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Video / 03 October 2017 at 10:30 GMT

Quarterly Outlook: Credit impulse contraction bad news for growth

Dembik Christopher
   • 'Forecasts may be a bit too rosy'
   • Credit impulse sending a warning signal
   • US business cycle peak 'now behind us'

 
By Christopher Dembik

The global recovery has driven equity markets higher over the past few months despite persistent lowflation in developed countries, monetary policy normalisation, and increasing geopolitical risk.

Under normal circumstances, these three elements would have caused a sharp decline in financial markets but this has not been the case so far because of optimistic growth forecasts. In our view, those forecasts may be a bit too rosy. The contraction in the global credit impulse suggests that an economic slowdown is just around the corner and could materialise as soon as next year.

What is the credit impulse?

The idea behind credit impulse is that since spending is a flow, it should be compared to net new lending, which is also a flow, rather than to credit outstanding, which is a stock. Therefore, credit impulse can be best understood as the flow of new credit issued by the private sector expressed as a percentage of GDP.

Our in-house global credit impulse reading is based on 18 countries representing 69.4% of global GDP (adjusted for purchasing-power-parity). It is updated on a quarterly basis in order to avoid too many seasonal adjustments and to provide an accurate picture throughout the year.

Why is it a critical indicator?

Credit impulse is a key derivate of global credit growth and is correlated with global domestic demand. It is a useful tool to point out the inflexion in credit that could spread all over the globe and influence global growth.

Since the beginning of the year, the global credit impulse has sent a warning signal to investors around the world. By our measure, the index declined by a whopping 9% (year-on-year) in Q2 2017, and the contraction is now at its highest level since 2009.

The remarkable difference this time is that there is no great financial crisis. Since the global credit impulse’s post-crisis peak in Q2-Q4 2016 a sharp deceleration has taken place, mainly due to negative evolution in the USA, China, and India. These three countries are of crucial importance to the evolution of the credit impulse since they represent 39% of our global indicator.

China: a tough choice between lower growth and further stimulus

As the world’s largest economy based on PPP, China is the main driver of the global credit impulse. A notable downturn (or increase) in China’s flow of credit will impact the evolution of credit in other parts of the world. Therefore, for investors, monitoring China’s credit impulse is as important for investors as watching the European Central Bank and Federal Reserve monetary policy meetings. 

Global credit impulse:
Global credit impulse
Source: Saxo Bank 

Since the end of 2016, credit policy in China has turned sharply restrictive, leading to a higher interbank rate. Combined with stricter bank regulation, especially in terms of wealth management products, it has resulted in a 15% y/y decline in the credit impulse in Q2 2017. 

The magnitude of this contraction reminds one of 2010. This time, however, it happened when the economy was much more robust, with constant price GDP growth at 10.6%. 

The focus on curbing financial risks – one that we will likely see reiterated at China’s upcoming 19th Party Congress – suggests that policymakers are more open to lower economic growth, but not at any cost. More substantial signs of weaker growth will be needed to force the authorities to step in as they have in the past. 

It is only a matter of time, however, before they do; this will probably occur over the course of the next year (read: after Xi’s consolidation of power).

SHIBOR versus five-year government benchmark bond yield:
SHIBOR
Source: Saxo Bank

US: the business cycle peak is behind us

The credit impulse in the US has also turned down and now points to zero as a result of weak demand for commercial and industrial loans and leases. The slowdown is visible in the second chart below, which illustrates that commercial bank loan creation only increased by 0.6% in Q2’17 compared with Q2’16 after a drop of 0.6% in Q1. 

The lack of significant credit growth is expected to constrain GDP growth in the coming quarters, confirming once again that the peak of the business cycle in the US is behind us. This could change, of course, if President Trump delivers on tax reforms and thereby creates positive economic incentives.

US data
Source: Saxo Bank

India: structural change in motion

The credit impulse in India declined in the second part of 2016 along with its Chinese and US counterparts, but since then it has seen a slight rebound. The trend, however, remains largely negative despite a recent interest rate cut by the Reserve Bank of India (the key 
lending rate was cut to 6% in August).

The cost of credit, however, is not the main issue facing India. Weak credit growth and low private investment levels are here to stay, mostly due to the structural changes that are in motion. Low capacity utilisation and the clean-up of bank balance sheets (the amount of nonperforming loans has multiplied five-fold since 2008, reaching 9.2% of banks’ total gross loans) are expected to substantially limit credit growth and therefore GDP growth in coming years. 

Credit impulse (India):
IndiaSource: Saxo Bank 

Europe: credit expansion still fueling growth

Of the six European countries we are monitoring (France, Germany, Italy, Poland, Spain, and the UK), credit impulse is still expanding in five of them. The exception is Italy where contraction has taken place since late 2016, indicating that GDP growth may run out of steam in the coming quarters. 

There is no mystery here: the positive change in the flow of credit since 2014 has been the major driver of GDP growth in the euro area. Currently, the eurocoin growth indicator is still following a positive trend and remains close to its post-crisis highs. However, this trend largely reflects the cyclical lag between the European economy and that of the US where recovery started earlier. 

Eurocoin growth indicator:
Europe
Source: Saxo Bank 

In our view, the main economic risk for the continent is not linked to the ECB’s monetary policy normalisation but rather to the contraction in global credit impulse that will inevitably spread to Europe, ultimately leading to a short-lived recovery.

Japan: positive momentum despite negative rates

Japan’s credit impulse has been rising since Q4’15 despite the introduction of negative rates in January 2016. At that time it was feared that the move would make banks reluctant to lend to prospective clients; in fact, surveys suggest that this is not at all what happened. 

According to the Tankan sentiment survey, the lending attitude of financial institutions has followed an upward trend, reaching its highest level since the financial crisis at 24 percentage points in Q1’17.

The FSA guidelines enacted in 2016 to encourage giving to borrowers with low credit scores have certainly played a major role in Japan’s avoidance of a credit growth slowdown. However, this positive impulse has a limited global effect since the country only represents 5.2% of our global index.

Credit impulse (Japan):
Japan
Source: Saxo Bank  

Growth at a key turning point

The message sent by the global credit impulse is that global growth is at a key turning point. After years of expansion, the credit dynamo has now completely reversed. Since this index leads by nine months we should expect softer data this autumn, and this could lead to a global economic slowdown over the course of next year. 
 
Lower economic growth is only a matter of time and in some respects would make perfect sense considering that the recovery began precisely eight years ago in mid- 2009 (in the US). 

So far, it has been the third longest expansion since 1850 (behind 1991-2001, 1961-1969 and 1982-1990). The implications of the credit impulse contraction are significant for financial markets. If an economic slowdown takes place, it will push the Fed and the ECB to reduce the speed and scale of their stimulus exits. It could also open the door to monetary and fiscal stimulus in China.

— Edited by Michael McKenna

Christopher Dembik is head of macro analysis at Saxo Bank
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