Credit Channel with Sovereign Credit Risk: an Empirical Test

Abstract

According to Bernanke and Gertler (1995), the Credit Channel amplifies the traditional monetary transmission and this amplification effect comes through the firm's external finance premium, which is a wedge between the expected return for the funds generated internally and the costs of funds raised externally to the firm. Traditionally, this wedge is the bank loan spread but we extend this concept to include the sovereign (country) credit risk and name it, Extended Credit Channel. Armed with this new concept and using a set up model, we estimate two econometric equations for the Brazilian economy after its inflation stabilization program . These two econometric equations measure: (1) the effects of the pure money channel (real interest rates and compulsory reserve requirements on demand deposits) and the extended credit channel (country credit risk and bank loan spread) on the economy's production, and (2) the impacts of the real interest rates, compulsory reserve requirements on demand deposits, and country credit risk on the bank loan spread. Both equations coefficients signs conform to the expected theoretical model. With the results of the estimated equation (1), we define a Product Loss Index Number to compare these two transmission channels (extended credit and pure monetary). This comparison shows that the extended credit channel is a relevant as the pure monetary channel.