditless recoveries (4.5 percent per year averaged across the full sample), even though it is less rapid than in recoveries with

Financial development may directly impact the incidence of creditless recoveries. Economies in their financial infancy might not be much impacted by the availability or the lack of credit, but credit constraints could be disruptive when companies rely heavily on credit.

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credit (6.0 percent). In high-income countries, the median speed of economic growth during the first three years of creditless recoveries is also impressive, 3.2 percent per year, just below the 4.1 percent annual growth rate during recoveries with credit. Yet the GDP growth rate may not be the best indicator for assessing the speed of recovery, because the global growth environment likely has an impact. Table 1 shows that GDP growth of trading partners used to be somewhat faster in recoveries with credit, though the difference is not large. Growth relative to trading partners was 2.7 percent during with-credit recoveries in low- and middle-

Table 1: Some key characteristics of creditless and with-credit recoveries

Recovery type Below 10% Creditless 38 Number of recoveries With-credit 112 % creditless 25.3% 4.8 Median real GDP growth (avg of three Creditless yrs after trough) With-credit 6.4 Creditless 3.5 Median real GDP growth of trading partners (avg of three yrs after trough) With-credit 3.7 Median real GDP growth relative to Creditless 1.2 growth of trading partners (avg of With-credit 2.7 three yrs after trough) Creditless 15 Median credit (% GDP) With-credit 15 Creditless 8 Median current account adjustment (%GDP) With-credit 5.5 Creditless 93 Median REER in 3 years after trough (%pre-trough peak) With-credit 91 52 Median openness (exports+imports, Creditless %GDP) With-credit 54
Source: Bruegel.

Per capita income (% US) 10%-60% above 60% 32 12 152 82 17.4% 12.8% 4.7 3.2 6.8 4.1 3.6 3.5 3.8 4 1.2 2.7 30 30 8.6 5.7 76 93 56 80 -0.5 -0.1 50 52 6.5 3 90 98 61 62

All 82 346 19.2% 4.5 6 3.5 3.8 0.8 1.9 27 26 8 4.6 86 94 56 63

Table 2: Wilcoxon-Mann-Whitney test for the equality of medians between the indicators creditless and with-credit recoveries
Median real GDP growth (average of three years after trough) Median real GDP growth of trading partners (average of three years after trough) Median real GDP growth relative to growth of trading partners (avg of three yrs after trough) Median credit (GDP %) Median current account adjustment (% GDP) Median REER in 3 years after trough (% pretrough peak) Median openness (exports+imports, % GDP) Full sample 4.21 (0.000) 2.78 (0.006) 2.95 (0.003) 0.49 (0.613) 4.03 (0.000) 2.18 (0.029) 1.18 (0.240) Excluding low income countries 3.21 (0.001) 2.2 (0.028) 2.01 (0.044) 0.28 (0.777) 3.75 (0.000) 2.8 (0.005) 1.18 (0.239)
group. Croatia, the 28th EU member from July 2013, would also belong to this group. The other eleven EU member states would be in the high-income group. 8. These results are consistent with the findings of Abiad, DellAriccia and Li (2011), who analyse 362 recoveries. 9. Note that we classify countries according to GDP per capita at PPP relative to the US in the year of trough, and therefore the twelve high-income countries with creditless recoveries also include the Bahamas in 1975 and Gabon in 1978 (see Appendix 2).

Source: Bruegel. Notes: p-values are in parentheses. Test statistics significant at 5 percent level are in italics. The WilcoxonMann-Whitney test is a non-parametric statistical hypothesis test.

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income countries, and only 1.2 percent during creditless recoveries, which is still quite substantial. In high-income countries, the difference between growth relative to trading partners of the two types of recoveries is smaller. Financial development We measured financial development using the credit/GDP ratio, which is an imperfect measure, but the only one available for a large number of countries across several decades. The median of this indicator is practically identical for creditless and with-credit recoveries, and therefore within an income group, financial development does not seem to make a difference for the incidence of creditless recoveries. However, Table 1 also confirms that economic and financial developments correlate positively and we have already found that the incidence of creditless recoveries declines with the level of economic development. Therefore, we can also conclude that creditless recoveries are rare at a higher level of financial development, which is confirmed by Figure 3. Current account Next, Table 1 indicates the magnitude of current account adjustment, which is defined as the difference between the maximum of current account/GDP positions during the three years after Figure 3: Histogram of the credit/GDP ratios of the 82 creditless recoveries
14 12 10

the trough, minus the minimum during the three years before the trough. Creditless recoveries are associated with greater current account adjustment, by about 3 percentage points of GDP, in all three income groups. Real exchange rate Current account adjustments are facilitated by adjustment in the real exchange rate. Table 1 shows that all recoveries in all three income groups tended to be associated with lasting real effective exchange rate depreciations, and depreciations tended to be greater in creditless recoveries compared to with-credit recoveries, except in low-income countries. The difference in median cases of creditless and with-credit recoveries is significant (Table 2). In the middle-income countries, the median real effective depreciation is 24 percent from the pre-trough peak until three years after the trough in the creditless cases, and only seven percent in the with-credit cases. The same figures for high-income countries are 10 percent and two percent. And in several cases, part of the depreciation was corrected by the third year after the trough. However, while creditless recoveries tend to be accompanied by sizeable and durable real exchange rate depreciations, this is not always the case. Figure 4 indicates that the median real exchange rate clearly tends downward during creditless recoveries in middle-income countries, but the upper boundary of the interquartile range remains close to 100, implying that there was no depreciation in about every fourth creditless recovery. Among the high-income countries, in two of the 12 cases the real exchange rate was at a higher level three years after the trough than the maximum before the trough. Consequently, not all, but most, creditless recoveries are associated with sizeable and durable real exchange rate depreciations, and the median depreciation is significantly larger than the depreciation during recoveries with credit in middle- and high-income countries.

Frequency

8 6 4 2 0 0 20 40 60 80 100 120 140 160 180

Credit (% of GDP) Source: Bruegel. Note: the four cases with more than 100 percent of GDP credit stock are Hong Kong in 1989 (169 percent), Malaysia in 1998 (156 percent), Thailand in 1998 (156 percent) and in Portugal 1975 (106 percent). In these cases the depreciation of the real exchange rate in three years after the trough compared to the pre-crisis peak was 8 percent, 16 percent, 58 percent and 18 percent, respectively.

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Figure 4: REER developments during creditless recoveries in middle- and high-income countries (pre-trough peak in REER = 100)
105 100 95 90 85 80 75 70 65

Middle-income countries

105 100 95 90 85 80 75 70 65

High-income countries

75% percentile Median 25% percentile

trough t+1 t+2 t+3 t-2 t-3 t-1

trough

t+1

t+2

Source: Bruegel. Note. The pre-trough peak in real effective exchange rates occurred in different years (see also eg Figure 2: in trough minus one year in Argentina, in trough minus two years in Chile and Mexico, and in trough minus three years in Uruguay), and therefore the median is not equal 100 in any particular year before trough. The 75 percent and the 25 percent refer to the first and third quartiles of the distribution of the REER developments (ie denote the boundaries of the interquartile range).

t+3

t-2

t-3

t-1

Trade openness Finally, we also checked if creditless recoveries emerged in countries more open to international trade, but this is not the case. If anything, countries with with-credit recoveries are somewhat more open (Table 1), but the difference is not significant (Table 2). 3 UNDERSTANDING CREDITLESS RECOVERIES As Abiad, Dell'Ariccia and Li (2011) rightly argue, creditless recoveries are puzzling from a theoretical perspective. While Calvo, Izquierdo and Talvi (2006a), and Biggs, Mayer and Pick (2009) sketch brief analytical models, it is fair to claim that comprehensive theoretical models have not been developed to understand creditless recoveries. Instead, authors studying such recoveries put forward certain hypotheses to explain them, as follows: Absorption of idle capacities: creditless recoveries used to happen after deep recessions and thereby idle capacities are available for growth: firms could exploit these capacities without investing (eg Calvo, Izquierdo and Talvi, 2006a, b; Abiad, Dell'Ariccia and Li, 2011; and Coricelli and Roland, 2011)10; Role of liquidity: following a liquidity crunch, liquidity is restored by discontinuing investment

projects, meaning that firms do not borrow (eg Calvo, Izquierdo and Talvi, 2006a, b); Incorrect measurement of credit developments: the change in credit growth may matter more for output growth than credit growth itself. When, for example, credit falls sharply in the trough year, but credit growth stabilises in the next year (even if at a negative growth rate), then the change in credit growth is positive in the year after the trough, and that may help economic recovery (Biggs, Mayer and Pick, 2009); Alternative financing: firms can rely on alternative sources of financing, such as trade credit (eg Claessens et al, 2009; Coricelli and Roland, 2011); Reallocation: a reallocation from more to less credit-intensive sectors takes place (eg Claessens et al, 2009; Abiad, Dell'Ariccia and Li, 2011; Coricelli and Roland, 2011); Strong external demand: disruptions to the supply of credit may not matter much for firms that are highly dependent on outside funding, if they produce goods that are highly tradable (IMF, 2009).

These explanations could all be valid to some extent, except perhaps the last one, because, as we found in Tables 1 and 2, GDP growth of trading partners tended to be faster in recoveries with credit. But our preceding analysis underlined that one more factor has to be added:

10. The results of the probit model estimates of Bijsterbosch and Dahlhaus (2011) are consistent with this interpretation, since they find that among the statistically significant variables linked to the incidence of creditless recoveries, two variables, the preceding output fall and the occurrence of a banking crises, are economically significant.

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Real exchange rate depreciation: can help finance exporting firms via increased trade revenues. We cannot claim causality that the weak real exchange rate causes output to recover when credit does not expand because GDP growth, credit growth and the real exchange rate are endogenous variables and we do not have a well identified formal model to back us up. Yet the stylised fact we established suggests that economic growth may prove to be difficult in the absence of sizeable real exchange rate depreciation, if credit growth does not return. 4 IMPLICATIONS FOR EUROPE Before the crisis, there was probably too much bank credit in several European countries. But the stock of bank loans at the end of 2011 was either similar to the 2008 stock or even lower in all countries and areas indicated in Table 3. The only notable nominal increase can be observed in the seven central and eastern European countries outside the euro area (CEE7). But this is largely due to the revaluation effect of foreign currency loans, because currency exchange rates depreciated in Hungary, Poland and Romania, where foreign currency loans were widespread. In real terms, there was a fall in all areas and countries indicated in the table. Table 3: Loans to non-nancial corporations measured in domestic currency (2008=100)
nominal real nominal United Kingdom real nominal Denmark real nominal Sweden real Cent. & east- nominal ern Europe 7 real Euro area 17 2000 56 67 41 48 48 56 44 51 33 45 2008 100 100 100 100 100 100 100 100 100 100 2011 102 96 89 80 91 86 101 96 110 98

Two major issues have to be discussed for the assessment of the potential for creditless recoveries in Europe: the role of supply and demand in credit contraction, and the potential for alternative source of financing beyond bank loans. Credit supply and demand The fall in credit aggregates could be related to both credit supply and credit demand, but also the writing-down of loans: Credit supply: banks facing a deteriorating loan portfolio during a recession can tighten credit standards and reduce credit supply. New requirements for higher capital and liquidity ratios and lower leverage can also lead to a reduction of credit. Credit demand: with the fall in output and increased uncertainty about the outlook, firms reduce their production and investment activities, and thereby reducing credit demand. Also, highly indebted firms may wish to deleverage during a downturn. Write-downs: in a recession bankruptcies increase and banks suffer losses on their loan portfolios and write-down some claims, which also reduces the aggregate stock of loans. All three factors can play a role during creditless recoveries and from a policy perspective they have different implications. However, several research papers suggest that credit supply had a major role, both during earlier creditless recovery episodes and during the current episode of sluggish credit development. Regarding earlier episodes, it was found that industries that are more dependent on external finance are hit harder during recessions (a finding corroborated by Braun and Larrain, 2005) and these industries recover disproportionately less during a creditless recovery than those that are more self-financed (a finding of Abiad, Dell'Ariccia and Li, 2011). When bank loans, debt securities and equity are not perfect substitutes, these findings suggest that impaired financial intermediation, and hence limitations in credit supply, was a major reason for past creditless recoveries. There is also abundant academic research con-

Source: Bruegel using data from the Financial balance sheets and Harmonised indices of consumer prices databases of Eurostat and the Non-consolidated financial balance sheets by economic sector database of the OECD. Note: CEE7 is the aggregate of the seven countries in central and eastern Europe that are not members of the euro area: Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland and Romania.

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cluding that recently, limited credit supply was an important factor in credit developments in several advanced economies. Hampell and Sorensen (2010) adopt a panel-econometric approach applied to a unique confidential dataset of results from the Eurosystems bank lending survey, and conclude that even after controlling for various demand-side factors, loan growth is negatively affected by supply-side constraints. Using a different technique panel vector autoregression identified with sign restrictions Hristov, Hlsewig and Wollmershuser (2012) find that that loansupply shocks significantly contributed to the evolution of the loan volume and real GDP growth in euro-area member countries during the financial crisis. The role of credit supply is also corroborated by country-specific studies, for example for Italy by Del Giovane et al (2012) and for Spain by Jimnez et al (2012). Empirical results for non-euro area countries are similar. Aiyar (2011) looked at UK banks using detailed confidential balance sheet data reported to the Bank of England, and found that shocks to foreign funding caused a substantial pullback in domestic lending. Using US firm-level data, Becker and Ivashina (2011) interpret switching by firms from loans to bonds as a contraction in credit supply, conditional on the issuance of new debt. They find strong evidence of substitution of loans by bonds during periods characterised by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. They also find that this substitution behaviour has predictive power for bank borrowing and investment of small (out-ofsample) firms, which are not able to issue bonds. In a related paper, Adrian, Colla and Shin (2012) also document the shift from loans to bonds in the composition of credit in the US, and argue that the impact on real activity comes from the spike in risk premiums, rather than contraction in the total quantity of credit. Gertler (2012) adds, by sketching a simple conceptual framework, that credit spreads are a more useful indicator of credit supply disruptions than credit quantities. Gertler (2012) cites Gilchrist and Zakrajsek (2012), who conclude that the increase in spreads during the recent financial crisis was likely symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers11. Certainly, the above-mentioned studies analysed data that was available at the time of writing and therefore their sample periods end between 2009 and 2011. Since then, a number of attempts were made by European governments and the European Central Bank to help restoring normal lending and therefore the finding that credit supply was limited up to 2009 or 2011 may not necessarily imply that such limitations exit now as well. However, European banks still suffer from a large, 400 billion, capital shortfall according to the OECD (2013); the share of non-performing loans continues to be high; bank share prices are low even after the recent increases; and banks need to meet tight capital, liquidity and leverage requirements, even though some of the Basel III requirements were relaxed in January 2013 (Basel Committee, 2013). These factors suggest that credit supply may remain constrained in the EU. Substitution of bank loans While there was notable substitution of bank loans with debt securities in the US, this was not really the case in continental Europe, as Figure 1 indicated for the aggregate of the euro area12. Figure 5 shows the share of loans in debt liabilities of EU countries (including Croatia) in 2008 and 2011. The country-specific evidence confirms the main message that the issuance of securities has hardly replaced loans in continental Europe. Note that since we are using balance sheet data, all kinds of loans, and not just loans from domestic banks, are included. Lack of substitution of bank loans with debt securities is a typical problem in bank-based economies,

11. These authors argue that a credit supply disruption emerges when banks take losses on their loan portfolio, leading to large losses on their equity capital. Tightening of bank credits increases the demand for open market credit by non-financial firms, which, in conjunction with financial frictions, leads to an increase in open market interest rates as well. 12. See Bijlsma (2013) for a comprehensive account of the mega-trends of financial intermediation in Europe.

Lack of substitution of bank loans with debt securities is a typical problem in bank-based economies, and likely has an implication for the speed of economic recovery. Market-based economies experience significantly stronger rebounds than bank-based economies.

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Figure 5: The share of loans in debt liabilities of non-nancial corporations in the EU, 2008 and 2011
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

2008 2011

Latvia

Lithuania

Bulgaria

Romania

Slovakia

Slovenia

Croatia

Estonia

Malta

Denmark

Cyprus

N lands

Sweden

Germany

Hungary

Czech Rep

Portugal

Finland

Greece

Poland

Austria

Spain

Ireland

Italy

Belgium

Source: Eurostat Financial balance sheets database. Note: countries are ordered according to the share of loans in 2011.

and likely has an implication for the speed of economic recovery. By studying 84 recoveries in 17 OECD countries between 1960-2007, Allard and Balvy (2011) found that market-based economies experience significantly and durably stronger rebounds than the bank-based economies13. 5 CONCLUDING REMARKS The literature on creditless recoveries is cautiously optimistic, concluding that while they are not optimal because of weak investment performance, they are not rare and the speed of recovery is still impressive. We also found, by studying historical episodes of economic recoveries in 135 countries during the past five decades, that average yearly real GDP growth during the first three years after the trough was 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries14. Many policymakers would probably be very happy if real GDP growth could reach such rates now. However, we have drawn a sceptical conclusion on the implications of the historical episodes of creditless recoveries for current European circumstances, for two major reasons. Firstmore, the incidence of creditless recoveries is much lower in high-income countries, which are characterised by high levels of financial development, than in low-income countries in their financial infancy. Since most European countries heavily depend on bank loans, credit constraints could be disruptive. Also, in contrast to the US,

where the issuance of debt securities compensated for the withdrawal of bank loans, there has been rather limited substitution in continental Europe. Furthermore, the issuance of debt securities is not an option for small and medium-sized enterprises (SMEs), which account for a significant share of the total number of firms, and play a crucial role in economic growth and employment. A recent report from the OECD (2012) showed that during the recent credit crunch, SMEs were harder hit than big firms and faced more severe lending conditions. Access to finance thus remains vital for the creation, growth and survival of SMEs. Consequently, pursuing further policies to restore the ability of banks to lend is vital. Second, during historical episodes of creditless recoveries, exchange rate depreciation have likely played a role by increasing revenues from foreign trade, which could have supported company financing when access to credit was limited. We found that while both creditless and with-credit recoveries tend to be associated with real exchange rate depreciation, the depreciation was significantly larger and more persistent during creditless recoveries. In middle-income countries, the median depreciation of the consumer price index-based REER from the pre-crisis peak to three years after the trough was 24 percent, but during with-credit recoveries it was 7 percent. In highincome countries, the same numbers are 10 percent (creditless) and 2 percent (with-credit). Since the current global financial and economic

13. However, they also found that stronger recoveries tend to be associated with greater economic flexibility. When employment and product market flexibility are taken into account, the comparative advantage of market-based economies in recoveries is less significant and therefore it is difficult to claim causality. 14. These growth rates are high even though they are lower than growth during recoveries with credit. Also, when looking at growth relative to the growth of trading partners, creditless recoveries were less speedy than growth during recoveries with credit, yet still impressive: there was a 1.2 percent extra growth relative to trading partners in middle income countries and a 0.5 percent growth shortfall relative to trading partners in high income countries.

France

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crisis erupted, the depreciation in most euro-area countries fell short of these benchmarks. In Ireland, a high-income country, the 15 percent depreciation from pre-crisis peak to 2012 was greater than the benchmark, and the depreciations in Germany (9 percent), the Netherlands (8 percent), Finland (8 percent) and France (8 percent) are not far from it. But the depreciations in Italy (6 percent), Spain (5 percent), Portugal (5 percent) and Greece (4 percent) are far below the benchmark for the middle-income country group, ie the group to which they belong15. Unfortunately, these southern European countries are also those that experience sizeable contractions in the outREFERENCES Abiad, Abdul, Giovanni Dell'Ariccia, and Bin Li (2011) Credit-less Recoveries, Working Paper 11/58, International Monetary Fund Adrian, Tobias, Paolo Colla and Hyun Song Shin (2012) Which Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007-9, Working Paper No. 18335, NBER Aiyar, Shekhar (2011) How did the crisis in international funding markets affect bank lending? Balance sheet evidence from the United Kingdom, Working Paper No. 424, Bank of England Allard, Julien and Rodolphe Balvy (2011) Market Phoenixes and banking ducks: Are recoveries faster in market-based economies?, Working Paper No. 11/213, International Monetary Fund Basel Committee (2013) Basel Committee releases revised version of Basel III's Liquidity Coverage Ratio, Press Release, Basel Committee on Banking Supervision, 7 January, http://www.bis.org/press/p130107.htm Bayoumi, Tamim, Jaewoo Lee and Sarma Jayanthi (2006) New Rates from New Weights, Staff Papers 53(2), 272-305, International Monetary Fund Becker, Bo and Victoria Ivashina (2011) Cyclicality of Credit Supply: Firm Level Evidence, Working Paper No. 17392, NBER Bijlsma, Michiel (2013) Banks versus markets the changing financial landscape, Working Paper, forthcoming, Bruegel Biggs, Michael, Thomas Mayer and Andreas Pick (2009) Credit and economic recovery, Working Paper No. 218/2009, De Nederlandsche Bank Bijsterbosch, Martin and Tatjana Dahlhaus (2011) Determinants of credit-less recoveries, Working Paper No. 1358, European Central Bank Braun, Matas and Borja Larrain (2005) Finance and the Business Cycle: International, Inter-Industry Evidence, The Journal of Finance 60(3), 1097-1128 Calvo, Guillermo A., Alejandro Izquierdo, and Ernesto Talvi (2006a) Phoenix Miracles in Emerging Markets: Recovering without credit from systemic financial crises, Working Paper No. 12101, NBER Calvo, Guillermo A., Alejandro Izquierdo, and Ernesto Talvi (2006b) Sudden Stops and Phoenix Miracles in Emerging Markets, American Economic Review, 96(2), 405-410 Claessens, Stijn, M. Ayhan Kose and Marco E. Terrones (2009a) A recovery without credit: Possible, but..., 22 May, voxeu.org Claessens, Stijn, M. Ayhan Kose and Marco E. Terrones (2009b) What happens during recessions, crunches and busts?, Economic Policy Vol. 24, Issue 60, 653-700 standing stock of bank loans to non-financial corporations and therefore they face the double challenge of limited real exchange rate depreciation and sizeable contraction in credit16. We did not set up a causal model and hence cannot claim that the real exchange rate depreciation was a cause of creditless recoveries, because GDP growth, credit growth and the real exchange rate are endogenous variables. Yet the stylised facts we established suggest that if credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation.

15. In some of these southern euro-area members, the unit labour cost-based REER index depreciated more than the consumer prices index-based REER, even when controlling for the changing composition of the economy (Darvas (2012b). Unfortunately, the fall in unit labour costs was largely the result of massive lay-offs (Darvas (2012b), and did not translate into a fall in prices, as discussed by Wolff (2012). 16. In Italy, the real stock of credit to non-financial corporations remained broadly stable until mid-2011, when it started to fall by about 8 percent until end2012. This cumulative decline is smaller than the declines in Greece, Portugal and Spain and is similar in magnitude to what happened more gradually in Germany between 2008 and 2012.

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Darvas, Zsolt (2012a) Real effective exchange rates for 178 countries: a new database, Working Paper 2012/06, Bruegel Darvas, Zsolt (2012b) Compositional effects on productivity, labour cost and export adjustment, Policy Contribution 2012/11, Bruegel Del Giovane, Paolo, Ginette Eramo and Andrea Nobili (2012) Disentangling demand and supply in credit developments: A survey-based analysis for Italy, Journal of Banking & Finance 35, 2719 2732 Gilchrist, Simon and Egon Zakrajsek (2012) Credit Spreads and Business Cycle Fluctuations, American Economic Review 102(4), 16921720 Gill, Indermit, Martin Raiser, and others (2012) Golden growth: Restoring the lustre of European economic model, World Bank, available at www.worldbank.org/goldengrowth Jimenz, Gabriel, Steven Ongena, Jos-Luis Peydr and Jess Saurina (2012) Credit Supply versus Demand: Bank and Firm Balance-Sheet Channels in Good and Crisis Times, European Banking Center Discussion Paper No. 2012-003 Hempell, Hannah Sabine and Christoffer Kok Srensen (2010) The impact of supply constraints on bank lending in the euro area: Crisis induced crunching?, Working Paper No. 1262, European Central Bank Hodrick, Robert and Edward C. Prescott (1997) Postwar U.S. Business Cycles: An Empirical Investigation, Journal of Money, Credit, and Banking, 29(1), 1-16 Hristov, Nikolay, Oliver Hlsewig and Timo Wollmershuser (2012) Loan supply shocks during the financial crisis: Evidence for the Euro area, Journal of International Money and Finance 31, 569 592 International Monetary Fund (2009) Box 3.2. Is Credit a Vital Ingredient for Recovery? Evidence from Industry-Level Data, Chapter 3, World Economic Outlook OECD (2012) Financing SMEs and Entrepreneurs 2012: An OECD Scoreboard, OECD Publishing OECD (2013) Strengthening Euro Area banks, http://www.oecd.org/eco/economicoutlookanalysisandforecasts/strengtheningeuroareabanks.htm Ravn, Morten O. and Harald Uhlig (2002) On adjusting the Hodrick-Prescott filter for the frequency of observations, The Review of Economics and Statistics 84(2), 371-375 Veugelers, Reinhilde (2011) Assessing the potential for knowledge-based development in transition countries, Society and Economy 33(3), 475-504 Wolff, Guntram B. (2012) Arithmetic is absolute: euro area adjustment, Policy Contribution 2012/09, Bruegel

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APPENDIX 1: DATA SOURCES FOR THE CALCULATIONS IN SECTION 2 GDP: GDP at constant prices is from the IMFs World Economic Outlook (WEO) October 2012 for 19802017 (when available). Missing data and earlier data was chained to the WEO data from IMF International Financial Statistics, World Bank World Development Indicators (WDI), EBRD and the Maddison dataset. GDP of trading partners: for each country we calculated the weighted average of real GDP growth of trading partners, using country-specific weights derived on the basis of Bayoumi, Lee and Jaewoo (2006). Due to missing data (mostly for transition economies before 1990), we calculated two indices: one using GDP data of 145 countries, which is available form 1960, and another one using GDP data of 175 countries for recoveries in 1993 and later. GDP per capita at PPP (purchasing power parity) relative to the United States: the main source of GDP per capita at PPP is the October 2012 IMF WEO, which includes data for 1980-2017 with some gaps for some countries. The figures relative to the U.S. were calculated from this database for 1980-2017. Missing values during from 1980, and values before 1980, were approximated by calculating the change in real GDP per capita relative to the US and chaining this ratio to the most recent data available on relative GDP per capital at PPP in the IMF WEO. Real GDP growth rates are from the sources described above, while population data is from World Bank WDI. Credit: Claims on private sector, line 32D, from IMF International Financial Statistics. Credit/GDP: nominal credit divided by nominal GDP, which is from the IMF World Economic outlook October 2012 and IMF International Financial Statistics. Real credit: nominal credit deflated by the consumer price index, which is from the IMF International Financial Statistics. Real effective exchange rate: updated database of Darvas (2012a). Due to missing data, we have calculated the real effective exchange rate against four different country groups: against 172 countries for 1993-2012, against 145 countries for 1980-2012, against 99 countries for 1970-2012 and against 67 countries for 1960-2012. For each case of recovery, we use the broadest available REER. Exports and Imports (% GDP): for most countries, data is available in the IMF International Financial Statistics for all three variables (exports of goods and services, imports of goods and services, and GDP; all are at current prices). Missing data for exports and imports were filled from UNCTAD.

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APPENDIX 2: LIST OF CREDITLESS RECOVERIES
High income countries Norway 1990 United States 1991 Denmark 1975 France 1993 Italy 1993 Hong Kong 1998 Sweden 1993 United Kingdom 1975 Bahamas 1975 Gabon 1978 Finland 1993 Iceland 1961 Middle income countries Greece 1987 Barbados 1973 Gabon 1987 Portugal 1986 Portugal 1975 Mexico 1983 Trinidad and Tobago 1984 Jamaica 1976 Mexico 1995 Malta 1974 Malaysia 1998 Argentina 1990 Brazil 1992 Argentina 2002 Uruguay 1985 Botswana 1994 Uruguay 2002 Suriname 1993 Chile 1983 Ecuador 1983 Colombia 1985 Guyana 1973 Paraguay 1983 Colombia 1999 Tonga 1989 Ecuador 1987 Thailand 1998 Ecuador 1999 Botswana 1977 Paraguay 2002 Belize 1982 Western Samoa 1991 Low income countries Guyana 1990 Congo, Rep. 1987 Philippines 1985 Ivory Coast 1984 Indonesia 1998 Sri Lanka 1989 Djibouti 1996 Madagascar 1973 Senegal 1983 Ghana 1976 Papua New Guinea 1997 Ivory Coast 1992 Cameroon 1994 Papua New Guinea 1990 Niger 1969 Pakistan 1972 Nigeria 1987 Tanzania 1965 Tanzania 1969 Sierra Leone 1992 Tanzania 1974 Comoros 1991 Benin 1989 Central African Republic 1983 Zambia 1995 Guinea Bissau 1998 Mali 1978 Haiti 2004 Togo 1993 Uganda 1980 Tanzania 1994 Malawi 1981 Burkina Faso 1990 Burundi 1980 Sierra Leone 1997 Sudan 1985 Sudan 1996 Malawi 1994

Note: the cases are ordered according to GDP per capita in the year of trough.