Credit Market

Abstract

The credit market is fundamental to the global financial market. It operates as a "shadow bank," providing a marketplace wherein corporations and governments may sell their debt, or credit. This credit is sold to investors against the promise to repay the loan within a specified period of time. The degree of credit as it directs the global marketplace gives economists an indication of problems in the financial markets long before other distress signs would appear.

Overview

In practice, economics has no present tense. The global financial market, that is the complex and often volatile international dynamic that tracks the supply and the demand of goods and services through the necessary cooperation of both private corporations and public institutions, exists for all practical purposes solely in the future tense. What happens today is most useful only in planning for tomorrow. Economists (as well as private money managers and a range of government agencies and entities designed to maintain the integrity of a nation’s economy) constantly monitor money activities and transactions in the present largely as a way to chart potential areas of growth and, far more often, as a way to avert potential interruptions in the healthy and robust circulation of monies in the international marketplace. The credit market exists as a fundamental element of that global financial market—it is a kind of shadow bank, a massive and very intricate virtual marketplace wherein corporations and governments actually sell their debt as a strategy for financing their continuing operations as well as their plans for growth and evolution.

Economists carefully monitor the fluctuations within this global credit market. The growth of real debt can have a killing impact on a business’s or country’s economic health. Indeed, few economic prognostications in 2015 elicited as much attention (and concern) as the accumulating evidence of deleterious activity within the credit market that was taken as a harbinger of a serious and significant (and fast approaching) economic downturn. Because charting this credit market involves extrapolating from existing economic data and then predicting a reasonable course of probable events, economists themselves do not entirely agree on the implications of the credit market’s short or long-term viability or on the dimensions of the problem. One premise economists across the board agree on is that the build-up of significant debt globally cannot be sustained forever.

Money fuels economic growth and stability. Credit serves as a warning that the money flow is being dragged down by debt, that is, by corporations and governments largely running on credit, which is sold to investors. The management of debt through these negotiations in the credit market is virtually impossible to sustain in developing countries struggling to maintain any level of long-term economic growth as investors need significant indications of a return, a guarantee difficult to sustain in developing countries. A 2015 study of economic viability in Colombia, for example, found that "entrepreneurs in developing countries face less efficient financial markets, more volatile macroeconomic conditions, and higher entry costs than their counterparts in high income economies" (Bond, Tybout, & Utar, 2015). The credit market, however, is a robust element of the economic system in post-industrialized economies such as in Europe and the United States, and along the Pacific Rim. The credit market, thus, is a way to measure, even evaluate how investors with deep pockets are sizing up the financial markets, where they expect growth and where they suspect problems. The credit market offers financial analysts a way to measure the solvency of a corporation (or a government for that matter). So in many ways a robust credit market poses a most insidious problem.

Any network—from a neighborhood grocery to a city government, from a major industrial plant that manufactures cars to a federal government, from a public school system to an Internet marketing company—needs money to continue its operations, and revenue alone is often insufficient to sustain necessary levels of operations much less allow for the expansion of those operations or even to pursue entirely new directions that might promise future revenue. The international economic marketplace is fueled by three strategies of financing and/or investing. A business may acquire a competitor’s business in its entirety by purchasing it outright using straight-up cash transactions. A company may raise money by selling stock interest that represents an investor’s opportunity to purchase a part of that entity’s ongoing and projected financial revenue stream and to profit (or lose) as that company succeeds or fails. By far, the largest (and most volatile) of these markets is the buying and selling of bonds, which are loans made by investors to governments or corporations, and these transactions are what is tracked in the credit market. In the end, debt—specifically how companies and governments handle debt—runs the global economy.

Although there are dozens of different types of bonds, bonds generally are a way to package debt. The difference in the types of bonds is in the risk involved. Companies and governments need investing in order to remain financially solvent. Selling bonds is a strategy for maintaining operations. Most often these bonds are negotiated in denomination of $1000, and then most often in lots, usually ten bonds per lot. That loan, in turn, is negotiated with a rate of interest that will govern the entity’s repayment of the loan to the investor—the loan, thus, is perceived as temporary. It is financing for general operations—and those operations, it is assumed, will maintain the economic health of the entity thus guaranteeing the repayment.

The credit market is an ongoing dynamic. Indeed, any loan is extended to what is called a maturity date, that is a time anywhere from 60 days to two years in which the debt is expected to be entirely repaid. The entity agrees to repay the loan in increments, most often every six months, or in some cases in a single lump sum at the end of a specified period. It is the movement within those exchanges that creates the credit market, basically a global marketplace for the movement of loans and the accumulation and management of debt. The degree of that movement is determined in large part by the risk involved in the negotiation.

Firms with strong debt ratings who sell their debt through bonds in the credit market most typically use investment-grade bonds, traditional long-term bonds secured and backed through collateral, or they use short-term commercial paper, bonds that do not need to be secured with any collateral because they have been issued by corporation (or a government) to cover some short-term financial squeeze or to provide a temporary infusion of capital. Perhaps the least vulnerable of the bonds negotiated in the credit market are Treasury bonds, issued by the federal government and backed with the full faith and credit of the federal government, issued for a specific period of time (usually ten years) and held to a fixed interest rate that ensures regular payments of the debt to the investor. Although multinational corporations as well as state and city government sell bonds, the largest bond issuer in the world is, of course, the U.S. government.

Because they represent virtually riskless investing, government Treasury bonds are a favorite investment of the retired looking for a safe place to allow their monies to bring in regular income (interest payments come every six months); those who control the growth of company’s pension funds and who see guaranteed returns as a safe investment; and/or simply individuals who are in the process of creating an investment portfolio. At the other end of the spectrum in the credit market are so-called junk bonds, high-risk bonds issued usually by a company in significant financial stress and/or a company searching for a strategy to rescue its short-term financial viability. Often junk bonds are issued by entrepreneurs working out the basics to start a new business. In either case, the investor is offered higher interest payments, or yields, as incentive but faces a significantly higher risk that the company will default on the loan (Kitchens, 2008).

For economists in the United States, the critical relationship to watch is between interest rates, as set by the Federal Reserve, and the value of bonds sold in the credit market. If the government raises interest rates, that signals a robust economy, a more secure employment picture, and the promise of expanding businesses and the start-up of new businesses. It also means the value of bonds, which measures debt, will fall. Conversely, if the Federal Reserve drops interest rates, that signals a more fragile economic picture and the possibility of significant stock market volatility. In that case, the value of the bond, which measures in part the vulnerability of businesses who must operate in the red, increases. It is a kind of wonderland relationship: The healthier the economy, the lower the credit market activity; conversely, the more vulnerable the economy, the more robust the credit market activity. Rapid growth in the credit market often ends in crisis (Elekdag & Wu, 2013).

Applications

A robust credit market is a signal to economists of a difficult and even catastrophic economic forecast. Like a loan negotiated between two people, the bond between an entity (which functions as the borrower) and the lender (or investor) involves a specified sum of money that moves from the lender to the borrower. In this case, the monies received allow the entity to continue to function and/or to finance new directions or plans for expansion. In the wake of the global financial crisis of the mid-2000s, debt became a boom venture.

The total global debt among countries and corporations as of mid-2015 was estimated to be just over 82 trillion dollars, of which just under half belongs to the United States alone. These are numbers difficult for anyone not directly involved in the global marketplace to even conceive. The implications are, in turn, formidable. The more bonds are sold (and companies and governments that find a ready market for their debt are inevitably drawn to issuing more credit), the healthier the bond market, the more troublesome are the implications for the stock market, which trades on the actual on-going business operations and which are significantly compromised if a company is negotiating deeper and deeper into the red. The more bonds negotiated, the more that stock is inevitably devaluated. If the credit market continues to thrive, there comes a tipping point when debt itself becomes unmanageable.

Given the dimension of debt that these loans measure, economists as early as late 2014 began to warn businesses and governments of a fast approaching credit crunch and its potential implications. Some economists predict a downward spiral of rising credit and falling asset prices (Wang & Zhang, 2014). The heavy volume marketing of debt as a way to survive what had been nearly six years of depressed global economic growth was quickly becoming a much larger problem than the far more talked-about problems: the stagnant housing market, the budget crises in state and city governments; the skyrocketing costs of education and the crisis in funding public education; the rise in underemployment, that is, qualified job applicants being forced to accept employment for which they are overqualified for lower wages or fewer hours; and the precipitous drop in business start-ups (Altman & Kuehne, 2015).

The debt bubble, economists began to argue, was inevitably going to burst and businesses and governments that had strung out their operations and pinned their long-term financial stability on the income from selling their debt on the credit market were inevitably going to face a difficult reality. No more than an individual with a credit card, economists warn, a business cannot live off its debt forever. Eventually, that business must confront hard choices just to sustain economic viability against such time as economic growth might be factored in.

That complex crisis is exponentially multiplied when applied to governments when their bonds default, a signal of a government spiraling into economic collapse as its debts have so completely outweighed its revenue and even its potential for revenue that growth is out of the question and current levels of operations must be entirely shut down, in effect dismantling the very apparatus of the government, a level of fiscal crisis that rocked Greece, Chile, Turkey, and Russia in the latter years of 2000s. When the U.S. federal government faced the chilling reality of its long-standing top-tier credit rating being decreased by Standard & Poor’s in 2011, largely seen as a result of generally poor fiscal management, political infighting at the expense of genuine budgetary reform, and the exponential increase in government expenditures, the implications of such a downgrade in confidence in the American government’s ability to pay its debts sent a shockwave through the economic community and through the apparatus of government itself (Constantine, 2014).

Viewpoints

The credit market is a powerful tool for companies to pursue bold initiatives. The marketing of debt secures growing companies the opportunity to aggressively follow significant new directions. Energy companies, for example, can fund explorations for new oil reserves or replacement green technologies; a growing domestic business can look overseas for new markets; a cutting edge electronics conglomerate can expand their research and development into new fields from medicine to communications; a grocery store chain can merge with a trucking concern and enhance both companies’ revenue. The credit market also offers a second chance for young entrepreneurs, often visionary and risk-taking, who face the daunting challenge of coming back from a catastrophic business failure (Schumacher, Gerling & Kowalik, 2015). In addition, the credit market offers established companies caught in unexpected financial straits or companies directed into risky ventures by management to maintain operations (such as meeting payroll or maintaining utilities) in the short-term before regaining financial stability and health. From a conservative economic perspective, the credit market is simply an investment platform that maintains the stability of the global financial system.

But financial stability is a dynamic between assets and debt. Debt is an all too easy negotiable. Often, debt breeds more debt. "[W]hen … credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity" (Lopez-Salido, Stein & Zakrajšek, 2015). When the credit market sustains the functioning of a business (or government for that matter), when liquidity (that is the flow of cash as assets and services negotiated in real-time in real-value) is compromised, the credit market is a powerful harbinger of approaching market correction when such massive debt is "called in," which can result in a catastrophic, even chaotic economic environment: drops in real spending power; evaporation of long-term employment opportunity; spiraling mortgage rates; and widespread cutbacks in goods availability and services provided. Those conditions began to shape the narrative of global economics in mid-2015.

The interpretation of financial conditions emerged as the most compelling economic development of the closing months of the year in the wake of the Federal Reserve’s announcement in early December 2015, of its intention to raise short-term interest rates, a sign of its attempt to drive down the value of bonds as a way to curb debt negotiation and investor demand and ultimately to manage any potential economic shortfall.

Terms & Concepts

Bond: A legally-binding instrument of debt investment from the bond issuer (usually a corporation or government) to the bond holder, or investor, to be repaid in a pre-determined period of time and with an agreed-upon interest rate.

Bubble: An economic period of great activity that exceeds normative practices and then moves quickly to a corrective downward spiral, most often characterized by widespread sell-offs.

Commercial Paper: A short-term (usually six months) debt instrument typically issued by a corporation with solid credit ratings but interested in short-fall funding for emergency situations and/or to remedy short-term revenue distress.

Credit Rating: A calculation, based on recent economic activity and most often rendered in a number or percentage. It is used to measure a corporation’s or government’s ability to meet financial obligations and to set interest rates on bonds.

Junk Bond: A high-risk, high-yield bond, often issued by start-up companies or by companies (or governments) that struggle with a poor credit rating.

Liquidity: The conditions (and speed) under which assets can be traded in the open market at stable and commercially viable prices.

Treasury Bond: A fixed-interest bond issued by the federal government to cover government debt, issued most often for a period of ten years and considered the safest bond investment

Yield: The income returned to the investor of a bond.

Bibliography

Altman, E.., & Kuehne, B. (2015). Credit market bubble building. Business Credit, 117(3), 8–9. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=101133896&site=ehost-live

Bond, E., Tybout, J., & Utar, H. (2015). Credit rationing, risk aversion, and industrial evolution in developing countries. International Economic Review, 56(3), 695–722. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=108612081&site=ehost-live

Constantine, W. (2014). Justice or retribution: The S&P downgrade and lawsuit. Review of Banking & Financial Law, 33(2), 504–513. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=111210960&site=ehost-live

Elekdag, S., & Wu, Y. (2013). Rapid credit growth in emerging markets: Boon or boom-bust. Emerging Markets Finance & Trade, 49(5), 45–62. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=93646429&site=ehost-live

Kitchens, S. (December, 2008). Shopping for junk. Forbes, 182(12), 144. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=35483725&site=ehost-live

Lopez-Salido, D., Stein, J., & Zakrajšek, E. (May, 2015) Credit-market sentiment and the business cycle. Working Papers: US Federal Reserve Board’s Finance & Economic Discussion Series, 1–38. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=103169827&site=ehost-live

Schumacher, H, Gerling, K., & Kowalik, M. (2015). Entrepreneurial risk choice and credit market equilibria. B.E. Journal of Economic Analysis, 15(3), 1455–1480. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=110441446&site=ehost-live

Wang, F., & Zhang, T. (2014) Financial crisis and credit crunch in the housing market. Journal of Real Estate Finance & Economics, 49(2), 256–276. Retrieved December 26, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=96577315&site=ehost-live

Suggested Reading

Allen, L., Boudoukh, J., & Saunder, A. (2003). Understanding market, credit, and operational risk: The value at risk approach. Hoboken, NJ: Wiley.

Fabozzi, F. (2015). Bond markets, analysis, and strategies. Rev. ed. New York, NY: Prentice-Hall.

Skoglund, J, & Chen, W. (2015). Financial risk management: Applications in market, credit, asset and liability management. Hoboken, NJ: Wiley.

Soros, G. (2009). The crash of 2008 and what it means: The new paradigm for financial markets. New York, NY: PublicAffairs.