The Great Leveraging was an episode of rapid credit growth and booming housing markets leading up to the global financial crisis. It is important to identify the key drivers of the Great Leveraging and, to this end, the purpose of this paper is to model the relationship between domestic credit and net foreign liabilities in the EU countries most affected by the crisis.
The analyses show that domestic credit and net foreign liabilities were cointegrated one-to-one for Greece, Italy, Portugal and Spain, while there was no cointegration for Ireland. Estimation of vector error correction models (VECMs) shows that the adjustment to deviations from the cointegrating relationship took place through changes in domestic credit for Greece and Italy, while the adjustment was bidirectional for Spain and maybe also for Portugal.
These results suggest that external factors in the form of foreign capital inflows were important drivers of the pre-crisis leveraging in the southern crisis countries, although to varying degrees across the countries.
Key novelties include the use of stock variables instead of flow variables and the estimation of VECMs for the countries individually instead of in a panel.
The authors would like to thank the participants at the ECEE6 Conference in Tallinn, a seminar in Eesti Pank, a "lunch seminar" at INET in New York, the 2015 Conference of the Eastern Economics Association in New York and the IV Meeting on International Economics in Vila-Real for valuable comments. The usual disclaimer applies. Juan Carlos Cuestas acknowledges the financial support from the MINECO Research Grant No. ECO2014-58991-C3-2-R and Generalitat Valenciana Project Grant No. AICO/2016/038. The views expressed are those of the authors and not necessarily those of Eesti Pank.
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