The prospects for recovery from the 2008 global financial crisis appear to be on the horizon. The focus in the blogosphere has likewise shifted from forecasting the recession’s depth to predicting the letter characterising the recovery’s output path – U, V, W, or L (Eichengreen and O’Rourke, 2009).
What determines the path of recovery from a recession associated with a financial crisis? About 7 months ago, my colleagues and I presented results from research done at the IMF on patterns of recovery from financial crises in advanced economies (Kannan, Scott, and Terrones, 2009). Recoveries from recessions associated with financial crises were found to be slower relative to a typical recovery. The average time taken for output to return to its previous peak was about six quarters, compared to three quarters for all other recoveries. One year after the trough of the recession, the average growth rate of output was only about 2% for these episodes, compared to an average growth rate of about 4% for recessions that were not associated with a financial crisis.
One particularly striking finding from this research is that recoveries from recessions associated with financial crises in advanced economies feature a near-absence of growth in domestic credit (Figure 1). Credit remains essentially flat even up to two years after the end of the recession, a pattern that is significantly different from all other recovery episodes. Although the demand for credit is generally lower in the aftermath of a financial crisis as households and firms deleverage, stressed credit conditions during these episodes suggest that restrictions in the supply of credit are also important.
Figure 1. The behaviour of credit and output during recoveries
In new research, I investigate whether the stressed credit conditions that arise during financial crises tend to persist even after output has started to recover, thus constraining the pace of recovery (Kannan 2009). The empirical approach I use is based on the Rajan and Zingales (1998) identification scheme – if credit conditions are important, industries that are more reliant on external finance or more subject to financial frictions should recover relatively slowly following a recession associated with financial crises. Additionally, as the severity of frictions increases, so should the impact of the dependency on external finance on growth during recovery.
My findings suggest that credit conditions play an important role in constraining recovery from recessions associated with financial crises. Industries that rely more on external finance grow more slowly during recoveries from these episodes relative to all other recoveries, suggesting that credit conditions remain stressed well after the trough of the recession. The effects are strongest during the first year of the recovery phase and become insignificant only after three years. Importantly, this differential growth rate is significantly different from what we observe during a typical recovery.
Looking at two partitions of the sample by financial frictions – the average degree of tangibility of assets in an industry and the share of industry output that is traded – provides evidence of the importance of credit conditions. Industries characterised by a higher degree of tangible assets are in a better position to pledge these assets as collateral and thus have a lower cost of external finance, while industries that produce goods that are more tradable have an easier time accessing credit from external sources either through trade credits or by pledging export receivables. Industries that rely more on external finance perform even worse during recovery from a financial crisis when they also have less tangible assets or produce goods that are relatively less tradable.
Are these effects unique to banking crises? Instead of relying on the crisis dates of Reinhart and Rogoff (2008) and Laeven and Valencia (2008), which feature primarily banking crises, I also look at recessions that featured large drops in equity prices. Such episodes are associated with large falls in the net worth of firms, thus raising the cost of external finance. My results show that industries that rely more on external finance grow more slowly during recoveries from recession episodes that feature large equity price drops. The magnitude of the differential, however, is much smaller than in recessions associated with financial crises, suggesting that the impact of banking crises on credit conditions tend to linger on more forcefully than in the case of recessions associated with equity price collapses.
The findings from this line of research (see also Claessens, Kose and Terrones, 2009) convey an important message regarding the role of policies directed at the financial sector during episodes of financial crises. Policies aimed at recapitalising financial institutions, resolving distressed financial assets, and ensuring adequate provision of liquidity are crucial to restoring the health of the banking system, such that the flow of credit can be resumed quickly. Equally important are policies aimed at improving the balance sheets of non-financial firms through expedited bankruptcy procedures, for example. These policies not only ensure a swift return to stability in financial markets and institutions but also provide a strong foothold for economic recovery.
Claessens, Stijn, Ayhan Kose and Marco Terrones (2009), “Creditless Recoveries: What do we know?”, VoxEU.org, 22 May.
Eichengreen, Barry and Kevin O’Rourke (2009), “A Tale of Two Depressions”, VoxEU.org, 1 September.
Kannan, Prakash, Alasdair Scott and Marco Terrones (2009), “From recession to recovery: A long and hard road”, VoxEU.org, 6 May.
Kannan, Prakash (2009), “Credit Conditions and Recoveries from Recessions Associated with Financial Crises”, unpublished.
Laeven, Luc and Fabien Valencia (2008), “Systemic Banking Crises: A New Database,” IMF Working Paper 08/224.
Rajan, Raghuram and Luigi Zingales (1998), “Financial Dependence and Growth,” American Economic Review, 88(3), pp. 559-586.
Reinhart, Carmen and Kenneth Rogoff (2008), “Is the 2007 US Sub-Prime Financial Crisis So Different? An International Historical Comparison,” American Economic Review, 98(2), pp. 339-344.