How to get around credit constraints? The role of renting and leasing during financial crises

Peter Gal, Gabor Pinter 21 September 2013

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How does the ownership of capital affect the aggregate behaviour of the economy? Does it matter whether firms own or rent production capital such as machinery, equipment, offices, and structures? This question has been somewhat neglected by macroeconomists, mainly because in a frictionless world the question of capital ownership is irrelevant – firms are indifferent between renting and owning (Jorgenson 1963). However, in the presence of credit constraints, the issue of leasing versus buying may become relevant for firms’ investment decisions, as emphasised by the corporate finance literature (e.g. Eisfeldt and Rampini 2009).

This question is especially relevant in the current economic context. Historical studies show that financial crises are generally associated with long-lasting negative consequences for the economy (see Reinhart and Rogoff 2009). In particular, the current slow recovery in many countries has been partly due to weaknesses in the banking sector and its insufficient provision of credit, especially to those firms – typically young and small – with little collateral. A well-functioning rental market may help to allocate capital to such credit-constrained firms, and thereby contribute to a quicker recovery.

The housing market has already been investigated from this perspective. For example, Ortega et al. (2011) analyse the Spanish housing market and find that the introduction of a rental subsidy and improvements in rental market efficiency are welfare-enhancing if house purchases are subject to credit constraints. Further, using cross-country data, Casas-Arce and Saiz (2006) show that regulations that are unfavourable to the owners of rental properties can hamper the development of the rental market. Finally, in the press, The Economist has regularly reported on the increasing demand for rentals during the financial crisis, linking this to the difficulties of obtaining credit (The Economist 2008, 2012). These findings point to the increased role of renting possibilities in providing an alternative to credit-financed purchases during times of financial distress.

The growing role of corporate rentals

In contrast, the macroeconomic impact of leasing by the corporate sector has received less attention. This is so despite the fact that leasing activity has been steadily increasing over time, reaching 20% of total capital expenditure in the US over the last decade (Figure 1 below). This upward trend of the last 30 years has been present in virtually all sectors of the US economy (Gal and Pinter 2013). The reasons behind this secular increase are important topics for future research, and they probably involve both an increased supply of rentals driven partly by regulatory changes, and a growing demand by companies for more flexibility in their production capacities.

Figure 1. Renting has become more important over the last decades in the US

Source: Calculations in Gal and Pinter (2013) using Compustat annual financial statements data for the US and NBER recessionary periods.

Note: *Rental expenses as percentage of total capital expenditures. Shadings represent recessionary periods defined by the NBER.

Regarding the type of capital goods rented, the most natural candidates are offices and vehicles (Eisfeldt and Rampini 2009). Yet, some industries such as airlines (Gavazza 2011) routinely rely on renting to obtain their main productive capital good. Even certain parts of complicated manufacturing assembly lines can now be rented, not to mention IT infrastructure, with cloud computing and storage gaining popularity in recent years.

To assess the macroeconomic consequences of corporate rental activity, our research (Gal and Pinter 2013) focuses on the co-existence of credit-constrained purchases and the possibility of renting. It emphasises the role of renting in understanding the business cycle and especially downturns caused by financial disruptions.

Empirical findings on corporate rentals and their macroeconomic impacts

Our study uses US Compustat data to show that more financially constrained firms (i.e. those with less collateral) tend to rely more on renting, as indicated by their higher share of renting among capital expenditures. Capital renting includes firms’ expenses on operating leases of machinery, equipment, offices, and structures, while capital expenditure captures all spending related to the expansion and maintenance of firms’ capital stock. Further, we establish that capital renting is countercyclical. This is shown in Figure 2 below. The pattern is also present at more disaggregated levels – rental activity picks up both at the industry and firm level during downturns.

Figure 2. Renting is countercyclical

Source: Compustat (rental share), firms incorporated in the US, and Bureau of Economic Analysis (GDP).

Note: The cyclical components of rentals and GDP in the US.

*Rentals are measured rental expenses as the percentage of total capital expenditures. Cyclical components are obtained by applying a Hodrick-Prescott filter for annual data.

Finally, using cross-country aggregate data, we show that countries with a larger rental sector experience a smaller output loss in the aftermath of financial crises. This negative relationship is shown in Figure 3.

Figure 3. More rentals are associated with smaller real costs of financial shocks

Source: Calculations from Gal and Pinter (2013) based on the OECD STAN database for the size of the rental sector and Laeven and Valencia (2012) for cumulative output loss.

Note: 1970–2009, 20 countries.

* The size of the rental sector is measured by the ratio of value added of the rental sector (industry 71 “Renting of machinery and equipment without operator and of personal and household goods” in NACE Rev 1.1) to gross fixed capital formation at the country level.

** Cumulative output loss is measured, as a ratio of GDP, as the cumulative sum of the differences between actual and trend real GDP over the period [T, T+3], expressed as a percentage of trend real GDP, with T the starting year of the crisis.

One may argue that countries with larger financial systems have systematically larger (or smaller) financial meltdowns once a financial crisis breaks out, and that the size of the rental sector may grow hand-in-hand with the rest of the financial sector. Nevertheless, we find that the negative relationship between rental activity and the output loss after crises is robust to including various measures of financial development such as the size of liquid liabilities, bank deposits, total deposits, and the capitalisation of the stock and bond markets. The relationship is also significant and negative when we account for the size of the booms during the pre-crisis periods. The robustness of this finding suggests a more causal interpretation of the mitigating role of rentals during downturns caused by financial distress.

Understanding the stylised facts

We investigate our empirical findings with a dynamic general equilibrium model along the lines of Kiyotaki and Moore (1997), where firms’ decisions to purchase capital are subject to credit constraints. In contrast, firms’ decisions to rent capital are assumed to be unconstrained (Eisfeldt and Rampini 2009). The model is used to explain both the observed countercyclicality of rentals and why the presence of rentals mitigates crises, while matching some key business-cycle properties of the US economy.

The intuition behind the countercyclicality of renting in our model is that in a crisis, when the real interest rate falls, the cost of renting (the rental fee) falls by the same extent. By contrast, the cost of owning is reduced by falling interest rates only proportionally to the share that is credit-financed. At the same time, downpayment requirements associated with capital purchases become relatively higher. This asymmetric impact of a crisis on the cost of investment choices means that capital renting becomes relatively cheaper, and firms naturally substitute owned capital with rented capital.

To explain the mitigating impact of renting in the face of financial distress, we point out that the possibility of capital renting may serve as an extra margin of adjustment for both savers and borrowers. This extra margin serves the purpose of allocating the extra savings that cannot be absorbed by parts of the economy where credit conditions tighten and the capital accumulation process is impeded.

Implications for further research and policy

The majority of Dynamic Stochastic General Equilibrium (DSGE) models used by policymakers and academics do not distinguish between owned and rented capital, whereas our empirical and theoretical results suggest that the owning-versus-renting choice may be a relevant issue, especially in the presence of malfunctioning financial markets. Ignoring the extra margin of adjustment that rental markets may provide could lead to mis-specification for the increasing number of DSGE models featuring financial frictions and financial shocks.

The policy implication of our findings is that well-developed rental and leasing markets may effectively offset part of the negative effects of malfunctioning credit markets. In times when collateral requirements are higher and thus many businesses cannot fund their capital investments, renting may serve as an alternative way to obtain capital. To ensure that rental possibilities are widespread and cover many types of capital goods, the appropriate legal and regulatory framework needs to be in place, coupled with an efficient judicial system to facilitate the repossession of capital goods in the case of foreclosing rental contracts.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Casas-Arce, Pablo and Albert Saiz (2006), “Owning versus leasing: do courts matter?”, Federal Reserve Bank of Philadelphia Working Paper No. 06-21.

Čihák, Martin, Aslı Demirgüç-Kunt, Erik Feyen, and Ross Levine (2013), “Benchmarking Financial Systems around the World”, NBER Working Paper No. 18946.

Eisfeldt, Andrea L and Adriano A Rampini (2009), “Leasing, Ability to Repossess, and Debt Capacity”, Review of Financial Studies 22(4): 1621–1657.

Gal, Peter N and Gabor Pinter (2013), “Capital over the business cycle: renting versus ownership”, Bank of England Working Paper No. 478.

Gavazza, Alessandro (2011), “Leasing and Secondary Markets: Theory and Evidence from Commercial Aircraft”, Journal of Political Economy 119(2): 325–377.

Jorgenson, Dale (1963), “Capital Theory and Investment Behavior”, The American Economic Review 53(2): 247–259.

Kiyotaki, Nobuhiro and John Moore (1997), “Credit Cycles”, Journal of Political Economy 105(2): 211–48.

Laeven, Luc and Fabian Valencia (2012), “Systemic Banking Crises: An Update”, IMF Working Paper No. 12/163.

Ortega, Eva, Rubio Margarita and Thomas Carlos (2011), “House Purchase versus Rental in Spain”, Banco de Espana Working Papers No. 1108.

Reinhart, Carmen M. and Kenneth Rogoff (2009), This Time is Different, Princeton University Press.

The Economist (2008), “Housing market – Rent now, buy later”, Print Edition, 31 July.

The Economist (2012), “The housing market – Pulling its weight at last”, Print Edition, 5 August.

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Topics:  Financial markets

Tags:  financial crises, investment, business cycles, credit constraints, rental markets

Economist, OECD

Adviser at the Centre for Central Banking Studies, Bank of England

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