Current Account and Credit Growth: The Role of Household Credit and Financial Depth

Understanding the impact of financial variables on the current account balance is one of the priorities of academic literature and policy makers. Evidence from a broad panel of countries shows that an increase in the credit growth causes a significant deterioration in the current account balance. We find that this result is driven by household credit. Furthermore, we show that total and household credit growth rates have a stronger negative effect on the current account balance for lower levels of financial depth. In other words, the demand boom associated with the credit expansion gets weaker for higher levels of financial depth. Thus, our findings are in line with the ``too much finance'' hypothesis which states that positive impact of financial development on economic growth vanishes as the level of financial depth increases. Our results suggest that targeted policy measures which curb the excessive household credit growth might be more effective to reduce the external imbalances particularly at the early stages of financial deepening.