Global, national and local economic trends affect credit demand and quality; credit factors also impact economic growth, employment, inflation, and the fiscal surplus or deficit of federal, state and local governments. Credit demand tends to decline in a weak economy. The repayment of credit previously extended often slows during and after a recession. By contrast, firms expand investment in working capital and plant & equipment as sales improve during initial economic recovery and later growth. In addition, the quality of credit recovers during economic expansion. Economic trends are important to the credit industry. Yet, it is difficult to forecast accurately whether and when the economy will recover, expand, slow or contract. This article reviews the recent empirical relationship between the economy and credit factors. We then demonstrate how credit managers can use readily available financial market data to forecast economic trends.
Economic Conditions and Credit Factors
As of mid-year 2004, the U.S. economy appears poised to expand after recovering slowly and unevenly from the last recession marked by the National Bureau of Economic Research between March and November 2001. Business and government had invested heavily in computers and software prior to Y2K. Equity investors bid up stock prices for companies within the technology sector and the promising dot.com component. The market euphoria ended early in 2001 and marked the end of the prior ten-year period of growth. Financial market relationships highlighted in this article were flashing signs of an impending recession six to nine months earlier.
Table 1 illustrates the annual dollar change in credit market instruments (i.e., commercial paper, corporate bonds, bank loans, etc.) and trade payables for non-financial business. The table shows the flow of funds and represents the dollar change in funding from one year to the next. A positive value indicates growth while a negative value indicates contraction. A less positive value than the prior year indicates growth at a slower or lesser pace.
* Industry has relied on the issuance of net new credit market instruments over each of the past five years. However, the rate of growth sharply declined in the recession year of 2001 and the year after as capacity utilization rates declined and working capital requirements fell. Interest rates often decline in a recession and many firms elected to replace short-term commercial paper and bank loans with long-term fixed-rate bonds.
* The impact of the recession is clearly visible when evaluating the importance of trade payables. Trade credit did not increase at a decreasing rate as shown for credit market instruments; trade credit plummeted in 2001 and expanded very little the year after ms many firms had little reason to buy goods or services on credit given slack within many sectors of the economy.
There is normally a close positive relationship between economic trends and the demand for credit by business.
By historical standards, the recession of 2001 was shallow. The central bank aggressively engineered monetary accommodation by reducing the trading range of federal funds 13 times from 6.5 percent to just one percent. The federal government provided fiscal stimulus by increased spending on defense and homeland security, and reduced personal income tax obligations. The combined governmental actions provided a catalyst to jump-start the jobless recovery for much of 2002 and 2003.
Despite the relatively short and shallow recession, credit quality deteriorated. Table 2 illustrates the annual trend in the percentage of large bank loans that were charged off and other loans 90+ days slow in payment or placed in non-accrual status.
* Large banks with assets in excess of U.S. $10 billion incurred larger loan charge-offs and fewer recoveries in the recession year of 2001. …