Credit Crunch during a Currency Crisis: The Malaysian Experience

Abstract

I. Introduction The recent East Asian financial crisis was characterized by widespread disruption of the financial system, massive contraction of bank credit, and a sharp deceleration of economic activities. A growing body of economic literature recognizes the role of bank in macroeconomic fluctuations, where disruption in the banks' capacity to lend -- either reflecting tight monetary policy, or fragility of the intermediaries' balance sheet -- have far-reaching consequences on the spending behaviour of bank-dependent borrowers. This article evaluates the extent to which the contraction in loans and advances in the banking system during the severe recession in Malaysia, following the outbreak of the East Asian currency crisis can be attributed to the supply-side credit phenomenon. The issue is whether the sharp decline in bank lending was the result of reduced supply caused by the weak balance sheet position of financial intermediaries, which therefore heightened lenders' concerns about quality, or the result of a lack of demand by potential borrowers. The issue has important policy implications for measures to be adopted to enhance bank lending, and to increase spending by corporations and households. Recently, there have been several studies investigating the existence of a crunch in Korea, Thailand, and Indonesia during the recent financial crisis (Ghosh and Ghosh 1999; Kim 1999; Ferri and Tae 1999; Ito and da Silva 1999). The present article presents the evidence for Malaysia. The article is organized as follows: Section II analyses the different channels by which the crunch can be transmitted through the banking system, and examines the factors that influenced the supply of in Malaysia during the currency crisis. An econometric model for evaluating the magnitude of the crunch is presented in Section III, together with the empirical findings. Section IV concludes. II. Conceptual Framework and Factors Affecting the Supply of The Mechanisms of a Credit Crunch A crunch can be defined as a restriction of by financial intermediaries, to an amount that is less than the quantity that is desired by the borrowers, even if they are willing to pay for the cost of credit, and are able to satisfy the non-price terms of that are posted by the lenders. Defined in this way, a crunch represents a significant shift in the supply schedule of intermediated credit. The leftward shift in the supply curve of bank loans can be caused by the erosion in the intermediaries' capital position or deposit base, and by the portfolio reallocation decisions of the banks. For banks to extend loans, they must have the necessary funds in the form of customers' deposits, interbank borrowing, and shareholders capital. Tight monetary policy, by draining the banking system of its reserves, reduces the amount of funds banks can source from the interbank market. The reduction in the interbank funds, unless it is offset by an increase in customers' deposits, will lead to a reduction in loans. If borrowers are heavily dependent on intermediate for financing their operations, then the cutback in lending would lead to reductions in real spending. According to the credit view of the transmission of monetary policy, this channel of monetary policy operates mainly through the availability of credit, and does not rely on an increase in the interest rate to depress the demand for funds, as envisaged by the traditional money view of the transmission mechanism of monetary policy. To the extent that banks use other criteria, besides raising the lending rate, to allocate the limited amount of available among the potential borrowers, the channel can be associated with rationing of credit.(1) The channel focuses on the impact of tight monetary policy on the reduction in reserves, and the decrease in the availability of funds for making loans. …