How Bank Lending Standards Drive Growth and Inflation in Mongolia’s Credit-Dependent Economy

The IMF and Bank of Mongolia study shows that tightening bank lending standards in Mongolia significantly reduces credit growth, economic activity, and inflation for several quarters, with effects that persist over time. By isolating true credit supply shocks from demand, the paper demonstrates that bank-driven credit conditions are a key driver of macroeconomic fluctuations in bank-dominated emerging economies.

An IMF Working Paper, authored by researchers from the International Monetary Fund (IMF) in collaboration with economists from the Bank of Mongolia, examines how shifts in bank lending standards shape macroeconomic outcomes in Mongolia. The study is set in an economy where banks dominate financial intermediation, capital markets remain underdeveloped, and credit conditions play a central role in transmitting shocks. Mongolia’s heavy reliance on mining exports, exposure to volatile commodity prices, and sensitivity to external financial conditions make it an ideal case for studying how changes in credit supply, rather than credit demand, affect growth and inflation.

A Rare Window into Credit Supply

The analysis draws on a confidential quarterly Bank Lending Survey conducted by the Bank of Mongolia since late 2017, covering the entire banking system with a full response rate. Banks report changes in lending standards and credit demand for total loans, enterprise loans, and household loans. These qualitative responses are transformed into diffusion indices that capture system-wide movements in credit conditions. However, the authors stress that raw survey indicators mix supply and demand forces, since the same macroeconomic developments can influence both banks’ willingness to lend and borrowers’ desire to borrow. Disentangling these forces is therefore essential for understanding the true macroeconomic role of bank credit.

Isolating True Credit Supply Shocks

To identify genuine credit supply shocks, the paper uses bank-level panel regressions that “purge” lending standards of demand-related and macroeconomic influences. The regressions control for persistence in credit standards, contemporaneous credit demand, expectations of future GDP growth, current macroeconomic conditions such as inflation and policy rates, and bank-specific characteristics including risk tolerance, loan composition, and funding structure. The residuals from these regressions represent adjusted credit supply shocks, changes in lending standards driven primarily by banks’ internal constraints, regulatory pressures, and risk perceptions. The results show that lending standards are highly persistent and move countercyclically with credit demand, while banks’ own risk tolerance plays a decisive role, especially in household lending.

How Credit Tightening Hits Growth and Inflation

Using these adjusted credit supply shocks, the authors estimate a vector autoregression model to trace their effects on lending growth, output growth, and inflation. The findings are clear and economically significant. A tightening in credit supply leads to an immediate contraction in loan growth, followed by declines in economic activity and inflation. At its peak, a one standard deviation tightening reduces lending growth by about five percentage points, output growth by roughly one percentage point, and inflation by close to one percentage point. These effects persist for several quarters before gradually fading, underscoring the delayed but lasting impact of restrictive credit conditions. When credit supply shocks are broken down by loan type, household credit tightening has a stronger effect on output growth, while enterprise credit tightening has a larger impact on inflation. The paper suggests that household credit often leaks into imports, muting inflationary pressure, whereas enterprise lending affects production costs that are more easily passed on to prices.

Lessons for Policy and Emerging Economies

Variance decomposition analysis shows that adjusted credit supply shocks explain a large share of fluctuations in loan growth and a meaningful portion of movements in output and inflation, outperforming unadjusted credit standards. A battery of robustness checks, including alternative model specifications, different variable orderings, and controls for exchange rates, commodity prices, and major government credit programs, confirms the strength of these results. The paper concludes that monitoring lending standards should be a priority for policymakers in Mongolia, as credit supply shifts have powerful short- and medium-term macroeconomic effects. More broadly, the findings offer lessons for other emerging economies with bank-centered financial systems, highlighting how changes in banks’ lending behavior can amplify business cycles and shape the trajectory of growth and inflation.