Theoretical and Applied Economics

Volume XXII (2015), No. 4(605), Winter, pp. 229-236

The Influence of Lending Activity on Economic Growth

in Romania
Cătălin Emilian HUIDUMAC PETRESCU
Bucharest University of Economic Studies, Romania
catalinhuidumac@yahoo.com
Alina POP
Bucharest University of Economic Studies, Romania
alina_aserom@yahoo.com

Abstract. The banking system has the role to eliminate the fund deficit by transferring the
capital towards investments in order to support the economic growth. Economic
development it is possible if there is an adequate level of capital in the economy that will
ensure efficient business conditions. Credit expansion allows consumers to borrow and
spend more and businesses to borrow and invest more. Increasing consumption and
investment creates jobs and expands income and profits. The study aims to analyze the
impact that the banking system loans have on economic growth in Romania. The analysis
involves a regression model where economic growth will be measured by the growth
domestic product, considered the dependent variable and loans, interest rates and inflation,
the independent variables.

Keywords: credit, economic growth, inflation, interest rate.

JEL Classification: E51, O10.

230 Cătălin Emilian Huidumac Petrescu, Alina Pop

Introduction
Economic growth is a key objective in any economy. Financial markets development it is
positively correlated with the economic growth process. The literature presents various
studies analyzing the link between the banking sector and the real economy. The role of
the banking system, which is to make deposits and to channel funds to those units that
lack the resources necessary to carry on their activities in good conditions is was
recognized a long time ago.
The banking sector is of particular importance because in many developing countries in
the world this sector is either the only way savings can be attracted, or the main source of
financing the economy. However, the development of financial activities, in particular the
expansion of lending activities must be carried out prudently in order to avoid the
negative effects that excessive lending can generate.
In the early 2000s, Romania's economy experienced a strong boom mainly due to the
domestic demand. Consumption and investments experienced a period of growth fueled
by financial development and the expansion of lending. With the onset of the crisis some
loans proved unsustainable and foreign private capital inflows fell sharply. This decline
reflected both the increased risk aversion of financial markets and Romania’s
vulnerabilities. The contraction of capital inflows led to an external financing gap, which
was ultimately alleviated by borrowing from the international financial institutions.
The structure of the financial sector in Romania, it is similar to other countries in Central
and Eastern Europe and its components are banks, insurers and investment funds. Among
these the banking industry is prevailing. Credit institutions hold most of the assets of the
financial system (80%), followed by non-banking financial institutions and investment
funds. In the recent years, pension funds and investment funds have become increasingly
important in the Romanian financial system. However, the total assets of the financial
system as a percentage of gross domestic product (GDP) decreased, reaching 81.5% at the
end of 2013. In terms of business, banks in Romania are mainly engaged in traditional
financial activities. Loans represented 70% of total banking sector assets in 2014. Private
credit granted is distributed among households and companies in roughly equal
proportions. After the economic crisis, the volume of loans decreased primarily reflecting
the decrease in loans to households, both because of the reluctance of the population and
because of a greater caution from the banks. The decreasing trend was maintained in the
corporate sector as well. The growth rate of loans remains currently modest due both to
demand-side factors such as the high level of non-performing loans and tighter credit
conditions and to supply-side factors (European Commission, 2015, pp. 41-42).
The banking system was the main source of financing for Romanian companies, before,
during and after the crisis. In the last five years, banks have increased their ability to
allocate resources to sectors that add value to the economy. A better adjustment of the
funds to the diverse needs and changing economy, allowed banks to allocate resources
more effectively within certain sectors of the economy such as industry, construction and
service sector, while having a significant impact on GDP as well (Deloitte, 2015, p. 27).
This is of particular importance because the stock market is not sufficiently developed in
Romania so as to take some of the financing burden from the banks.
The Influence of Lending Activity on Economic Growth in Romania 231

The paper is divided into two sections. The first section provides a summary of the main
studies that have analyzed the impact that the financial system has on economic growth.
The second section presents the results of the regression model made to verify if in
Romania the banking sector supported economic growth in the last 25 years.

Literature review
The empirical data show that there is an undeniable connection between the real economy
and the banking sector. Although economic analysis focuses mainly on the role that the
banking sector plays in economic development, there are in fact reciprocal influences. As
the economy grows the size and the complexity of the banking sector tends to increase,
making it easier to transfer the resources between lenders and borrowers.
In 1862 the British economist Walter Bagehot argued that capital productivity is higher in
England compared to other countries because in England, the more developed and better
organized capital markets direct resources to more productive investments. This shows
that since then it has been awarded an important role in allocating resources and in
supporting growth to the financial sector (Salvadori, 2003 p. 342). Other economists such
like Schumpeter and Hicks highlighted the role of financial markets in economic
development. Hicks argued that the industrial revolution was mainly due to the expansion
of the financial system which allowed the development and the application of new
technologies. Schumpeter argued that development and economic growth requires credit.
For a state to be able to develop there must be additional liquidity advanced beyond
the liquidity that circulates current output (Bezemer, 2014, p. 2).
The analysis of the link between finance and economic growth has become the subject of
a large number of scientific papers in recent years. In a study conducted by Goldsmith in
1969, he tried to explain the link between financial development and economic growth,
using data for the period 1860-1963 for a total of 35 countries. The objective of the
analysis was to show how the financial structure changes as countries develop. The
research results were however constrained by the lack of theories on the financial
development and financial structure.
Following the developments in economics research, particularly in the financial area in
1973 it was developed the Mckinnon - Shaw Model. This represented the starting point of
the main analysis and monetary policy decisions in upcoming years. Prior to 1970, most
developing countries were subject to a financial repression which consisted in adopting
low interest rates, below the inflation rate and high rates of reserve requirements (Huang,
2010, p. 2).
In the McKinnon - Shaw Model, the two economists analyze the effects of reducing the
financial repression within the domestic financial system in the developing countries. The
analysis showed that reducing financial constraints in these countries, mainly by allowing
the free determination of real interest rates, can positively influence growth rates due to
the fact that interest rates will rise to the level of equilibrium. Under this analysis,
imposing limits set artificially for interest rates will lead to lower savings and capital
accumulation and discourage efficient allocation of resources. McKinnon and Shaw's
232 Cătălin Emilian Huidumac Petrescu, Alina Pop

assumptions argued that liberalization, which is associated with higher real interest rates
stimulate saving. Therefore, higher savings rates will enable the financial sector to
finance more investment, which will lead to a higher economic growth rate (Gemech and
Struthers, 2003, pp. 2-3).
Starting with the McKinnon - Shaw Model there were conducted several studies that
analyze the relationship between finance and growth. In his work Finance and Growth:
Theory and Evidence, Levine shows that the financial sector is a key element in economic
development. In addition, research results show that more developed financial systems
reduce the financing constraints faced by firms. Some of these studies were based on
exogenous growth models, subsequently adopting the endogenous growth models.
The latest research has focused on the problems of information asymmetry on the
financial sector. In The Theory of Economic Growth work: a "Classical" Perspective,
Salvadori says that costs of information asymmetry problems can cause financial
arrangements different from those based on the assumption that economic agents are fully
or symmetrically informed. Therefore, the structure of the financial system is the result of
the economic units’ attempts to reduce these costs endogenously determined hence, the
financial structure it cannot be analyzed as an exogenously determined structure.
Information asymmetry occurs when one party to a financial contract holds less information
than the other party. Asymmetric information favors the emergence of two problems in the
financial system: adverse selection and moral hazard (Mishkin, 1997, p. 56).
Adverse selection is a problem of asymmetric information that appears before transaction.
In case of loan contracts, customers who want to take higher risks will be the ones who
will actively pursue a loan, therefore the probability that they would be selected to benefit
from this loan increases.
Moral hazard is a problem of asymmetric information that occurs after the transaction.
Moral hazard problem stems from the fact that the debtor might be tempted to invest in
risky projects which bring high profits, but in case of failure, the costs will be borne
largely by the lender. An example of moral hazard is state guarantees for the loans. When
banks know that the loans are guaranteed by the government they will be tempted to
undertake risky projects to make higher profits knowing that if they fail, the majority of
the costs will be borne by the state.
Given the role that the financial system plays in the economy, the emergence of obstacles
(for example: excessive or inadequate regulation, a low number of market operators)
which would not allow to fulfill this role efficiently will lead to the malfunctioning of the
economy and to a slowdown in growth. Many existing studies in the literature show that
one of the main reasons for why poor countries remain poor is that their financial sector
remains underdeveloped.
In a work performed by Khan and Senhadji (2000) for a total of 159 developed and
developing countries it is shown that the level of financial development is a determinant
factor for the differences in growth registered in these countries.
Kunt and Levine-Demirgüç (2008) shows that countries with a developed financial system
tend to grow faster than other countries. The size of the banking system and the liquidity of
The Influence of Lending Activity on Economic Growth in Romania 233

the stock markets are each positively correlated with economic growth. A better functioning
of the financial system is needed to reduce external financing constraints. External funds,
where internal funds are not sufficient, enable firms and industries to expand which will
implicitly lead to the development of the economy in question. The manifestation of the
positive effects of the financial system on the real economy entails the fulfillment of certain
conditions. First, a well-functioning financial system requires stable macroeconomic
policies and a strengthened regulatory framework. Thus, improving the financial
infrastructure should be a priority. Secondly, the financial system should be characterized
by low barriers to entry to allow the entrance of other financial institutions so that work is
carried out in a competitive environment. Thirdly, the impact that the policies adopted by
national governments have on the financial sector should also be reviewed to ensure that
they do not contravene to the proper functioning of the system.
Cojocaru, Hoffman and Miller (2011) showed in a study conducted for the period 1990-2008
in 25 countries in Central and Eastern Europe and former Soviet Union states, including
Romania that the loan granted by the banking sector contributes significantly to the economic
growth registered in the countries included in the analysis. The study also shows that there is a
negative relationship between the interest rate spread and economic growth.

Methodology
The hypothesis from which we started in the analysis is that the loans granted by the
banking sector positively affect economic growth, as the economic theories presented in
the previous section suggest. We also assumed that between interest rates, inflation and
economic growth there is an inverse relationship.
The methodology is based on econometric modeling using Eviews 8.0. The data series
used in the regression model have a yearly fervency; the period for which the analysis is
carried out is 1990-2014.
The data on the four indicators analyzed were collected from various national and
international databases. For inflation data were obtained from the website of the National
Institute of Statistics, the data for interest rate and credits were obtained from the website
of the National Bank of Romania (NBR) and refer to values recorded at the end of each
year, and for gross domestic product per capita (GDP per capita) from the database of the
International Monetary Fund (IMF) - Word Economic Outlook.
Regarding the credits, the data for the period 2007-2014 are composed of loans to
households, non-financial corporations, non-monetary financial institutions, government
and non-residents and for the period 1990-2006 they relate to nongovernment and
government credits.
Given the high record values for GDP per capita and loans, they were logarithmic.
The aim of the research is to identify the relationship and the impact of the credits,
inflation and interest rate on economic growth.
To avoid getting the wrong regression results it was applied the Augmented Dickey-Fuller
Unit Root Test to ensure the stationary nature of the data series used in the analysis. The
234 Cătălin Emilian Huidumac Petrescu, Alina Pop

Augmented Dickey-Fuller Unit Root Test (ADF) allows highlighting stationary or non-
stationary nature of dynamic series, by determining the deterministic or random trend.
The Augmented Dickey-Fuller Unit Root Test hypothesis:
Null hypothesis: the variable has a unit root (it is not stationary);
Alternative hypothesis: variable does not have a unit root (it is stationary).
The results achieved for the Augmented Dickey-Fuller Unit Root Test are shown in Table 1.
Table 1. The Augmented Dickey-Fuller Unit Root Test
Variables The obtained 1% critical Status Conversion Value after 1% critical
value value at level conversion value at level
LNGDP -7,687 -3,769 stationary - - -
LNCREDITS -3,954 -3,737 stationary - - -
Inflation rate -6,886 -2,692 stationary - - -
Interest rate -1,473 -2,674 Not First -3,880 -2,685
stationary difference
Source: own calculations.
The values obtained by applying the ADF test show that the GDP per capita (LNGDP),
loans (LNCREDITS) and inflation series are stationary in level. The series for interest
rate is non-stationary in level, therefore, it was converted into a stationary series by
conversion to the first difference, and the result is also presented in the table above.
To analyze the link between the three independent variables, credits, interest rate and inflation
rate and GDP per capita the dependent variable, the regression function can be expressed as:
GDP = f (loans, inflation, interest rate)
or
LNGDP = C (1) + C (2) * LNCREDITS + C (3) * Interest_rate + C (4) * Inflation_rate
Where:
C (1) – it is the constant;
C (2), C (3), C (4) – represent the slope of the regression line;
LNGDP - natural logarithm of GDP;
LNCREDITS – natural logarithm of credits.
Figure 1. The estimated regression model

Source: own calculation Eviews 8.0

The Influence of Lending Activity on Economic Growth in Romania 235

The regression results model presented in Figure 1 shows the relationship between the
examined variables and can be expressed as follows:
LNGDP = -6.013 + 0.890 * LNCREDITS - * 1.216 Dinterest_rate - 0.139 * inflation_rate
The analysis of the results confirms the initial hypotesis that, that there is a positive link
between loans and economic growth.
Conversely, between the interest rate, inflation rate and the GDP variable used in the
equation to quantify growth, there is a negative relationship. The model results show
however, that the two independent variables respectively, inflation and interest rates are
not significant in statistical terms, growth was mainly influenced only by the volume of
credits.
The values obtained for the correlation coefficient R = 0.96 and R2 = 0.95 suggest a
positive linear correlations. This indicates that 95% of the variation in the dependent
variable is explained by variations in the independent variable, loans.
Overall, the data suggests that loans to the financial sector had a significantly positive
impact on economic growth in Romania between 1990 and 2014. This shows on the one
hand that the banking sector is a driver of growth in Romania and secondly that a
malfunction (e.g. the increasing number of nonperforming loans) thereof can have a
major impact on the economy.
The regulations in the field require banks to create provision for risks which are recorded
in their balance sheet causing therefore an increase of the costs and a decrease of the
profit. Consequently, as bigger the volume of nonperforming loans as smaller becomes
the profit. In recent years, banks have transferred the nonperforming loans to specialized
recovery companies, but this does not solve the problem unless they are recovered, but
even so, provisions that were already created diminished the profits. In these
circumstances banks could become more reluctant in granting credits, and this would in
turn affect economic growth.
Conclusions
The banking sector plays an important role in the economy by supporting saving, capital
accumulation and targeting resources towards profitable investment projects. Economic
development is closely connected with the development of the banking sector in an
economy. Expanding and developing economic activities require additional funding,
funding which most often and especially in Romania, comes from the banking sector.
The analysis on the Romanian economy for the period 1990-2014 shows that much of the
economic growth recorded during this period was due to funds coming from the banking
sector in the form of loans. These results highlight the importance of the banking sector in
supporting economic growth. Therefore, future action should further encourage the
provision of both long-term and short-term loans and their orientation towards profitable
economic activities.
236 Cătălin Emilian Huidumac Petrescu, Alina Pop

Providing support to the economy by granting loans should occur in parallel with the
development of a strong regulatory framework in order to prevent the excessive risk
taking that could turn the granted loans into nonperforming loans.

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