News-Driven International Credit Cycles

Economists and policy-makers often argue that the surge in bank credit and the expansion of output in the European periphery after the euro was introduced resulted from expectations for a favourable economy in the future. This follows the argument that countries that experienced the European Exchange Rate Mechanism (ERM) crisis in 1992–93 perceived that joining the single currency would eliminate future crises. However, the global financial crisis undermined this confidence. Instead, capital flows reversed, bank balance sheets shrank and credit spreads of non-financial firms rose steeply.

This paper studies how news about economic fundamentals affects credit allocation both within and across countries. I present an international macroeconomic model with banking in which I study financial crises associated with occasionally binding leverage constraints. Optimistic news about the future valuation of capital triggers the boom part of the cycle, and later unfulfillment of the positive news induces the bust.

A calibrated version of the model reasonably captures the pattern of Spanish current account dynamics and asymmetric credit allocation between traded and non-traded sectors during the euro’s first decade. I disentangle how both the banking sector and international capital flows contribute to dynamics that are consistent with the Spanish data. Bank balance sheets transmit fluctuations from the non-traded sector to the traded sector, pushing the economy into an overall recession. International borrowing contributes to higher bank leverage ratios and further amplifies the effects of financial frictions. I also argue that unconventional policies—in the form of direct asset purchases and liquidity facilities—reduces the magnitude of the downturn. Liquidity injections to illiquid banks proves to be more effective than direct asset purchases from the non-traded sector.