The Role of the Financial Cycle1 in Macroprudential Policy Decision Making

THE CREDIT-TO-GDP gap is used as a tool for macroprudential policy making. However, in Lesotho GDP data is only available on an annual basis. Therefore, the purpose of this study is to find an appropriate proxy for the credit-to-GDP gap. The study follows Karfakis (2013) and utilizes three methods to reach its aim, namely; cross-correlations, in-sample Granger causality, and the VAR model.

The study uses annual bank credit to private sector, M2 and trade-deficit as a percentage of GDP data covering the period from 1973 to 2013. The study examines the relationship between the credit cycle and credit-to-GDP gap and discovers that the credit cycle is synchronous with the credit-to-GDP gap in Lesotho. In addition, the relationship between the M2 cycle and credit-to-GDP gap is explored and it is established that the M2 cycle leads the credit-to-GDP gap by one (1) year and can suitably be used as a proxy for the credit-to-GDP gap. In addition, there is a bi-directional causality between M2 cycle and credit-to-GDP gap. The study recommends the use of the credit cycle as a proxy for creditto-GDP gap in line with empirical evidence found, and also recommends the use of M2 cycle on the basis of empirical evidence found in this study.