When interest rates rise, credit growth should… accelerate?

October 29, 2012

Latin America has defied one of the most elementary rules of macroeconomics in the past decade, Citigroup economists Joaquin Cottani and Camilo Gonzalez found in a report.

Lower interest rates reduce the cost of money and therefore should encourage businesses and consumers to borrow, as we’ve repeatedly heard from analysts and government officials for decades. Puzzlingly enough, credit growth accelerated after central banks in countries like Brazil and Peru raised rates, and slowed when borrowing costs fell. Why is that?

The keyword here is confidence. In this commodity-exporter region, with a long history of deep, painful crises caused by currency devaluations and global downturns, perhaps it’s worth paying more attention to what happens abroad than to the cost of money – and how the global background might affect the local business cycle.

Said Cottani and Gonzalez:

A favorable confidence shock, typically coming from abroad, increases credit demand and/or reduces credit rationing. In a context of ample international liquidity and very low interest rates in advanced economies, interest rate hikes might not prove sufficient to restrain credit expansion, especially if the ensuing exchange rate appreciation raises the value of LatAm collateral and therefore boosts creditworthiness, or at least the perception of it by lenders.

This may help explain why Brazil is recovering only slowly even after the central bank chopped interest rates ten times in a row for over one year to a record low of 7.25 percent. It also gives insight on why credit in Latin America’s top economy continues to slow down on an annual basis – prompting Dilma Rousseff’s government to cut taxes and talk up Brazil’s economic prospects to convince businesses to roll up their sleeves.

The findings also suggest credit control measures, rather than sharp interest rate hikes, will likely play a major role in restraining credit growth as soon as accelerating economic growth begins to fuel worrisome inflationary pressures. This may be the case in Brazil and Chile next year, Bank of America Merrill Lynch economists said in a separate report.

The expansion of credit in a rising rate environment may seem counterintuitive, but the trend reflects something John Maynard Keynes noted decades ago: expectations are a key component of consumption and investments.

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