Bank credit — VietEcon

Banks are really confusing and, frankly, weird. Loans are an asset. Cash deposits are a liability. It mixes up the way we think about the world.

The banks analyst at my last firm, very smart guy, said just think of money as any other product. A company buys raw materials for $9, uses these to make widgets and sells them for $12. In the case of the bank, they buy money, and they sell loans. That is the basic model of banking, but it’s hard for me to get my head around it.

Unfortunately, banking is really, really important. In the US, finance and insurance represent 7.4% of GDP. This is the same size as healthcare.

Finance is also important because it can really drive economic growth, especially because lending is a big driver of investment, which can result in more GDP over time.

But at times credit-driven growth can come with its own problems. Over time, the debt burden of a country can become too big.

As I read in Crashed, the European banks were much bigger than their economies. For example, in 2008 Iceland had liabilities (deposits and wholesale liabilities) of more than 900% of the country’s GDP. Ireland was above 700%, and the UK was 500%+. The US, which is seen as the epicenter of the crisis, had around 100%.

Why is this bad? Well, 1) in times of crisis, the liabilities of these banks are impossible for the country to take on. Or at least very hard. 2) If this credit is going into the domestic economy (in Iceland a big portion was mortgages outside of Iceland), when it starts to be pulled back, you start to see problems with people that have been living on this credit. For example, if company needs to refinance a loan but credit is no longer available, then it may have to raise a whole lot of money to repay the loan. If the company can’t, it goes bankrupt. Also, and this is a tautology, growth depends on every increasing amounts: ever increasing homes, more remodels, greater consumer goods, etc. If there are no mortgages, then there are no new home sales, and therefor no new homes being built, meaning a declining real estate market. When this happens across the economy, you get a recession.

So does Vietnam need to worry? Maybe a bit: Looking at Vietnam right now, domestic credit to GDP is actually pretty high at 141% of GDP. That is still below those big European levels but is a bit more than other ASEAN countries. Much less than China (218%) and S. Korea (177%).

Is credit necessary for growth? This is the larger question. Intuitively, I would think so. More credit means more activity and more growth. But intuition is not always correct in economics.

So I looked at Vietnam, South Korea, Japan and the US. It’s funny, because for some of the countries, it seems clear that credit growth and real GDP per capita growth are necessary. Below I have the charts for South Korea and Vietnam, with real GDP per capita vs. domestic credit to GDP. If you look at these, then credit growth goes up with GDP per capital. And it appears to be increasing before the increase in per capita GDP.

Now let’s look at Japan and the US. Well, in this case, per capita GDP in the US didn’t increase in the same way as per capita GDP. In fact, per capita GDP grew despite a decrease in domestic credit at times. Japan is the opposite. Credit grew ahead of per capita GDP, then stopped growing in line with the GDP. It doesn’t seem like credit is necessary to drive growth in all cases.

Looking into the literature, it seems like looking at these four countries was actually pretty exemplary. Based on this survey of the literature there are a few findings:

Development of finance is positive for economic growth (as we saw with Vietnam and S. Korea).
But the benefit decreases as countries get richer. (as we saw with the US and Japan)
As per capita GDP grows, non-bank financing becomes more important to drive further growth. That’s because these non-banks can be more innovative.
Increased banking competition can decrease inequality.

Vietnam is probably in a place where more credit means more economic growth, but it could start to decline or the marginal utility of additional credit may fall. Surprisingly, Vietnam already has a fairly big non-bank sector, or at least a lot of non-bank (meaning VC and PE firm) interest in the country. I wrote about this on September 25 (scroll down).

In conclusion, credit is already high, it probably contributes to economic growth, but at some point its marginal utility will decrease. And that’s normal.