Credit where Credit is Due: Fiscal Consolidations, Sovereign Risk and Bank Credit

Using quarterly data on bank credit to the private sector and a comprehensive database on fiscal policy announcements for a sample of 32 advanced economies and emerging markets, we estimate the dynamic response of bank credit to fiscal consolidations. Our results show that the relationship between fiscal consolidation announcements and real bank credit differs by country groups. In countries with high sovereign risk, consolidation announcements “crowd-in” bank credit, particularly credit to the corporate sector, whereas countries with low initial risk experience credit contractions. Further, we present evidence that the composition of fiscal consolidations matters: expenditure-based consolidations are associated with a more favorable bank credit response than revenue-based ones. Finally, we show that bank credit responds more favorably to fiscal consolidations in countries with flexible exchange rate regimes, lower levels of household indebtedness, and when consolidation are announced during periods of robust economic activity.