Surname, Name Module !

ssi"nment, date 'ord count Introduction

Contreras, Gonzalo CF325 Macro Economic Policy & Financial Markets 20 3 Session 3 20 3s3C325#$M!0 , % &une 20 3 253(

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. n the light of this e!perience, the basic concepts develop in the economic theory of monetary policy will be e!posed, trying to use as well some of the empirical e!amples e!tracted from literature. n other words, the case of Spain will be used to review the most relevant theories of monetary policy " particularly at the credit channel level. #lthough the sentence proposed for discussion is comprehensive in meaning, for simplicity purposes the different aspects will be discussed separately. $irstly, it will be analysed the e!tent 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 ban%ing sector within the financial system as a matter of &uantity of resources available in the system. The implications of both perspectives will be summari'ed in the conclusions, with the intention of show the lin% between both topics. Entry point: effects of monetary policy within the Spanish macroeconomic situation. (et us start our pivot case study in )adrid, in a single morning of the beginning of 2011 at the *entral +an% head&uarters placed in the centric street of #lcala. )r +arbero " responsible for monetary policy monitoring in the +an% " is analysing the different facts to follow monetary policy effects on the economy. The impacts of the financial crises that started in the ,S# in 200- are unmista%ably 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 0uropean *entral +an% was clearly stated1 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 mar%et, inter2

ban%ing interest rates in real terms in chart 2 and a comparison between nominal rates in mortgages, consumption, and short term deposits. *hart 1. 0volution of interest rates.
+*0 nominal interest rates

0volution of mar%et interest rates

)ortgages 8ne year 9eposits

*onsumption nterban% .one year/

Souces1 +*0 and Spanish *entral +an% .+d0/

#n unambiguous impact could be observed1 after the significant drop in the +*0 interest rates at the end of 2008 and beginning of 2003 .more than 34/, the monetary policy seems to be succeeding in the purpose of moderating the rates in the inter2ba%ing mar%et, short term deposits and mortgages within a year lag. The only rate that loo%s to be unaffected is consumption loans. #t this point, the subse&uent &uestion to be made would be1 are the different sta%eholders ta%ing the advantage of these 5affordable6 interest rates7 f so, to what e!tend7 These &uestions focus the discussion on the effective access to credit through the mar%et at that moment. To that effect, the following two charts intend to give some insight of the inter2annual variation of credit use by sta%eholder between 2010 and 2013, and a wider trend .2008 " 2012/ by productive and building sector firms.
*hart 2. #ccess to credit of non2financial sectors. nterannual variation rates. *hart 3. #ccess to credit by sector

>ublic nstitutions =on2financial firms ?ouseholds Total

T8T#( >roductive Sector ?ouseholds ?ousing and *onstruction

Souces1 +d0. 0conomic +ulletin .2013/

)r. +arbero finds these facts as revealing results1 households and firms are not reaching the credit mar%et as the trend of inter2annual average variation decreases substantially within the period .from 124 in 2008 to 21:4 in 2012. *hart 3/. t could be argued that the need for credit of public sector for credit produced a crowding out effect over private access to credit. # more detailed loo% to the evolution of interest rates in 2010 shows that short term bonds issued by public sector .from : to 12 months/ were paying interest of 3.0;4, and the credit for non2financial corporations 3.2<4 .source1 +0/. The returns terms comparing bonds and private sector credit might be a good reason to understand this crowding out effect noted. n this moment, &uantity of money 5available6 in the economy emerges as an important issue. )1 during the period 2008 2 2003 e!panded at inter2annual rates of more than 104 .chart < and ;/. Then its pace of growth slowed down after 2003 to end the period increasing again in 2012. This trend reflects an interest of the +*0 in providing li&uidity to the system after the impact of the international crisis in the 0urope in 2008. =evertheless, )3 trend shows that despite the increase in the monetary base, broad money dropped dramatically in the 0uro'one after 2008, and then moderately recovered between 2003 and 2013. *hart <. )3 0volution *hart ;. )1 0volution

Source1 +*0 #ll in all, despite the efforts in the +*0 strategy for monetary policy for the period 200822013, )r. +arbero " our *entral +an% analyst 2 can observe that firms and households that were not accessing credit in the period as intended. Ta%ing this into account and considering the negative scenario of the mid2term financial crisis, it was not surprising that investment and savings levels were performing &uite badly. n this sense, it could be argued that in the Spanish case, the transmission mechanism has not affect investment and consumption as pretended. n other words, if the transmission mechanism functioned, it was not in a very powerful manner. The following charts show the modest results on %ey macroeconomic variables1 inter2annual trends of consumption declines strongly since 2010 and investment in capital goods performed modestly.

*hart :. Spain and 0uro'one 4 B9> . nterannual variation rates.

*hart -. #ggregate demand components nterannual variation rates.

?ousehold consumption S># = ?ousehold consumption 0uro'one Bross *apital $ormation S># = Bross *apital $ormation 0uro'one

S># = 0uro'one 9iff.

Souces1 0,E8ST#T and Spanish Statitics =ational nstitute

Souces1 +d0. 0conomic +ulletin .2013/

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.6 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 @30s. #s noted in +ernan%e A Bertler .133;/, 5we donCt thin% of the credit channel as a distinct, free2 standing alternative .D / but rather as a set of factors that amplify and propagate conventional interest rates effects6. The %ey element of this approach is that firmsC internal finance composition is a %ey 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 mar%ets are not perfect and some inefficiencies are affecting the relation between borrowers and lenders .mainly the asymmetry of information between principals and agents/. $ollowing the empirical studies depicted in +ernan%e, *redit *hannel has two main componets1 the +alance Sheet *hannel and the +an% (ending *hannel. The first one is

resumed as follows1 5the strongest financial position of the firm, the smaller is its e!ternal finance premium6. n the Spanish case, we have seen that the financial position of non2financial companies have deteriorated during the period and thus, its cash flow position. 0!ploitation results of companies have gone down since 2008 and the debt F internal resources ratio has also decreased continuously since then .*hart 8/.
*hart 8. )easures of porfitability of firms

=et returns over investmentF own resources

=et returns before ta!esF own resources

=et returns after ta!es F own resources

Source1 *entral of +alances 2012. +d0

The +an% (ending channel basically states that a reduction in the supply of ban% credit .D/ is li%ely to increase the e!ternal finance premium and to reduce real activity .+ernan%e. 133;/. n the Spanish case, and wih the data set presented above, it can not be observed any effect related to ban% lending channel. =evertheless the effects of several ban%s bail out and intervention from Spanish *entral +an% .mainly *aGas de #horro/ is very li%ely to have affected negatively to firms in the +an% (ending channel .$inancial Stability report nforme, 2012 2 +d0/. #s we have seen in the case of Spain, the cost of capital channel shows different interest rates depending on the sta%eholder .i.e. +*0, +an%s, $irms, )ortages, credit to consumption/. The influence of the +*0 in those rates has been e!plained before. To sum up, the monetary policy transmission mechanism, as the complement of cost of capital channel and credit channel effects " balance sheets and ban% lending " seems to be affecting the credit mar%et positively apart from the effects of the ban% lending channel. The final influence of those in at output level has been clearly insufficient, as it has been depicted in B9> and demand components .charts : and -/ and on

unemployment .to be observed in the following charts/.

*hart 3. ,nemployment rates

Souces1 +d0. 0conomic +ulletin .2013/

#s 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 ban% lending channels 2 seems to be a plausible theory to launch indirect measures to influence output. =evertheless, the Spanish case 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 uantity of finance available is the key determinant of a firm!s investment e"penditure# #s we have seen before, aggregate investment decisions of firms are relatedto interest rates, among other issues. The most used methods to analyse and ta%e capital budgeting decisions are the =et present Halue 9ecision Eule and the nternal rate of return rate. 0ach of them ta%es into account the value of money in time .discount/. The =et present Halue 9ecision Eule is based on two assumptions1 i/ there is certainty about the future returns on the investment and ii/ that there is a uni&ue interest rate against which we can discount those certain future returns. n the nternal rate of return rate, the purpose is to find out the interest rate that would ma%e the investment possible. f that internal interest rate is smaller than the cost of capital, then the investment should be underta%en.

The assumptions stated in both methods, are not always confirmed an empirical basis .)yers and )aGluf, 138< and $a''ari, ?ubbard and >etersen, 1388/. There is not a uni&ue interest rate and different sta%eholders of the financial mar%ets, include uncertainty in their calculation of the interest rate to be agreed between borrower and lender. #nother assumption often used in the classic models is that the only source of e!ternal finance for firms is ban% credit. n the real world firms have several sources of financeI each of them has a different interest rateI and each sta%eholder is managing different information to calibrate uncertainty. #ll these factors lead us to thin% that it could be possible that companies have a different finance hierarchy depending on the amount and cost of each source of finance. n the literature this 5$inancial hierarchy6 .)yers and )aGluf, 138</ is based on the assumption that the different sources of finance are not perfect substitutes. 0mpirical evidence shows that firms ran% first internal sources above e!ternal ones .)iles and Scott, 2012/. n other words, firms are constrained by the amount of finance available at each level. n the case studied in this assignment, the evolution of Spanish companies returns .chart 8/ might be indicating that internal sources of finance are li%ely to be scarce. #fter years and a half since the star of the crises in Spain, companies have e!periment a continuous decrease in their returns and margins and thus, its &uantity of finance through internal sources. #s we have seen too, due to a crowding out effect from public financial entities, the access to e!ternal 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 mar%et in Spain and the 0ro'one.

*hart 10. Stoc% )ar%et evolution. +ase 13< K 100

The Beneral nde! of the )adrid Stoc% 0!change +0L23; 0,E8 ST8LL 0,E8 ST8LL ;0

Souces1 +d0. 0conomic +ulletin .2013/

Je made a point here in the light of the mar%et stoc% trends depicted in these charts to syntheti'e the implications of the & Theory .Tobin, 13:3/ in the Spanish case. The & ratio tries to give advice on investment to decision ma%ers based on the value of share and the replacement cost of firms capital stoc%. f the ratio is bigger that 1, then firms are enhanced to invest in new assets. t is assumed that the selling price of companiesC productsFservices remain constant and that firms can obtain e!tra inputs for production at same costs. n our case, we have seen that aggregate investment in Spain was decreasing 1:4 annually in 2003, and after that the trend stabili'es at 2<,;4 of average from 2010 to 2013. $ollowing the & Theory it could be said that if the value of shares in the mar%et stoc% is decreasing heavily through the period .chart 10/ and the gross capital formation has been negative .chart -/, the replacement cost variable is more e!pensive than value of firmsC shares in the stoc% mar%et. ?aving said that, there is another sort of problems that some companies might suffer. (iterature shows that even though companies have a financing hierarchy that ran% higher internal sources, they might find that e!ternal credit is not available at any cost. n the Spanish case, we have seen that although the interest rate for credit are been %ept low due to 0*+ monetary policies, companies are not accessing to this source of finance due to the mentioned crowding out effect caused by the public sector.

#s 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 stoc% mar%et values during the period 2003 " 2012. >utting all together it can be stated that both internal and e!ternal sources of finance had being too scarce during the period. #s a conclusion of the second part of the sentence analysed in this assignment, the role of ban%s as %ey players in the credit channel it might be less important as stated1 theory and empirical case show that other aspects are also important around the &uantity of finance, .e.g. 5finance hierarchy6/ or the completion with other players .case of Spain/. Some conclusions on the discussed statement: implications for the Spanish case. f 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 e!ternal shoc% since 2008, it can be concluded that1 i/ ii/ iii/ iv/ t is notable a positive influence of +*0 nominal interest rates on the different interest rates of the mar%et. The &uantity of money available in the system .)1/ has been increased, but the )3 has not amplified the li&uidity in the overall system as e!pected. 9espite the effect on interest rates, companies and households have not effectively access to credit 2 as enhanced through the credit channel. #dditional measures that have been ta%en .ban%ing system bail out, ban%ing sector restructure laws, etc./ seem to be positively affecting the economy through ban% lending channel. v/ =evertheless, 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 *ost 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. t is probably that this will affect to output in long term output. vii/ The role of ban%s as %ey players in the credit channel might be less important as stated in our set off1 theory and empirical evidences show that other aspects should have been also ta%en into account regarding the &uantity

of finance at firms level .e.g. 5finance hierarchy6/. viii/ t seem to be a perverse cycle related to fiscal policies at the level of the 0uro'one that affects Spaniard economy1 public sector is crowding out financial resources from the system, in a moment that an increase it is necessary to revive other sta%eholders in the economy .households and firms/.

$eferences. +ernan%e, +s. S and Bertler, ) .133;/ @ nside the +lac% bo!1 the *redit *hannel of )onetary >olict TransmissionC. The Mournal of 0conomic >erspectives, Holume 3, ssue <. *entral of +alances Spanish *entral +an% .2012/ 9avid )iles, #ndrew Scott and $rancis +reedon .2012/ )acroeconomics1 ,nderstanding the Blobal 0conomy. $a''ari S), EB ?ubbard and +* >etersen .1388/ @$inancing constraints and corporate investmentC +roo%ings >apers on 0conomic #ctivity, Hol. 1388, =o. 1 )yers S and = )aGluf .138</ @*orporate financing and investment decisions when firms have information that investors do not haveC, Mournal of $inancial 0conomics, vol 13. Spanish *entral +an% 0conomic +ulletin .)arch, 2013/ Tobin, M. .13:3/1 N# general e&uilibrium approach to monetary theory,N Mournal of )oney *redit and +an%ing.