Commodity Prices and the Twin Balance Sheet Crisis

In the workhorse new Keynesian models, sectoral deflation is of little consequence unless it affects overall inflation. But in practice, sectoral deflation combined with nominal debt contracts and rigidity in the labour market can have large and significant adverse effects. Using data from India (the second-largest steel producer in the world), we estimate the effect of large movements in metal prices during 2011-16. As expected, a decrease in commodity prices led to a decline in profit in general, with defaulting firms experiencing an even larger decline in their profitability. Using a difference-in-differences design, we find that banks with higher exposure to the metal sector declared significantly higher non-performing assets after the commodity price crash, compared to banks with little or no exposure. Hence, a large decline in commodity prices can cause a prolonged twin balance-sheet crisis, an area that has not received enough attention in the existing literature. This type of balance-sheet crisis hurts credit and economic growth in the medium run. Results also suggest that the large decline in domestic metal prices post 2011 was mostly driven by lower prices of imports from China and the less-than-proportionate depreciation of India’s nominal exchange rate.

Keywords: Metal Prices; Sectoral Exposure; Exchange Rate Pass-Through; Profitability; Nonperforming Assets

Media

Getting Indian banks back on the track – Hindustan Times