Academic journal article Economic Inquiry

Studying the Effects of Household and Firm Credit on the Trade Balance: The Composition of Funds Matters

Academic journal article Economic Inquiry

Studying the Effects of Household and Firm Credit on the Trade Balance: The Composition of Funds Matters

Article excerpt

I. INTRODUCTION

The implications of higher levels of financial development have been investigated in a large number of studies, both in the empirical growth and in the financial crisis literatures. (1) A widely used indicator of financial development is the relative importance of loans issued by commercial banks and other financial intermediaries to the entire private sector; that is, the private credit-to-gross domestic product (GDP) ratio, following the definition by King and Levine (1993a, 1993b).

A higher level of private credit indicates better developed financial markets and easier credit access for businesses and households. Yet, these two types of borrowers vary in terms of the use of credit and might have different effects on macroeconomic performance. In this article, we study the link between the components of private credit and the trade balance. We focus on the distinction between household and corporate sector credit and investigate whether these two types of credit have adverse effects on the trade balance of goods and services.

This article builds on a theoretical framework by Backus, Kehoe, and Kydland (1994) who study the dynamics of the trade balance. We extend their work by assuming two types of households, one being credit constrained due to enforcement problems. We then ease the credit constraints on households and firms and study the hypothesized effects by comparative statics analysis. More specifically, we argue that an increase in household credit raises the demand for consumption goods, whereas firm credit growth raises the demand for investment goods. While both can have a negative impact on the trade balance, the difference is important because borrowing to finance consumption does not add to the productive capacity of an economy and to greater export earnings (Frankel and Rose 1996). Firm credit, on the other hand, has the potential to increase investment by relaxing the credit constraints on firms, thus increasing exports and trade balance.

Exploring the decomposition of private credit in emerging countries is relevant for several reasons. First, the effects of the increased level of household credit in emerging economies are still ambiguous. On the one hand, better access to credit helps credit constrained households to smooth out their consumption; on the other hand, it boosts spending and hence decreases savings. In an influential paper, Japelli and Pagano (1994) show that liquidity constraints on households raise the saving rates. They also find empirical evidence that an increase in household credit decreases saving rates for a sample of Organization for Economic Cooperation and Development (OECD) countries. Yet, the effects of household credit in emerging economies have not been explored.

Second, if we find that household and firm credit have different impacts on the trade balance of goods and services, this underlines the importance of the decomposition of private credit, which will also have key implications for the financial development growth link. The level of private credit in emerging economies has been rising steadily after the financial liberalization process that took place in early 1990s. However, higher levels of total private credit do not necessarily imply higher levels of firm credit. In fact, data for emerging economies show that household credit, rather than firm credit, has been rapidly increasing in the past decade. The higher share of household credit in the total private credit can crowd out investment, especially in countries where stock and bond markets are not well developed to finance investment.

Finally, a possible negative link between household credit and trade balance has important policy implications for emerging economies. As argued by Wood (1997), "[...] the [International Monetary] Fund continues to place most emphasis within its programmes on the stabilisation objective and therefore the core of IMF programmes continues to be based upon the restriction of domestic credit creation [. …

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