The credit cycle: what is its role in economic crises?

In general terms, the expansion of credit to households and companies has a beneficial effect on the economy. Nevertheless, this does not mean that this activity is risk-free, as explained by MAPFRE Economics, MAPFRE’s research arm, in the report Credit and insurance activity, which analyzes the evolution and role of credit in the economy and its relationship with insurance demand.

Excessive and accelerated credit growth, coupled with the relaxation of credit criteria, can trigger or aggravate economic crises. This must also be added to the reaction of financial institutions in these situations, which tend to restrict the granting of credit, often leading to significant corrections in asset prices, thereby prolonging and deepening the initial economic crisis.

One of the key indicators used to assess the stage of the credit cycle in a given economy is the credit gap. This measures deviations in credit relative to GDP compared to its long-term historical average. This ratio is used, among other indicators, by banking supervisors to assess systemic risks and determine the anti-cyclical cushion requirements for credit institutions.

In Japan, we can point out the expansionary credit cycle that took place in the late 1980s and early 1990s, characterized by a wide positive credit gap for both households and the corporate sector. During the 1980s, a combination of low interest rates, lax monetary policies, and an excess of confidence in the continuity of economic growth led to an accelerated increase in land and home prices. Banks and financial institutions heavily expanded mortgage-guaranteed loans for land and homes whose valuations continued to increase, and companies heavily invested in real estate assets by resorting to borrowing, which generated a new rise in the prices of these assets and all prices in general, causing an inflationary spiral. Faced with this situation, in the early 1990s, the Bank of Japan began to increase interest rates to control inflation, which caused an abrupt correction of asset prices. The real estate market collapsed, leaving banks, non-financial corporations, and individuals with huge debts and devalued assets, which slowed the new construction of homes and triggered a deep economic recession that lasted a decade and had long-term consequences for the Japanese economy.

In the case of the United States, the 2008 real estate crisis also originated from the uncontrolled expansion of credit and speculation in the real estate market. For years, low interest rates and lax mortgage lending practices, especially those involving “subprime” loans, fueled a real estate bubble. Millions of people, even with low incomes and a poor credit history, obtained mortgage loans, believing that housing prices would continue rising indefinitely. Many of these loans were securitized and sold to institutional and retail investors worldwide, thanks to the profound development of the U.S. capital markets.

This reheating of the real estate market ended up affecting the rest of the economy, generating an inflationary spiral, as happened in Japan in the early 1990s. Thus, when the Federal Reserve began raising interest rates in 2004 to control inflation, many homeowners found themselves unable to pay their mortgages, leading to a massive increase in foreclosures. The value of homes collapsed, dragging down banks and financial institutions that had invested in derivative products backed by these mortgages. The result was a liquidity crisis that spread rapidly throughout the global financial system, triggering what ended up being called the ‘Great Recession.’

Another economic crisis that originated in excess credit is the real estate crisis in Spain, with its peak between 2007 and 2008 and which lasted until 2011-2012, linked to the sovereign debt crisis in the eurozone. The Spanish real estate crisis was the result of a speculative bubble in the construction sector that had been building since the late 1990s. It was also influenced by the rapid expansion of credit in the early 2000s, coinciding with Spain’s entry into the eurozone. Factors such as easy access to credit, low interest rates, and growing demand, both domestic and foreign, led to an excessive rise in prices and new housing construction. The number of new homes was increasing at an unsustainable rate, often in areas with low real demand, fueled by credit. This created expectations that prices would continue to rise indefinitely. The trigger behind the crisis in Spain was the global financial crisis of 2008. Credit increased, demand contracted, and prices began to fall. Thousands of households were unable to pay their mortgages, which caused an increase in mortgage foreclosures and aggravated the crisis. The construction sector, an engine of the Spanish economy for years, collapsed, dragging down other sectors and causing a sharp increase in unemployment.

The real estate crisis had a profound impact on the Spanish economy, and since then, the pace of new housing construction has not returned to the levels seen at the peak of the credit cycle that triggered the subsequent crisis. As a result, there was a banking restructuring and consolidation in the following decade that completely changed the landscape of the banking and insurance sectors.

Which countries currently have the most risk of suffering a credit-related crisis?

Analyzing a historical series of the credit gap to the private sector, households, and non-financial corporations in the three countries mentioned (Japan, the United States, and Spain) that have experienced crises caused by excessive credit, it becomes evident that these economic crises impacted variables directly linked to insurance activity. These include new housing construction, real estate prices, and new vehicle registrations, in addition to the effects on nominal GDP and private consumption, which also have negative repercussions on insurance activity.

The analysis of the credit gap calculated at the end of the first quarter of 2024 (credit to GDP gap) reveals that Argentina’s economy currently presents the highest risk regarding its credit cycle, mainly due to the large gap in credit to the public sector, which stands 19.2 percentage points of GDP above its long-term historical average at the end of the first quarter of 2024. Following Argentina are Ireland, Norway, and Denmark, due to the significant gaps in both household and non-financial corporate credit, with GDP percentages substantially higher than their long-term historical averages. The cases of the Czech Republic and China are also notable, due to the credit gap for non-financial companies, with percentages of GDP significantly higher than their long-term historical average.

In contrast, economies like Japan, Spain, and the United States, after experiencing deep real estate crises, entered into a prolonged process of deleveraging by households and the corporate sector. As a result, they currently present lower credit risk, all having negative credit gaps with GDP percentages below their long-term historical averages. The same applies to countries like Greece and Portugal. However, in these countries, as well as in Spain and, more broadly, the rest of the eurozone (except for Germany), the negative credit gap to governments is closing rapidly, which could create vulnerabilities in the future.

RELATED ARTICLES: