The Credit-to-GDP Gap and What it Means for the World's Economy

Hidden away on page 33 of the Bank of International Settlements (BIS) Quarterly Review from September 2015 we find this interesting table:

While I realize that the concept is rather abstract, for the purposes of this posting, we will be focussing on the little-discussed metric, the credit-to-GDP gap.  

Before we delve into the concept of the credit-to-GDP gap, let's get some background information first.  As we found out during the Great Recession, losses in the banking sector can be massive when an economic downturn is preceded by a period of excessive lending/credit (i.e. a credit bubble).  These losses can destabilize the banking sector and this instability can further spread throughout the economy which then feeds back to the banking sector.  One way of protecting the banking sector from this circular crisis is to have the banks build up additional capital defences.  According to the Basel III regulatory framework, banks must build up a countercyclical buffer to ensure that the banking sector capital requirements take account of the macrofinancial environment in which they operate.  Here are the three key elements of the countercyclical buffer regime:

"(a) National authorities will monitor credit growth and other indicators that may signal a build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallises or dissipates.

(b) Internationally active banks will look at the geographic location of their private sector credit exposures and calculate their bank specific countercyclical capital buffer requirement as a weighted average of the requirements that are being applied in jurisdictions to which they have credit exposures.

(c) The countercyclical buffer requirement to which a bank is subject will extend the size of the capital conservation buffer. Banks will be subject to restrictions on distributions if they do not meet the requirement."

By implementing the countercyclical buffer, the banking sector hopes to have a buffer of capital that will protect it against future potential losses.

Now, let's go back to the subject of this posting.  The credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-term trend.  The more familiar term, the credit-to-GDP ratio, is the ratio of a country's national debt to its gross domestic product.  The credit-to-GDP gap is a measure that provides advanced signals of banking system stress and can be used to as part of a set of central bank policy tools to mitigate banking system risk.  Under the Basel Committee on Banking Supervision (aka Basel III), as I noted above, the countercyclical capital buffer system of the banking system should be raised when a nation's credit-to-GDP ratio (where credit is defined as credit given to the household and private non-financial corporate sector or HH and PNFC credit) exceeds its long-term trend by two percentage points.  Research has shown that the credit-to-GDP gap worked well in providing an advance signal of past United Kingdom banking crises and other research has shown that indicators of excessive credit growth during credit booms provide advance warnings of financial crises as we can see on this chart:

It is quite clear that the credit-to-GDP gap rose significantly (i.e. the credit-to-GDP ratio rose at a much faster rate than it did over the long-term) just before the recession in the early 1970s, early 1990s and the Great Depression.

Now that we have that understanding (hopefully), let's go back to the table in the BIS Quarterly Review, focussing on the first column which shows the credit-to-GDP gap (i.e. the difference in the credit-to-GDP ratio from its long-term trend):

Where the cell is highlighted in red, the credit-to-GDP gap is greater that 10 and where it is beige, it ranges between 2 and 10.   As you can see, the credit-to-GDP gaps for Asia (which includes Indonesia, Singapore and Thailand), Brazil, China and Turkey are all well above 10.  The authors of the report note that:

 "...in the past, two-thirds of all readings above this threshold (of 10) were followed by serious banking strains in the subsequent three years."

It is also important to note that Canada, France, Japan, Mexico and Switzerland all have credit-to-GDP gaps that are above 5, well above the 2 percent mark that applied in the case of the United Kingdom as I noted above.  While the credit-to-GDP gap does not yet show that the banking systems in these five economies are under "strain", the high growth level of credit in these economies suggests that there could be problems with the banking sector down the road.

As we can see from this posting, it looks like China, with its extremely high credit-to GDP gap of 25.4, may find its banking sector under pressure as the massive expansion in its household and corporate sector credit comes back to haunt it.  At the very least, China's high credit-to-GDP gap shows us that we should expect further financial unrest in China.  And, as we know, what's bad for China is bad for the global economy.