Introduction to business cycle
A business cycle refers to the periodic fluctuations in the level of economic activity in an economy over time. These fluctuations are reflected in changes in national income, output, employment, investment, and prices. Every economy experiences periods of growth and decline, and these recurring movements constitute the business cycle.
Expansion phase
The expansion phase is the period when the economy shows a steady increase in economic activity. During this phase, production rises, businesses expand operations, and investment increases. Employment opportunities grow, leading to higher income levels and improved consumer confidence. As a result, consumption demand increases, which further supports economic growth.
In the expansion phase, banks generally experience higher demand for loans from industries, businesses, and individuals. Credit growth is strong, loan repayment capacity improves, and non-performing assets usually remain low. However, if expansion continues for too long, it may lead to inflationary pressures due to excess demand.
Peak phase
The peak phase represents the highest level of economic activity in a business cycle. At this stage, the economy is operating near full capacity, and most resources are fully utilised. Output, income, and employment reach their maximum levels. Business optimism is very high, and asset prices often rise sharply.
However, the peak also carries signs of overheating. Costs of production increase, inflation may rise, and profit margins start to decline. Interest rates often increase due to tight monetary policy aimed at controlling inflation. Credit risk begins to rise at this stage, as borrowers may have taken excessive loans based on optimistic expectations.
Contraction or recession phase
The contraction phase, also known as recession, begins after the peak. During this phase, economic activity starts to slow down. Production falls, investment declines, and businesses reduce output due to falling demand. Employment opportunities shrink, leading to rising unemployment and lower income levels.
Consumer confidence weakens, resulting in reduced spending. For banks, this phase is challenging as loan demand decreases and repayment capacity of borrowers deteriorates. Non-performing assets tend to increase, and banks become more cautious in lending. Monetary and fiscal authorities usually intervene during this phase to revive economic activity.
Trough or depression phase
The trough is the lowest point in the business cycle. At this stage, economic activity is at its minimum level. Output, income, and employment are very low, and business confidence is weak. Investment activity is minimal, and many firms may shut down or operate at heavy losses.
This phase is associated with high credit risk, weak loan growth, and pressure on profitability. However, the trough also creates conditions for recovery, as prices and costs are low and policy support is usually strong.
Recovery phase
The recovery phase marks the turning point from trough to expansion. Economic activity begins to improve gradually. Investment starts rising due to low interest rates and supportive government policies. Employment increases, income levels improve, and consumer demand starts picking up.
Banks play a crucial role during the recovery phase by providing credit to productive sectors. As business confidence returns, loan demand increases and asset quality stabilises. The recovery phase eventually leads back to expansion, completing the business cycle.
Key characteristics of business cycles
Business cycles are recurring but not regular. Their duration and intensity vary across countries and time periods. They affect almost all sectors of the economy but with different degrees of impact. Business cycles are also interconnected across countries due to global trade and financial linkages.
Importance of business cycle analysis for bankers
Understanding the phases of a business cycle helps bankers in better credit planning, risk management, and strategic decision-making. Banks can adjust lending policies, interest rates, and provisioning norms according to the phase of the cycle. This knowledge is essential for asset-liability management and long-term financial stability.