Surname, Name Contreras, Gonzalo

Module CF325 Macro Economic Policy & Financial Markets 2013 Session 3

Assignment, date 2013s3C325_TMA01, 19 June 2013

Word count 2537

Introduction

To analyse the sentence proposed, it will be used the evolution of Spanish economy

in the last decade, paying particular attention to the effects of monetary policy on

the most relevant macroeconomic variables between 2008 and 2013. In the light of

this experience, the basic concepts develop in the economic theory of monetary

policy will be exposed, trying to use as well some of the empirical examples

extracted from literature. In other words, the case of Spain will be used to review

the most relevant theories of monetary policy – particularly at the credit channel

level.

Although the sentence proposed for discussion is comprehensive in meaning, for

simplicity purposes the different aspects will be discussed separately. Firstly, it

will be analysed the extent to which the credit channel transmission mechanism

approach is achieving results at output and employment levels. Secondly, we will

continue with the implications of the importance of the banking sector within the

financial system as a matter of quantity of resources available in the system. The

implications of both perspectives will be summarized in the conclusions, with the

intention of show the link between both topics.

Entry point: effects of monetary policy within the Spanish macroeconomic

situation.

Let us start our pivot case study in Madrid, in a single morning of the beginning of

2011 at the Central Bank headquarters placed in the centric street of Alcala. Mr

Barbero – responsible for monetary policy monitoring in the Bank – is analysing

the different facts to follow monetary policy effects on the economy. The impacts of

the financial crises that started in the USA in 2007 are unmistakably felt in the

basis of the medium term macroeconomic perspectives of Spain in 2008. The main

strategy of the monetary policy designed by (or agreed with) the European Central

Bank was clearly stated: establish low level of nominal interest rates in order to

invigorate the capacity of firm for invest as an intermediate target to affect output.

The following three charts depict what the effects of this strategy on the different

interest rates of the market, inter-banking interest rates in real terms in chart 2

and a comparison between nominal rates in mortgages, consumption, and short

term deposits.

Chart 1. Evolution of interest rates.

An unambiguous impact could be observed: after the significant drop in the BCE

interest rates at the end of 2008 and beginning of 2009 (more than 3%), the

monetary policy seems to be succeeding in the purpose of moderating the rates in

the inter-baking market, short term deposits and mortgages within a year lag. The

only rate that looks to be unaffected is consumption loans. At this point, the

subsequent question to be made would be: are the different stakeholders taking

the advantage of these “affordable” interest rates? If so, to what extend? These

questions focus the discussion on the effective access to credit through the market

BCE nominal interest rates

Evolution of market interest rates

MortgagesOne year Deposits

ConsumptionInterbank (one year)

Souces: BCE and Spanish Central Bank (BdE)

at that moment. To that effect, the following two charts intend to give some insight

of the inter-annual variation of credit use by stakeholder between 2010 and 2013,

and a wider trend (2008 – 2012) by productive and building sector firms.

Mr. Barbero finds these facts as revealing results: households and firms are not

reaching the credit market as the trend of inter-annual average variation decreases

substantially within the period (from 12% in 2008 to -16% in 2012. Chart 3). It

could be argued that the need for credit of public sector for credit produced a

crowding out effect over private access to credit. A more detailed look to the

evolution of interest rates in 2010 shows that short term bonds issued by public

sector (from 6 to 12 months) were paying interest of 3.05%, and the credit for

non-financial corporations 3.24% (source: BE). The returns terms comparing

bonds and private sector credit might be a good reason to understand this

crowding out effect noted.

In this moment, quantity of money “available” in the economy emerges as an

important issue. M1 during the period 2008 - 2009 expanded at inter-annual rates

of more than 10% (chart 4 and 5). Then its pace of growth slowed down after 2009

to end the period increasing again in 2012. This trend reflects an interest of the

BCE in providing liquidity to the system after the impact of the international crisis

Chart 2. Chart 3.Access to credit of non-financial sectors. Access to credit by sector Interannual variation rates.

Public InstitutionsNon-financial firmsHouseholdsTotal

TOTALProductive SectorHouseholdsHousing and Construction

Souces: BdE. Economic Bulletin (2013)

in the Europe in 2008. Nevertheless, M3 trend shows that despite the increase in

the monetary base, broad money dropped dramatically in the Eurozone after 2008,

and then moderately recovered between 2009 and 2013.

Chart 4. M3 Evolution Chart 5. M1 Evolution

Source: BCE

All in all, despite the efforts in the BCE strategy for monetary policy for the period

2008-2013, Mr. Barbero – our Central Bank analyst - can observe that firms and

households that were not accessing credit in the period as intended. Taking this

into account and considering the negative scenario of the mid-term financial crisis,

it was not surprising that investment and savings levels were performing quite

badly. In this sense, it could be argued that in the Spanish case, the transmission

mechanism has not affect investment and consumption as pretended. In other

words, if the transmission mechanism functioned, it was not in a very powerful

manner. The following charts show the modest results on key macroeconomic

variables: inter-annual trends of consumption declines strongly since 2010 and

investment in capital goods performed modestly.

Considerations and implications from the literature over the statement: “The

credit channel of monetary policy transmission generates a direct impact on

aggregate demand and output.”

Chart 6. Chart 7.Spain and Eurozone % GDP . Aggregate demand components Interannual variation rates. Interannual variation rates.

Household consumption SPAINHousehold consumption EurozoneGross Capital Formation SPAINGross Capital Formation Eurozone SPAIN

Eurozone

Diff.

Souces: EUROSTAT and Spanish Statitics National Institute Souces: BdE. Economic Bulletin (2013)

The credit channel theory is presented in the literature as a complementary

approach to the cost of capital channel, which was the most shared until the ‘90s.

As noted in Bernanke & Gertler (1995), “we don’t think of the credit channel as a

distinct, free-standing alternative (… ) but rather as a set of factors that amplify

and propagate conventional interest rates effects”. The key element of this

approach is that firms’ internal finance composition is a key aspect in the

transmission mechanism of monetary policy. The theory is based on the

hypothesis that there is an external finance premium which is additional to the

internal cost of capital for firms. This is due to the fact that credit markets are not

perfect and some inefficiencies are affecting the relation between borrowers and

lenders (mainly the asymmetry of information between principals and agents).

Following the empirical studies depicted in Bernanke, Credit Channel has two main

componets: the Balance Sheet Channel and the Bank Lending Channel. The first

one is resumed as follows: “the strongest financial position of the firm, the smaller

is its external finance premium”. In the Spanish case, we have seen that the

financial position of non-financial companies have deteriorated during the period

and thus, its cash flow position. Exploitation results of companies have gone down

since 2008 and the debt / internal resources ratio has also decreased continuously

since then (Chart 8).

Chart 8. Measures of porfitability of firms

Source: Central of Balances 2012. BdE

Net returns over investment/ own resources

Net returns after taxes / own resourcesNet returns before taxes/ own resources

The Bank Lending channel basically states that a reduction in the supply of bank

credit (…) is likely to increase the external finance premium and to reduce real

activity (Bernanke. 1995). In the Spanish case, and wih the data set presented

above, it can not be observed any effect related to bank lending channel.

Nevertheless the effects of several banks bail out and intervention from Spanish

Central Bank (mainly Cajas de Ahorro) is very likely to have affected negatively to

firms in the Bank Lending channel (Financial Stability report Informe, 2012 - BdE).

As we have seen in the case of Spain, the cost of capital channel shows different

interest rates depending on the stakeholder (i.e. BCE, Banks, Firms, Mortages,

credit to consumption). The influence of the BCE in those rates has been explained

before. To sum up, the monetary policy transmission mechanism, as the

complement of cost of capital channel and credit channel effects – balance sheets

and bank lending – seems to be affecting the credit market positively apart from

the effects of the bank lending channel. The final influence of those in at output

level has been clearly insufficient, as it has been depicted in GDP and demand

components (charts 6 and 7) and on unemployment (to be observed in the

following charts).

As a conclusion of the first part of the sentence discussed in this essay, it could be

argued that the transmission mechanism of monetary policy – including cost of

capital, balance sheet and bank lending channels - seems to be a plausible theory to

launch indirect measures to influence output. Nevertheless, the Spanish case

Chart 9. Unemployment rates

Souces: BdE. Economic Bulletin (2013)

shows us that even a proper use of the transmission mechanism is not delivering

the results intended at output and employment levels.

“The credit channel presupposes that banks play an important role in the

financial system, as the quantity of finance available is the key determinant of

a firm’s investment expenditure”

As we have seen before, aggregate investment decisions of firms are relatedto

interest rates, among other issues. The most used methods to analyse and take

capital budgeting decisions are the Net present Value Decision Rule and the

Internal rate of return rate. Each of them takes into account the value of money in

time (discount). The Net present Value Decision Rule is based on two assumptions:

i) there is certainty about the future returns on the investment and ii) that there is

a unique interest rate against which we can discount those certain future returns.

In the Internal rate of return rate, the purpose is to find out the interest rate that

would make the investment possible. If that internal interest rate is smaller than

the cost of capital, then the investment should be undertaken.

The assumptions stated in both methods, are not always confirmed an empirical

basis (Myers and Majluf, 1984 and Fazzari, Hubbard and Petersen, 1988). There is

not a unique interest rate and different stakeholders of the financial markets,

include uncertainty in their calculation of the interest rate to be agreed between

borrower and lender. Another assumption often used in the classic models is that

the only source of external finance for firms is bank credit. In the real world firms

have several sources of finance; each of them has a different interest rate; and each

stakeholder is managing different information to calibrate uncertainty.

All these factors lead us to think that it could be possible that companies have a

different finance hierarchy depending on the amount and cost of each source of

finance. In the literature this “Financial hierarchy” (Myers and Majluf, 1984) is

based on the assumption that the different sources of finance are not perfect

substitutes. Empirical evidence shows that firms rank first internal sources above

external ones (Miles and Scott, 2012). In other words, firms are constrained by the

amount of finance available at each level.

In the case studied in this assignment, the evolution of Spanish companies returns

(chart 8) might be indicating that internal sources of finance are likely to be scarce.

After years and a half since the star of the crises in Spain, companies have

experiment a continuous decrease in their returns and margins and thus, its

quantity of finance through internal sources. As we have seen too, due to a

crowding out effect from public financial entities, the access to external credit has

not been easy for Spanish firms to access to that channel. The following chart

shows a comparison between the values in the share market in Spain and the

Erozone.

We made a point here in the light of the market stock trends depicted in these

charts to synthetize the implications of the q Theory (Tobin, 1969) in the Spanish

case. The q ratio tries to give advice on investment to decision makers based on the

value of share and the replacement cost of firms capital stock. If the ratio is bigger

that 1, then firms are enhanced to invest in new assets. It is assumed that the

Chart 10. Stock Market evolution. Base 194 = 100

The General Index of the Madrid Stock Exchange IBEX-35EURO STOXX EURO STOXX 50

Souces: BdE. Economic Bulletin (2013)

selling price of companies’ products/services remain constant and that firms can

obtain extra inputs for production at same costs. In our case, we have seen that

aggregate investment in Spain was decreasing 16% annually in 2009, and after

that the trend stabilizes at -4,5% of average from 2010 to 2013. Following the q

Theory it could be said that if the value of shares in the market stock is decreasing

heavily through the period (chart 10) and the gross capital formation has been

negative (chart 7), the replacement cost variable is more expensive than value of

firms’ shares in the stock market.

Having said that, there is another sort of problems that some companies might

suffer. Literature shows that even though companies have a financing hierarchy

that rank higher internal sources, they might find that external credit is not

available at any cost. In the Spanish case, we have seen that although the interest

rate for credit are been kept low due to ECB monetary policies, companies are not

accessing to this source of finance due to the mentioned crowding out effect

caused by the public sector.

As we have described, Spanish firms suffers i) difficulties for firms to access credit

mentioned before (chart 2), and ii) from a decreasing trend of the stock market

values during the period 2009 – 2012. Putting all together it can be stated that

both internal and external sources of finance had being too scarce during the

period.

As a conclusion of the second part of the sentence analysed in this assignment, the

role of banks as key players in the credit channel it might be less important as

stated: theory and empirical case show that other aspects are also important

around the quantity of finance, (e.g. “finance hierarchy”) or the completion with

other players (case of Spain).

Some conclusions on the discussed statement: implications for the Spanish

case.

If we were contrasting the theory and empirical evidence of literature about the

transmission mechanism (with a focus on the credit channel) in the case of Spanish

external shock since 2008, it can be concluded that:

i) It is notable a positive influence of BCE nominal interest rates on the

different interest rates of the market.

ii) The quantity of money available in the system (M1) has been increased,

but the M3 has not amplified the liquidity in the overall system as

expected.

iii) Despite the effect on interest rates, companies and households have not

effectively access to credit - as enhanced through the credit channel.

iv) Additional measures that have been taken (banking system bail out,

banking sector restructure laws, etc.) seem to be positively affecting the

economy through bank lending channel.

v) Nevertheless, the impact of the intermediate measures of monetary

policy has been proved to be insufficient to affect positively output and

employment.

vi) The structure of Cost of capital for Spanish firms seems to be far from

balanced in 2013. The result up to date has been a clear divestment

trend in gross capital formation. It is probably that this will affect to

output in long term output.

vii) The role of banks as key players in the credit channel might be less

important as stated in our set off: theory and empirical evidences show

that other aspects should have been also taken into account regarding

the quantity of finance at firms level (e.g. “finance hierarchy”).

viii) It seem to be a perverse cycle related to fiscal policies at the level of the

Eurozone that affects Spaniard economy: public sector is crowding out

financial resources from the system, in a moment that an increase it is

necessary to revive other stakeholders in the economy (households and

firms).

References.

Bernanke, Bs. S and Gertler, M (1995) ‘Inside the Black box: the Credit Channel of

Monetary Polict Transmission’. The Journal of Economic Perspectives, Volume 9,

Issue 4.

Central of Balances Spanish Central Bank (2012)

David Miles, Andrew Scott and Francis Breedon (2012) Macroeconomics:

Understanding the Global Economy.

Fazzari SM, RG Hubbard and BC Petersen (1988) ‘Financing constraints and

corporate investment’ Brookings Papers on Economic Activity, Vol. 1988, No. 1

Myers S and N Majluf (1984) ‘Corporate financing and investment decisions when

firms have information that investors do not have’, Journal of Financial Economics,

vol 13.

Spanish Central Bank Economic Bulletin (March, 2013)

Tobin, J. (1969): "A general equilibrium approach to monetary theory," Journal of

Money Credit and Banking.