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What is Credit Cycle and Business Cycle?

  • Hrithik Saini
  • Mar 14, 2022
What is Credit Cycle and Business Cycle? title banner

Credit is essential for healthy and long-term productivity expansion. High excessive credit development, on the other hand, can render highly leveraged banks and financial institutions more sensitive to shocks, leading to systemic economic collapse. 

 

With Central America, Panama, and the Dominican Republic's stock institutions remaining relatively shallow and controlled by banks, paying attention to the credit cycle and its impact on economic expansion is also an essential duty.

 

In this section, we will learn more about the credit cycle and business cycle. Further, we will understand the different stages of each cycle. So, let’s get started.

 

Also Read | Types of Credit Derivatives


 

What is a Credit Cycle?

 

The "credit cycle" is a colloquial term for the expansion and then contraction of financial access. "Credit" refers to debt — direct borrowing, business and municipal bond issues, mortgages, consumer lending, and so on – to both enterprises and individuals. The credit cycle is among the variables affecting the capital market. 

 

The businesses gain access to extra capital to widen and start producing more goods or services, and people allow access to capital to purchase or strengthen their homeowners, buy cars, go to school, and so on – all of which enhances the business activity and overarching health of the economy. 

 

This period, when money is plentiful and the economy is expanding, is known as the "expansion phase."


 

Four Phases of Credit Cycle

 

Because of the institutional arrangements of governments, businesses, and consumers, the interwoven relationship between debt, spending, saving, and deleveraging is dynamic. 

 

The credit cycle framework's strength lies in the detail it delivers as distinct cycle stages approach tipping points. As previously said, precise precision is unachievable, but limits and shared language are extremely useful. We’ve depicted the Four phases of Credit Cycle below :

 

  1. Downturn

 

Experts believe downturns are the simplest to understand since they occur during the cycle's crash stage. Strong economic growth and rampant inflation generally drive central banks to increase the money supply in the late cycle, ultimately pushing economies into downturns and credit cycles into downturns. 

 

Downturns demonstrate how the system's rot accumulated over time and was hidden by easy lending conditions and financial analysis. Investors who purchased less liquid, hazardous investments frequently sought relative safety and liquidity through the little departure door. 

 

  1. Credit Repair

 

Companies in credit restoration are compelled to strengthen their balance sheets. They offer exorbitant interest rates to lenders because they are desperate for funds. As corporations focus on credit risk administrators and survival, this is the ideal spot for credit investors.

 

Companies often cut personnel, sell assets, decrease capital expenditures, create cash, and reduce debt to strengthen their balance sheets. Businesses are compelled to deleverage as a result of an economic downturn. Deleveraging is insufficient for certain businesses, resulting in an increase in defaults.

 

Meanwhile, central banks turn on the credit taps in an effort to re-inflate the economy. As a result, liquidity rises from extremely low levels to become relatively abundant.

 

  1. Recovery

 

Profits often expand faster than debt during a comeback and default typically peak. Corporate devaluation is well established, particularly as asset values rise. Management values both shareholders and debtors equitably.

 

Credit spreads are narrowing, and equities are beginning to outperform. Economic growth is picking up, and central banks are beginning to ease their accommodative policies. Investors begin to adjust their holdings and take on greater risks. Risk appetite is increasing as the economic and earnings recovery gains traction.

 

Lending requirements are relaxing, and credit availability is increasing. Borrowing and spending are enjoyable; these are happy times, and asset values rise as a result of the liquidity provided by increasing lending and increasing profits.

 

  1. Late-Cycle Expansion

 

As businesses expand, shareholders take precedence and promote a larger return on a stock. The earnings bubble is ending, and debt growth is picking up.

 

Although risk appetite is still strong, central banks are aggressively reversing their loose money policies and rising interest rates. The balance sheets of financial intermediaries begin to increase, supporting the cycle. 

 

Importantly, when the economy enters its late-cycle, new kinds of money and credit emerge that go beyond the usual deposit-funded loan generation process. We have creative liquidity transformations with financing in short-term liquid securities and borrowing in longer-dated less developed capital markets at their core.

 

Also Read | Liquid Funds

 

 

What is a Business Cycle?

 

A business cycle is a pattern of changes in the Gross Domestic Product (GDP) that revolves itself around a sufficiently long pace of growth. It describes the rise and recession of an economy's economic activity throughout time.

 

When a business cycle has gone through a solitary boom and a single contraction in succession, it is said to be complete. The duration of the business cycle is the time it takes to complete this process. 

 

A boom is defined by fast economic expansion, whereas a recession is defined by relatively stagnant economic development. These are calculated in terms of real GDP growth that is inflation-adjusted.

 

 

Phases of Business Cycle

 

The constant development line is depicted in the diagram above by the flat surface in the center. The business cycle oscillates around the line. Each step of the business cycle is described in further detail below:


The image is titled - Phases of Business Cycles - Expansion, Peak Point, Recession, Trough, Recovery

Phases of Business Cycle


 

  1. Expansion

 

Expansion is the very first phase of the business cycle. Strong economic indicators like employment, revenue, production, salaries, profits, sales, and supply of products and services are increasing during this stage.

 

Debtors are typically making timely payments on their obligations, the volatility of the money supply is strong, and investment is high. This process will continue as long as socioeconomic conditions are conducive to growth.

 

  1. Peak Point

 

The economy then achieves a theoretical saturation, or peak, which marks the beginning of the new stage of the business cycle. The optimum rate of growth has been reached. 

 

The economic indices do not continue to rise and are at their peak. Prices have reached their apex. This stage denotes a turnaround in the tendency of economic expansion. At this time, consumers are able to rearrange their budgets.

 

  1. Recession

 

The recession is the time that follows the greatest level. During this stage, demand for products and services begins to fall swiftly and continuously. 

 

Producers do not immediately detect a decline in demand and continue to produce, resulting in an overabundance of demand and supply. Prices usually decline. All positive economic indices, such as revenue, output, wages, and so on, begin to collapse as a result.

 

  1. Trough

 

During the trough period, a country's economic activity falls below the typical level. An economy's growth rate goes negative during this time. Furthermore, during the trough period, national income and spending fell rapidly.

 

Debtors find it difficult to repay their obligations during this stage. As a result, interest rates fall, and banks are less willing to lend money. As a result, banks are seeing a rise in their cash balances.

 

Aside from that, a country's economic production plummets and unemployment skyrockets. Furthermore, during the trough period, investors do not invest in stock markets.

 

  1. Recovery

 

As previously stated, an economy achieves its lowest point of contraction during the trough period. This is the lowest point at which an economy may contract. When the economy reaches its lowest point, it marks the end of despair and the beginning of positivism.

 

During the recovery period, consumers increase their spending because they believe that product prices would not be reduced further. As a result, demand for consumer goods rises.

 

Bankers begin to put their considerable cash balances to use by lowering lending rates and expanding investment in different assets and bonds. Similarly, with a hopeful attitude, additional private investors begin investing in stocks. As a result, security prices rise while interest rates fall.

 

Also Read | Stock Market Analysis

 

Analyzing the trajectory of economic and financial cycles is critical for spotting aggregate credit risk building over the economic cycle, and authorities must adjust financial market measures accordingly. 

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