An analysis of the relationship between credit and economic growth with a focus on estimating the optimal credit growth for Malta

Abstract

The relationship between credit and economic growth has attracted academic attention since the early nineteenth century. Many seminal work have described banks as special financial institutions due to their combined role of accepting deposits and issuing of credit. More recently, the concept of credit growth has increased in importance after most countries endured a period of rapid credit growth before the onset of the Global Financial Crisis (GFC). This dissertation explores the credit-growth nexus by employing a Granger Causality test and estimates the optimal credit growth as fitted values from an Error Correction Model (ECM), for Malta, using quarterly data between 2005-2019. Findings indicate that in the short-term domestic bank credit Granger-causes Gross Domestic Product (GDP), supporting the supply-leading theory whilst a bi-directional relationship exists between domestic bank credit and GDP in the long-term. The quarterly optimal credit growth as a function of macroeconomic demand and banking supply variables ranges mostly between 1 per cent and 2 per cent, across the time period 2006Q3-2019Q4. Hence, this quarterly optimal credit growth range does not negatively impact the economy and banking sector. It is concluded that no excessive credit growth was experienced during this time period when the results are considered for Countercyclical Capital Buffer (CCyB) activation.