Working Papers Center for International Development at Harvard University

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1 Oveinvesmen, Cllaeal Lending, and Ecnmic Cisis Yng Jin Kim and Jng-Wha Lee CID Wing Pape N. 4 Mach 999 Cpyigh 999 Yng Jin Kim, Jng-Wha Lee, and he Pesiden and Fellws Havad Cllege Wing Papes Cene Inenainal Develpmen a Havad Univesiy

2 CID Wing Pape n. 4 Oveinvesmen, Cllaeal Lending, and Ecnmic Cisis Yng Jin Kim and Jng-Wha Lee* bsac This pape pesens a mdel in which a high gwh ecnmy becmes suscepible a sudden inancial cisis. In he mdel ims ae mivaed ve-inves because gvenmen subsidies and hen bea he buden he ineiciencies caused by he gvenmen disin. We assume ha he ims cmpensae hei lsses by baining ban lans and dmesic bans will cninuusly lend mney he ims as lng as he al amun accumulaed lans emain wihin he limi he cllaeal value eal esae. Dmesic bans bw m eign invess pvide lans he ims. Wih hese assumpins, we bain he llwing esuls ha may well be cnsisen wih he ecen expeience Eas sian cunies. Fis, a highe gwh ecnmy wih a highe gvenmen subsidy shws highe invesmen and GDP gwh aes, a highe level and gwh ae eal esae pices, and a highe level cuen accun deicis. Secnd, he apid gwh caused by highe gvenmen subsidies maes he ecnmy vey vulneable advese shcs. When advese shcs hi he ecnmy and he expeced lan-cllaeal value ai apidly inceases, eign invess becme suspicius abu he saey dmesic bans and begin wihdaw hei lans. Subsequenly, inancial panic and ecnmic cisis suddenly ccu. Thid, capial mae libealizain, by pving huge eign capial inlws and ulws, inceases he pssibiliy cisis and ampliies he scale cisis. JEL Cdes: E44, F34, O6 Keywds: Ecnmic Gwh, Financial Cisis, Indusial Plicy, Ban Run, Capial Mae Libealizain. Jng-Wha Lee is a Visiing Schla a he Cene Inenainal Develpmen, an assciae pess in Depamen Ecnmics a Kea Univesiy, and a develpmen assciae a he Havad Insiue Inenainal Develpmen. Yng Jin Kim is an ssciae Pess in he Depamen Ecnmics a Dngdu Wmen s Univesiy in Kea. * The auhs wuld lie han Rnald Findlay, Se-Ji Kim, Changyng Rhee and paicipans a he Kea Ecnmeic Sciey Macecnmics Wshp, he 57 h Japan Sciey Inenainal Ecnmics Cneence, and he Univesiy Washingn a Seale Cneence n he sian Cisis helpul cmmens and suggesins. Send cespndence : Jng-Wha Lee, Cene Inenainal Develpmen, Havad Univesiy, 79 Jhn F. Kennedy See, Cambidge, M (Tel) , (Fax) ( ) jngwha_lee@havad.edu

3 CID Wing Pape n. 4 Oveinvesmen, Cllaeal Lending, and Ecnmic Cisis Yng Jin Kim and Jng-Wha Lee I. Inducin Recenly inancial cises euped in he apidly gwing Eas sian ecnmies as lage-scale eign capial lwed u hese ecnmies llwed by huge depeciain dmesic cuencies. The causes hese cises have been he pic a h debae n nly because Eas sian ecnmies had been gwing apidly, seving as a gwh mdel ha many develping cunies have ied emulae, bu als because hei sudden cllapse was he leas anicipaed. Kugman (998) agues ha he sian cisis is a mal hazad cisis as a cnsequence ply egulaed and ve guaaneed bans ha have eclessly exended cedi isy pjecs. Radele and Sachs (998) egad he cisis in essence as a inancial panic iggeed by a sudden wihdawal eign capial. IMF (997) aibues he cisis a cmbinain acs, including a bm in inenainal lending caused by high gwh pemance, advese exenal shcs, mismanagemen macecnmic and exchange ae plicies, and wea inancial sec. Eas sian cises exhibi a cmplex mixue cuency cisis, baning cisis, and eign deb cisis, nne which can be singled u as being he sle cause he cises. Recen empiical sudies ha have examined a lage sample cunies he deeminans he cises culd n cme up wih a clea answe. Theeical mdels ae sill vey much sugh. In his pape, we pesen a mdel ha explains sme salien eaues he Eas sian ecnmies. The gwh pcess he Eas sian ecnmies is ypically chaaceized by high invesmen and ecnmic gwh, high eal esae pices, cuen accun deicis, and a sudden inancial cisis. Unil ecenly, he Eas sian ecnmies displayed high saving and invesmen aes, and apid GNP gwh. lng wih hese psiive signs wee a ew negaive nes such as declines in pduciviy, inceases in cuen accun deicis, and accumulain cpae debs. Then, suddenly, inancial cises swep hugh hese cunies. The pupse his pape is See Kaminsy and Reinha (996), Demiguc-Kun and Deagiache (997), and Eichengeen and Rse (997).

4 pesen a mdel in which a high gwh cuny becmes exemely vulneable inancial cises. The mdel pesened in he pape descibes an ecnmy in which ims, because a gvenmen subsidy, ae mivaed ve-inves. We assume ha ims pay axes and heeby bea he buden he ineiciency caused by he gvenmen disin. In un, hese ims bain ban lans cmpensae hei lsses. We als assume ha dmesic bans bw m eign invess pvide unds he ims. The eign bwing will cninue accumulae, as lng as dmesic bans and eign invess cninue pvide unds hem. One he ciical assumpins he mdel is ha dmesic bans will cninue lending mney ims as lng as he value he ims eal esae cllaeal cves he accumulaed lans. The mdel shws ha a high gwh ecnmy caused by a high gvenmen subsidy shws a highe pice eal esae, highe invesmen and GDP gwh aes, a highe cuen accun deici, and a highe ai deb--cllaeal value. Thus, his mdel shws ha a high gwh ecnmy is me liely be subjec a cisis. I als shws ha he undelying inancial agiliy endes he whle ecnmy exemely vulneable advese shcs. When he advese shcs hi he ecnmy and eign invess decide dmesic bans ae isy, inancial panic and ecnmic cises can suddenly ccu. In anhe wds, as sn as eign invess sa dub he saey dmesic bans, eal esae pices all such a level ha he mae value eal esae can n lnge cve he lans which wee based n hei pe-all value. s a esul, ims and bans becme banup. Baning and eign deb cises suddenly aise. This mdel als shws ha a libealizain he capial mae inceases he pssibiliy cisis and ampliies he scale cisis due huge eign capial inlws and ulws. The pape is ganized as llws. Secin 2 descibes he basic seup he mdel and chaaceizes is equilibium. Secin 3 deives seveal implicains elaed he quesin peviusly psed, and Secin 4 analyzes he eec pening inancial maes n he ecnmy. Secin 5 elaes his mdel he mdels pevius sudies such as Kugman (998), Csei e al (998), and Schneide and Tnell (998), and shws ha u mdel can be inepeed as he mal hazad mdel. Secin 6 pesens cnclusins. 2

5 II. The Mdel The ecnmy cnsiss idenical husehlds, ims and bans. The epesenaive agen (husehld) wns a epesenaive im hugh hlding shaes in he cmpeiive inancial maes. The agen cnsumes ne ype cmmdiy and husing sevice. The epesenaive im pduces a cmmdiy wih an K ype pducin echnlgy. 2 The im wns a huse as eal esae and uses i as cllaeal bw mney m bans. The bans ae assumed lend mney he im as lng as he accumulaed lss he im emains wihin he mae value he eal esae. 2.. Fim s Maximizain The im pduces an upu Y by emplying capial K. We assume ha he im eceives a gvenmen subsidy sy ppinal he im s upu. 3 The im beas he buden a lumpsum ax T. Me geneally, his ax epesens ineiciencies, ppinal he size he gvenmen subsidy, incued by he veinvesmen in he ecnmy. 4 These ineiciencies can be caused by he im s bibes pliicians, and he wne-manage s mal hazad behavi. 5 Each epesenaive im wns he ixed h unis eal esae and ens i husehlds 6. Hence, he im is cnducing w businesses- a pducin business and a eal esae business. O he im can be cnsideed as a business gup (lie a Chaebl in Suh Kea Keiesu in Japan) ha cnsiss w subsidiaies. 2 See Ba and Sala-I-Main (995, chape 3). 3 The gvenmen subsidy s is a ey paamee in his mdel. I capues he gvenmen plicy ha induces ims expand size and heeby diss esuce allcain. The gvenmen may impse his subsidy-cum-ax scheme n pduces in de maximize incme gwh ae (see secin 3.). This subsidy includes vaius exp pming schemes, such as exp inancing wih lwe inees aes, lwe ais n imps maeials and inemediae gds, pviding acy sies a cheape pices, and s h. 4 Sme empiical sudies supp ha gvenmen indusial plicies lead veinvesmen and ineiciency. Lee (996), example, shws ha, based n he manuacuing indusies Kea, ax incenives incease upu gwh aes by simulaing capial accumulain, and d n aec al ac pduciviy (TFP), while nnai baies decease bh he upu gwh aes and TFP. He als shws ha inancial incenives have n signiican eec n eihe he upu gwh aes TFP. 5 One he lgical linages beween veinvesmen and ineiciencies can be aibued cny capialism. 6 We assume ha nly ims can hld eal esae in de cus n he pblem ban lending ims. We uhe assume, as i is he case in Japan and Kea, ha ims ae viually phibied m eaning capial gains m eal esae sales due high ax aes n capial gains. Hence, he ixed pach land is n cnsideed as a vaiable cnlled by he ims. 3

6 The im nws he cuen peid s pduciviy in he beginning each peid bu cann bseve he nex peid s pduciviy ( ). change in can epesen a pduciviy shc, a ems ade shc, he shcs aecing he im s evenue. Then, he epesenaive im wned by a epesenaive husehld maximizes is expeced discuned pi 7 wih espec he capial sc ( ) as () max E [ ( ){( s) q h T } = 0 i= i whee epesens a gss inees ae a ime geae han ne, q h a enal evenue m a husehld, and s he gvenmen subsidy. Hee, we assume ha capial depeciaes by 00 pe cen a he end he peid simpliciy. The is de cndiin wih espec yields an equilibium inees ae as 8 (2) = ( s) The gvenmen balanced budge cnsain pduces he elainship (3) s = T We assume ha he im pays d a dividend schldes and he dividend equals he enal evenue, because he im s capial ha schldes wn is he eal esae. 9 (4) d q h = Fm equains (), (2), (3) and (4), he im s pi ae dividends will be 0 7 This pi is an peaing pi, which des n include capial gains m hlding eal esae. 8 The im s invesmen is inanced hugh dmesic savings a he dmesic equilibium ae. 9 In he wds, schldes ae being paid he mae equilibium yield wning he eal esae. 4

7 (5) π = T = s We assume ha he im will cmpensae he lss by bwing eign capial m bans. The lss will be accumulaed as lng as he im cninues bw Husehld s Maximizain epesenaive husehld lives in he huse ha she ens m he epesenaive im. The epesenaive agen living an ininiy lie maximizes he peeence 2 U j j j= 0 j (6) max = E [ {lg( c ) θ lg( h )}], 0 The seemingly unealisic assumpin ha he im maing lsses pvides shaehldes wih psiive dividends as equains (4) and (5) descibe can be ainalized by cnsideing ne business gup which cnls w subsidiaies. eal esae business subsidiay wns huses hugh equiy inancing and ens hem husehlds a mae aes. The ens ae disibued shaehldes. nd he he subsidiay, which pduces gds, incus lsses bu cves hem hugh ban lans. We can assume ha he eal esae subsidiay guaanees hese ban lans he pducin subsidiay by using he eal esae as cllaeal. This css-subsidiay deb guaanee is ne he well-nwn business pacices amng Kean Chaebls (see Wld Ban, 998). Dieenly, we can assume ha he cuen pducin subsidiay ges banup in each peid ae ne peid s business due is lsses, and ha a new and idenical subsidiay ding he same business is esablished by he business gup by bwing mney m he bans using is eal esae as cllaeal. This can ainalize psiive dividends he lss-incuing im. nhe ainalizain can be made llwing he mal hazad sy discussed in Secin 5. T simpliy he pblem, we assume ha all ecnmic agens ae mypic in he sense ha hey d n cnside he pssibiliy a inancial and ecnmic cisis. This assumpin is n vey sng because many sudies shw ha he Eas sian inancial cises wee leas anicipaed. The main esuls will n change by incpaing he pssibiliy a cisis. The im s maximizain pblem will n change even in he mdel when we cnside he pssibiliy a cisis. Hweve, he dividend shuld incease cmpensae he is a cisis. Then, he im s lsses als incease. Ne als ha as lng as he eign invess ae willing lend mney wih he cllaeal value cveing he deb, all he agens igne he im s lsses. This is because shaehldes ae well cmpensaed hei invesmen a he mae (is-adjused) ae and because he invesmen by dmesic bans and eign invess is saely secued by he cllaeal (wih eign inees aes aised cve he is a cisis). Owne-manages as well as shaehldes may even pee highe subsidies causing me lsses he ims since such subsidies, alhugh inceasing he im s lsses, aise he ecnmic gwh ae. 2 The husehlds d n cnside he pssibiliy cisis, as saed in he abve ne. One he easies ways incpae he cisis pssibiliy is saed in Fne 22. 5

8 whee E [ ] epesens an expecain pea cndiinal n he inmain se ime, c cnsumpin he cmmdiy a ime, h cnsumpin husing sevice 3 and a ime discun ae. The agen maximizes he discuned uiliy wih he budge cnsain (7) c qh = d, whee q denes he pice ne uni husing sevice, saving, a gss inees ae n he saving bsevable a ime in he cmpeiive inancial mae, and d he dividend m he hlding shaes a ime 4. The budge cnsain shws ha he husehld des n bea he buden he ax a all. 5 Using equains (2) and (4), equain (7) can be ansmed as (8) c = I = ( s) whee I epesens he husehld s dispsable incme ae paying ens a ime. The epesenaive cnsume s maximizain pblem (6) subjec (7) can be slved by seing up he value uncin as llws, neglecing he uiliy m husing sevice cnsumpin. 6 Hee, ime subscips ae mied and he pime n vaiables epesens he nex peid. 3 In equilibium, h = h. 4 The husehld wns he im by hlding is shaes. The pi he husehld bains hugh dividends can n be negaive due is limied liabiliy. T simpliy he pblem, we assume ha he dividend equals he en q h. 5 I he husehld beas he ull buden he ax, ims will n sue lsses since he ax is cmpleely inenalized by he husehld. Hweve, even in his case, ims can incu sme lsses due ineiciencies caused by he veinvesmen, as saed bee. 6 T slve he epesenaive cnsume s maximizain pblem, we es he Pae pimal pblem slving (6) subjec (8) and h = h. Then we can subsiue h = h in (6), and can neglec his vaiable in he value uncin when slving he he decisin vaiables he cnsume. 6

9 (9) V (( s) ) = max lg(( s) ) V (( s) ) dp( ) whee P ( ) is he cumulaive disibuin uncin cndiinal n he ealized value. e psiing he value uncin as (0) V ( I) = a blg( I), we can slve (9) using an envelp heem and he is de cndiin (FOC). Fis, we bain he llwing elainship by applying an envelp heem equain (9) and cmbining i wih equain (0) as b b () = = (( s) ) ( s) ( s) b ddiinally, equain () and he FOC wih espec yield (2) = ( s) = b( s) dp( ) ( s) 2 b dp( ) ( b )( s) Equain (2) yields a sluin b as (3) b = Thus, equain () pduces a sluin as 7

10 (4) = ( s) ls, m equains (8) and (4), we can slve an pimal cnsumpin decisin as (5) c = I b = ( )( s) Ne ha cnsumpin and invesmen decisins d n depend n he pbabiliy disibuin. Equains (4) and (5) pduce pimal gwh aes cnsumpin and capial sc as (6) = ( s) c = ( s) c Equains (5) and (6) shw ha he husehld in his ecnmy wih a psiive gvenmen subsidy, s>0, enjys highe cnsumpin-incme ais and highe cnsumpin gwh aes ve he peid. Uilizing he ppeies a lgaihmic uiliy uncin, we can slve he pice ne uni he husing sevice wih a geneal equilibium cndiin h = h as (7) q θc = h 2.3. The Equilibium Equain (6) shws ha cnsumpin and capial gw a he ae ( s). Cnsumpin and invesmen ais incme say cnsan ve ime, as we can see m equains () and (5). 8

11 Equain (8) implies ha excess demand gds ve GNP leads a cuen accun deici because he ax buden impsed n ims is n inenalized in he husehld s budge cnsain. s indicaed in equain (8), he husehld budge exceeds he geneal equilibium cndiin a cmmdiy mae by s, because he ecnmy pduces nly. Hweve, in an pen ecnmy, which we assume hee, he excess demand s will be inanced by he cuen accun deici. Ne ha an ecnmy wih s =0 saisies he geneal equilibium cndiin wih a cuen accun balance (see Table in ppendix) Ban s Behavi ssume ha dmesic bans bw mney m eign invess and lend i ims pay hei lsses. Fuhe we assume ha he bans will cninue lending he ims as lng as he cllaeal value eal esae cves he accumulaed ban lan (he im s accumulaed lss). 7 We als assume ha dmesic bans and eign invess ae is neual. In he wds, hey ae cncened slely wih hei expeced eun. Theee, i he expeced eun lans alls belw a ceain heshld level, hey will sp pviding unds he ims. When he expeced ai he cllaeal value lans alls belw a ceain heshld level, eign invess will n cninue lend mney dmesic bans. Dmesic bans ae als assumed behave as eign invess d by lending mney he ims unil he expeced ai cllaeal value lans alls belw he heshld level. 8 7 This assumpin implies ha bans ae ding business mainly hugh cllaeal lending, ahe han cedi lending based n cedi evaluain. This is a well-nwn business pacice adped by inancial insiuins in undedevelped cunies. 8 Even hugh he eign inves s heshld level can be much lwe han he dmesic ban s, we simply assume ha hese heshld levels ae idenical. This assumpin des n inluence he main implicain because, as lng as he eigne s heshld level is lwe han equal he dmesic ban s, he cisis depends nly n he eign inves s, n n he dmesic ban s. The pimal heshld level can be deived m he ban s pi maximizain pblem. 9

12 Using equains (2), (6) and (7), he pice ne uni eal esae will be calculaed as (8) P h = E[ ( j = 0 = = E[ ( j = 0 = = E[ ( g j = 0 = θ = c ( ) h θ ( s) = h j j j ) q j ] θ ) c h j θ ) c ] h ] whee g epesens he gss gwh ae incme a ime. Equain (8) says ha eal esae pices in an veinvesing ecnmy wih psiive gvenmen subsidies s >0 ae highe and gw ase han in an ecnmy wih s =0. Then, he ai eal esae value GNP will be Ph h (9) =θ ( s). Equain (9) implies ha an incease in s aises his ai. 9 Nw, ecall ha dmesic bans pvide lans ims by bwing mney m eign invess as lng as he al amun lans he ims des n exceed he cllaeal value he eal esae. T simpliy he analysis, we uhe assume ha he lending ae ims cmpensae hei lsses is he eign gss inees ae This paly explains why Kea and Japan shw vey high values his ai. One sudy shws ha Kea has a ai 4-5, Japan 2-3, cmpaed he U.S The esul will n change qualiaively when bans ae allwed chage ims a lending ae highe han he eign ae. We can assume ha he dmesic lending ae will all he level he eign ae hugh cmpeiin amng bans. 0

13 Fm equain (4), he im s accumulaed ban lan bea is lsses a ime can be calculaed be (20) ) ( )... ( s s L = =. Equain (20) implies ha he al amun ban lans can emain wihin he cllaeal value a any pin in ime, i he inequaliy < ε i hlds each peid and a ceain cnsan ε. In he discussin belw, we assume ha his inequaliy hlds ue. This inequaliy implies he llwing. I we deine he smalles value in he supp he disibuin as, hen ε = s ( ) and he inequaliy < ε i implies ha ) ( < s. Thus, he highe he dmesic pduciviy () and he subsidy (s) ae and he lwe he eign inees ae ( ) is, he me pbably his elainship hlds Cllaeal Lending Cndiin Equains (8) and (20) yield he expeced ai ban lan cllaeal value be (2) ] ) ( )... ( [ ] [ s s E h P L E h = θ. Ne ha a decease in he expeced inceases his ai, as we can see m (8) and (20), by lweing he land pice me han he accumulaed amun he lan. Thus, example, a negaive shc ems ade, which lwes, aises his ai. We call he cndiin he expeced ai, as expessed by (2), being less han ne as he cllaeal lending cndiin. 2 Wih an addiinal assumpin, ge seady sae implicains, 2 The cndiin ha he deb asse value ai is less han ne is cmmnly used descibe he ban s behavi cllaeal lending as in Kiyai and Me [997] and Schneide and Tnell [998].

14 ha eign deb sas m minus ininiy ime, equains (20) and (2) give he cllaeal lending cndiin ha maes his ai less han ne a any ime and any ealizain as L s (22) E[ ]. P h θ ( ε)( s) h We assume ha dmesic bans will cninue lend mney ims as lng as he abve cllaeal lending cndiin hlds. his pin, we uhe assume ha eign invess will als lend mney dmesic bans as lng as he cllaeal lending cndiin (22) is saisied, jus as dmesic bans will lend dmesic ims. Subsiuing ε = in equain (22), he inequaliy (22) can be ansmed ( s ) as (23) s( θ ) θ. This inequaliy can be inepeed dieenly depending n he value θ. Fis, i θ is geae han equal ne, hen inequaliy (23) always hlds ue nly i he eign ae is lwe han. In he wds, iespecive any ealizain i he cllaeal lending cndiin will be saisied any psiive value s. Secnd, i θ is less han ne, and i he eign ae is lwe han, hen (23) gives he inequaliy n s as (24) θ s. θ This equain implies ha i θ is less han ne, he lwe he eign inees ae and he gvenmen subsidy ae, he me pbable he cllaeal lending cndiin (22) hlds. In he wds, i he gvenmen subsidy is high, hen he cllaeal lending cndiin will n hld. We cnside ha his case θ less han ne is me plausible. Equains (6) and (7) imply ha 2

15 he husing enal expendiue is geae han he sum he cnsumpin expendiues, i θ is geae han ne. This is vey unealisic. Thus, we will cus n he case θ <. III. Implicains 3.. Welae Maximizing Gvenmen Plicy In his subsecin, we will exple he welae implicains a gvenmen subsidy ( s ). Equains (5) and (6) imply ha an incease in s aises he husehld cnsumpin in any peid 0 given a ixed capial sc. ls, ne ha he gvenmen subsidy (s ) 0 shuld saisy equain (23). Thus, we can guess ha he welae maximizing gvenmen subsidy plan will be se s he maximum value s subjec (23). Using equains (3) and (5), he expeced welae uncin (he discuned uiliy) a ime a epesenaive agen given he capial sc can be descibed by (25) i= 0 i E [lg c i ] = = lg c i i E[lg( c i= 0 j= E[ i= = lg( )( s) i g i ] g i i= )] i ( s) E [ i ], whee g epesens gss gwh ae a ime. 22 Thus, he pimal plicy s will be deemined by slving he maximizain pblem (25) subjec (23). Equain (25) implies ha an incease in s inceases he welae. In addiin, equain (23) implies ha, in he ealisic case θ <, he maximum pssible value s is cnsained by (24). Thus, we can easily ine ha he maximum value s ( s * ) will depend n 22 This welae uncin is calculaed unde he assumpins ha eign invess will cninue lend mney dmesic bans, as lng as he cllaeal lending cndiin is saisied, and ha all agens d n cnside he pssibiliy a cisis. Hweve, we can cnside he pssibiliy banupcy caused by he eign inves s behavi by plugging he paamee n having banupcy P. I we assume ha he vaiable P is exgenusly given and ha he uiliy unde banupcy is nil, hen all we have d is subsiue P in (25). 3

16 he value θ. I he cs vilaing he cllaeal lending cndiin (22) is lage enugh, hen s * will be he gvenmen s pimal plicy. Thus, a lemma llws: Lemma : I θ < and he cs vilaing he cllaeal lending cndiin is vey lage, he gvenmen s pimal subsidy will be: θ s* =. θ This lemma says ha i he gvenmen s subsidy induce a im s veinvesmen is lage han θ ( ) a ceain heshld value s ( s ), hen he cllaeal lending cndiin will n ( θ ) hld, i θ <. In he wds, an excessive gvenmen subsidy will hu he ecnmy by incuing a inancial cisis. On he cnay, i θ >, he deb eal esae value ai deceases in s, because he eal esae value inceases ase han he accumulaed lans ims as s inceases. nd, i θ is equal ne, (23) hlds iespecive he value s. Theee, i θ, hen he gvenmen pimal subsidy will be he ininie value s. Hweve, as saed bee, his case is n vey pbable in he eal wld Oveinvesmen, High Gwh, and Cuen ccun Deici The llwing ppsiin summaizes he esuls descibed abve. Ppsiin : n incease in he gvenmen subsidy ( s ), which induces veinvesmen in he ecnmy, aises incme gwh aes, he ai cnsumpin incme, welae, eal esae pices, and cuen accun deicis as lng as θ ( ) s andθ <. I θ, his always ( θ ) hlds ue any psiive value s, as lng as he dmesic inees ae is highe han he eign ae. (P) Ree Table in ppendix in which an ve-invesing ecnmy is cmpaed a nmal. 4

17 3.3. Financial Cisis The cninuus accumulain high cpae and eign debs aising m he cllaeal lending pacices dmesic bans maes his ecnmy vey agile. Wheneve he cnidence eign invess sas ale, he high deb ecnmy can hen cllapse easily. s sn as he eign invess hin ha he cllaeal lending cndiins will n be liely hld, hey sa ecall hei lans, which immediaely leads a inancial cisis in he cuny. Nw, we can illusae he eupin a inancial cisis by he llwing lemma and ppsiins. Lemma 2: In an ecnmy whee veinvesmen and deb accumulain exis, advese shcs ha lwe pduciviy ( ) aise eign inees aes ( ) can incease he expeced deb-cllaeal value ai s ha he cllaeal lending cndiin bh dmesic and eign bans des n cninue be saisied. This will be me liely happen in a highe gwh ecnmy wih a highe level gvenmen subsidy. (P) In equain (2), a decease in he expeced an incease in can incease he deb--cllaeal value ai abve ne by lweing he land pice me han he accumulaed amun he lan. ls, in equains (20) and (22), i is clea ha i a pemanen advese shc ces > i each i >, he al expeced value gwing lans will exceed he value eal esae cllaeal in a inie ime. The lae pa he p is bvius m Ppsiin. When advese shcs hi he ecnmy and eign invess expec he ai deb-cllaeal value ise abve ne, he eign invess becme sepical abu he uue saey he dmesic bans. Feign invess ae jusiied in hei misgivings abu he saey dmesic bans seveal easns in addiin he ac ha he ai lan land value exceeds ne. Fis, he BIS equiy-asse ai dmesic bans will cninuusly decease because ims debs will incease ve ime. Secnd, he lsses incued by dmesic ims lead he accumulain nn-peming lans in dmesic bans. Thid, due cninuus cuen accun deicis, he ecnmy is highly vulneable a eign cuency liquidiy cisis. 5

18 s a esul, his cuny wih an ve-invesmen plicy can easily becme a hsage a eign deb and baning cisis. The llwing ppsiin summaizes hese esuls. Ppsiin 2: Negaive shcs such as negaive ems--ade shcs can push a highe gwh cuny wih highe gvenmen subsidies in a inancial cisis by aising he deb--cllaeal value ai abve ne. ddiinally, his ecnmic cisis pssesses a eaue he sel-ulilling pphecy he ban un mdel Diamnd and Dybvig (983). In he wds, i eign invess sa egad dmesic bans as isy (even i he ai deb--cllaeal value is slighly less han ne), hen i will suely becme isy, because he glmy pspec amng eign invess aises his ai abve ne. T explain his eaue, we induce w me equains belw. Using (6), equain (2) can be ansmed in L s( ) (26) E[ ] = E[ ]. 2 P h θ ( s) h 2 I each eign inves expecs ha all he eign invess will n lend mney he dmesic bans, he cllaeal value will all. The easning is as llws. I ecnmic agens ealize ha bwing cann cninue due he behavi eign invess, hen hey will ine ha he ecnmy will shi an ecnmy wih s =0. In his case, (8) implies ha eal esae pices will all wih s =0. Since he high gwh he ecnmy can n be susained wihu eign bwing, ecnmic agens assume ha he uue expeced ens will dp and hen he eal esae pice, he expeced summain uue en lws, will all. Duing his peid wih a given amun he im s ban lan, he cllaeal lending cndiin (22) wih a ppe inequaliy may n be saisied. When he cndiin is n saisied, ims and bans g banup. Thus, cnsideing ha gvenmen subsidy is ced discninue as eign invess sp lending, he expeced deb--cllaeal value ai ises as belw. 6

19 (27) E L s [ ] E [ (... ) 0 0 = ]. P h θ h 2 Fm equains (26) and (27), we can deive an addiinal ppsiin elaed a selulilling pphecy. L Ppsiin 3: I < E [ ] < 2 wih s psiive valued, hen meely he belie a bad ( s) P h h pspec in he dmesic ecnmic cndiin amng eign invess can push he ecnmy wih a psiive s in a lwe gwh ecnmy wih s=0. I can als igge banupcies bans and ims in he cuny. (P) Cmpaing (26) wih (27), we can ine ha a eign inves will n inves when he he invess d n inves, because she expecs he cllaeal lending cndiin will n lnge be saisied. In he wds, i a cuny s deb is in such a isy psiin as L ( < E [ ] < 2 ) and i sme eign invess sp lending mney dmesic bans, ( s) P h h hen he eign invess will als sp lending. The mechanism his invess hed behavi is idenical ha he ban un mdel Diamnd and Dybvig (983). Speciically, an individual eign inves, i is a Nash equilibium sp lending mney, when he invess sp lending. I he inves cninues lending mney dmesic bans wheeas hes d n, hen she sues lsses. This is because he cllaeal value cann cve he al value deb and heeby dmesic ims and bans g banup, as we can see m equains (26) and L (27) unde he cndiin ha < E [ ] < 2. S, he p he secnd pa he ( s) P h h ppsiin is llwed by he ac ha i he deb--cllaeal value ai exceeds ne wihu uhe eign invesmen, hen dmesic bans and ims will g banup. 7

20 In a wd, i he ea he dmesic cuny ging banup becmes pevalen amng eign invess, hen i can un in a sel-ulilling pphecy. 23 Even when he ecnmy is hi by a empay advese shc, in ems ade example, he vulneabiliy he inancial sysem can esul in a cisis. Even a lile dub cncening he ecnmy s capabiliy uue deb sevice can mae a eign inves un a dmesic ban and ecall he lan, which can easily igge he invess uns n all he he bans. Radele and Sachs (998), and Chang and Velasc (998) amng hes explain he ecen Eas sian cises by his sel-ulilling ban un a la Diamnd and Dybvig. mypic a me cauius behavi eign invess can easily invie a inancial cisis. We have assumed ha eign invess will lend mney dmesic bans as lng as he cllaeal lending cndiin is saisied, jus as dmesic bans behave wad dmesic ims. Hweve, in he eal wld eign invess ae less lean and me cauius han dmesic bans in evaluaing he siuain he deb ecnmy because hey d n hld cllaeal diecly, n d hey have he lan guaanee, explici implici, which dmesic inancial insiuins bain m he gvenmen. Cnsequenly, eign invess may have heshld levels lwe han ne, dieen expeced ais in he cllaeal lending cndiin, which will mae he ecnmy uhe vulneable even smalle shcs. In he nex secin, we will discuss he abve implicains baning and ecnmic cises unde inancial libealizain. 23 This sel-ulilling pphecy is uhe senghened wih an addiinal assumpin ha land pice pssesses a psiive bubble em ha will vanish as sn as eign invess sp lending: i eign invess sp lending, he land pice will dp such a level ha he pbabiliy vilaing he cllaeal lending cndiin becmes much highe. 8

21 IV. Capial Mae Libealizain In pevius secins, we assume ha eign capial inlw is allwed nly cmpensae he lss he im indiecly hugh ban inancing. This secin cnsides he impac inancial pening n pmping baning and ecnmic cises. This cnsideain is impan because capial mae libealizain and cnsequen asse pice bm and bus en peceded baning and ecnmic cises in ms he cunies having expeienced ecen ecnmic cises (Kaminsy and Reinha, 996). We assume ha dmesic ims and inancial insiuins ae allwed bw eign capial eely a he wld inees ae as lng as he cllaeal lending cnsain is saisied. The he assumpins ae idenical hse in he pevius secins. 4.. Fim s Maximizain The epesenaive im maximizes is expeced discuned pi unde inancial libealizain as (28) max E [ {( s) ( ) q h ( ) T }] ( ) = 0 subjec saisying he cllaeal lending cnsain, whee clsed. indicaes he amun he equilibium capial sc when he capial mae is We assume ha < < ( s ). Then, he im s bjecive uncin implies ha an addiinal uni eign capial inceases he pi (hence, dividend) by ( s ). Thus, ae he pening, he enepeneu bws addiinal eign capial ( ) as much as he maximum allwed by he cllaeal lending cnsain. Hweve, his bwing deceases he GNP by, because we assume ha he maginal pduciviy capial is lwe han he 9

22 cs eign capial. 24 The abve maximizain pblem wih a cnl vaiable ( ), will pduce he elainships idenical hse in he pevius secins wih sme excepins as shwn in he equains belw. Nw, he gvenmen balanced budge implies (29) s ( ) = T. This als implies ha he cuen accun deici is s ) = ( T. Cnsideing ha he lwe bwing cs and he addiinal eign capial inlw caused by pening he capial mae incease he pi by [( ( s) )( )], he dividend will incease as (30) d = q h [( ( s) )( )] Fm he abve elainships, he im s pi ae dividends will be (3) π = T = s ( ) Recall ha he im will cmpensae his lss by bwing eign capial hugh he dmesic ban. The im will d business even while accumulaing lsses as lng as he im can cninue bw m he ban. 24 This assumpin is necessay mae veinvesmen ccu in his ecnmy. 20

23 4.2. Husehld s Maximizain The maximizain becmes vey cmplicaed mainly because inancial libealizain inceases he cnsume s dispsable incme m ( s) ( s)( ), and because eign capial lws in he ecnmy unil he cllaeal lending cndiin binds in each peid. T simpliy he pblem, we addiinally assume ha i =, and ha capial libealizain saed m minus ininiy ime ge seady sae implicains. Then, we can easily psi ha cnsumpin, dmesic capial and eign capial gw a a ae ( s) wih he cllaeal lending cndiin binding in each peid. This will be veiied in he nex subsecin. Thus, we will have he llwing mdiied elainships. (32) ( ) = ( s)( ), (33) c = ( ){ ( s)( ) }. The pimal gwh aes cnsumpin and capial sc ae idenical hse in he case bee capial mae libealizain. nd equain (7) implies ha he husing enal cs will ise because inancial mae libealizain inceases he husehld s incme. Tw ecnmiesne wih inancial libealizain and ne wihu- ae cmpaed in Table 2 in he ppendix. 2

24 4.3. Ban s Behavi and Implicains ssuming ha =, he pice ne uni eal esae is calculaed as (34) P h = E [ j= 0 = = E [ = j= 0 j= 0 q ( ( j θc ( j ( ( s) ) ) ) θ c ( s) h j ) j ] h j ] h θc j whee we assume ha < < ( s) and ha > ( s). Equain (34) implies ha he capial mae libealizain inceases he eal esae pice hugh w channels: by lweing he discun ae m he highe dmesic inees ae he lwe wld inees ae, and by inceasing he level cnsumpin. Nw, le us calculae he cllaeal lending cndiin. Using equains (3), and (34), and he ac ha he eign capial inlw cmpensae he cuen accun deici a ime is s ( ), we can explicily calculae he cllaeal lending cndiin. The expeced ai he ban lan cllaeal is less han ne, saing m he ime minus ininiy, as L F F F 2... F i... (35) E [ ] = E[ ], P h P h 2 h i whee F = s ( ) Righ ae he inancial pening, a huge amun eign capial will lw in he cuny up he limi in which equain (35) binds. s a esul, he eal esae pice will sa as saed abve. This als gealy inceases cnsumpin, invesmen, and incme level. This equilibium will cnvege he seady sae in which dmesic and eign capial as well as 22

25 incme and eal esae pice incease a he cnsan gwh ae ( s). Equains (32) (35) can easily veiy his in ha he gwh ae dmesic and eign capial des n vilae hese cndiins in he seady sae. Hweve, i changes ve ime as in he eal wld, hen he magniude eign capial inlw and ulw gealy lucuaes depending n he value. 25 Thus, he gwh aes incme, cnsumpin, and invesmen change as well because he eign capial lws in he cuny cninuusly he limi he cedi, which depends n he value, as (35) implies. Thus, his mdel explains he bseved empiical ac: capial mae libealizain leads huge eign capial inlws, which in un inceases incme, cnsumpin, and asse pices. This asse bubble induces a bm in lending isy pjecs. Sne lae, he asse bubble buss a he expense he baning sec. Then, i dives eign invess panic and wihdaw hei lans all a nce. Subsequenly, baning and ecnmic cises llw. The mdel pvides he causal lins as llws: inancial pening leads a huge eign capial inlw, because ims wan maximize hei pi by emplying cheape eign capial wihin he cllaeal lending cnsain. Then, he lwe wld inees ae and he highe cnsumpin, caused by he huge inlw cheape eign capial, will hie he eal esae pices up, encuaging me eign capial lw in again by lweing he deb--cllaeal value ai. This pcess bings abu a lending bm, inceasing he eal esae pice, incme, invesmen and cnsumpin levels. This lending bm can acceleae he gwh incme i i allws ims speculae in me isy pjecs wih a highe s. This will aise he eal esae pice even uhe. Then, inally he bubble buss and ecnmic cisis ses in. I he deb--cllaeal value ai was belw he sel-ulilling pphecy ange bee capial mae libealizain, hen he libealizain can push he deb--cllaeal value ai in he sel-ulilling pphecy ange pesened in Ppsiin Then, he sel-ulilling 25 I is a vey ineesing ac ha due he cedi cnsains impsed by cllaeal lending cndiins macecnmic vaiables change cnsideably as pduciviy changes. See Kiyai and Me (997) a mdel in which a dynamic ineacin beween cedi limis and asse pices maes he eecs pduciviy shcs pesis. 26 nhe cisis-iggeing mechanism can ccu as llws. s me eign capial lws in, cuen accun deicis and eign debs incease as implied by equain (29). I he incease in eign deb (paiculaly, shem) his a iggeing pin he minimum level eign eseves, hen eign invess will panic and mae 23

26 pphecy baning and ecnmic cises will ccu. The cisis wih capial mae libealizain will be much me sevee han he ne wihu capial mae libealizain, because he huge ulws eign capial mae incme, invesmen, cnsumpin levels and eal esae pices plumme me han in he pe-libealizain case. V. Relains Ohe Lieaue Recen heeical mdels n he sian Cisis such as Kugman(998), Schneide and Tnell (998), Csei e al.(998), and hes ae based n veinvesmen caused by he mal hazad behavi ims and bans. Even hugh u mdel des n pssess his eaue, we can einepe u mdel peecly wihin he cnex mal hazad behavi. The llwing psis a ypical mdel mal hazad behavi. In each peid, ims will have a gd a bad pduciviy shc. Due he implici bailu subsidy he gvenmen, bans viually eely pvide lans ims wih bad pduciviy shcs mae hem liquid and slven. Bu ims and bans egad hese lans as a gvenmen subsidy, which des n have be epaid. This mechanism induces veinvesmen in isy pjecs, a agile inancial sysem, an asse bubble and bus, and inally a baning and ecnmic cisis. The mal hazad behavi incus cises in he llwing pcess. The ve-invesmen caused by he mal hazad will incease he gvenmen buden he implici bailu subsidy. The ban s bad lans ae inanced cninuusly by eign capial ve ime. Then, when he eign deb gws lage cmpaed he size he al liquid asses he ecnmy, eign invess sa dub he gvenmen s abiliy pay bac eign deb. his pin in ime, hey sa mae sudden wihdawals eign capial, and hus pve a baning and ecnmic cisis. Ou mdel is bsevainally a cmplee equivalen his ind mal hazad mdel. In he wds, us can be einepeed as he mal hazad mdel wihu having change any he equains in he pevius secins bu nly wih a slighly dieen inepeain equains and vaiables. The llwing einepeain will ansm u mdel in he mal hazad ne. sudden wihdawals hei capial. In Csei e al. (998), he iggeing base is he minimum level eseves. F he einepeain he mdel as a mal hazad mdel as in Csei e al., ee Secin 5. 24

27 ssume a cninuum ims indexed by i [ 0, ]. In each peid, hal he ims, chsen andmly, will have a gd pduciviy shc ( s ), while he he hal a bad shc ( s ). Thus n he aggegae, he aveage pduciviy is ceain wih. ssume als ha bans will pvide lans he amun 2s pe ne uni capial he lwe pduciviy ims cmpensae hei bad luc. his pin, ims and bans egad hese bad lans as an implici gvenmen bailu subsidy. These lans ae inanced by eign capial which eign invess pvide as lng as hey cnside hem be baced by gvenmen subsidy. Thus, a he aggegae level, all he ims behave as i hey have he pduciviy shc ( s ) a ime as in u mdel. We uhe assume ha a pai ne im and ne ban is wned by an idenical se shaehldes and manages, simpliciy. nd his pai wns he eal esae. Then, he vaiable T in his newly einepeed ecnmy equals he al amun lans pvided all he ims wih a bad pduciviy shc a ime. In he wds, T denes he implici bailu subsidy lw bad-luc ims a ime. nd he vaiable L epesens he al accumulaed eign deb by bans which eign invess believe will be paid by he gvenmen as a bailu subsidy. In his new einepeed ecnmy, when eign invess sa dub he gvenmen s abiliy pay bac, and hus wihdaw hei lending, a baning and ecnmic cisis will ccu. Then, he mechanism iggeing a cisis in his new mal hazad ecnmy is as llws. ssume ha i he ai debs gvenmen s asses, including is eign eseves, plus he ban s eal esae asse inceases abve a ceain iggeing pin, hen eign invess will panic and mae a sudden wihdawal hei invesed capial. This iggeing mechanism is plausible and simila ha in Csei e al. (998). I he ai he gvenmen asses eign debs emains cnsan, i he gvenmen s asses ae negligible, hen he iggeing pin will be he ai he eal esae value he deb, as in u mdel. Thus, he einepeain equains and vaiables can ansm u iginal mdel in a mal hazad ne, as in Kugman (998), Schneide and Tnell (998), and Csei e al. (998) Ou mdel in he vesin he mal hazad disinguishes isel m he mdels in he llwing aspecs. The mdel in Csei e al. des n include he implicains asse bubble and bus. Even hugh Kugman, and 25

28 VI. Cnclusin This pape aemps mdel he ecen expeience Eas sian ecnmies chaaceized by high gwh and sudden inancial cisis. The mdel descibes an ecnmy in which ims, subsidized by he gvenmen, ae mivaed ve-inves and bans eclessly lend mney he ims. The mdel shws ha he high gwh ecnmy caused by high gvenmen subsidies becmes me vulneable advese shcs and me liely becme hsage ban and eign exchange cises when eign invess sp lending mney dmesic bans. This pape als demnsaes ha capial mae libealizain augmens he lielihd an even me sevee cisis, especially in a high gwh ecnmy. The ecnmic cisis pesened in his pape has a eaue simila he sel-ulilling pphecy a ban un. When eign bans eign invess sa egad he ecnmies as isy, hen i will suely becme isy. One eign inves s un n a dmesic ban can igge he invess un n bans. The ban un eaue he mdel implies ha inancial cises can be cnagius amng simila cunies wih high debs. Once eign invess have expeienced a cisis in ne cuny, hey will becme me cauius in maing invesmens in ecnmies wih simila inancial sysems. Fuhe invesigain in his sel-ulilling eaue inancial cisis acss he Eas sian cunies will be an impan agenda uue eseach. Schneide and Tnell cus n he mechanics asse bubble and bus, hei mdels d n have he eaues a geneal equilibium mdel as ully as us d. 26

29 Reeence Ba Rbe, and Xavie Sala-I-Main, Ecnmic Gwh, McGaw-Hill, Cambidge, M. Chang, Rbe and ndes Velasc, 998, Financial Cises in Emeging Maes: Cannical Mdel, NBER wing pape N.6606, June. Csei, Giancal, Pal Peseni, and Nuiel Rubini, 998, Pape Tiges? Peliminay ssessmen he sian Cisis. Wing pape, New Y Univesiy. Demiguc-Kun sh and Enica Deagiache, 997, The Deeminans Baning Cises: Evidence m Develping and Develped Cunies, IMF Wing pape 97/06. Diamnd, D. and P.Dybvig, 983, Ban Runs, Depsi Insuance, and Liquidiy, Junal Pliical Ecnmy, 9(3), pp Inenainal Mneay Fund, Wld Ecnmic Oul, Ineim ssessmen, Decembe 997. Kaminsy, G. and C.M. Reinha, 996, The Twin Cises: The Causes Baning and Balance Paymens Pblems, Wing pape, Fedeal Reseve Bad. Kiyai Nbuhi, and Jhn Me, 997, Cedi Cycles, Junal Pliical Ecnmy, 05(2), pp Knai, Jans, 979, Demand vesus Resuce Cnsained Sysems, Ecnmeica 47, pp Kugman, Paul, 994, The Myh sia s Miacle. Feign ais, pp Kugman, Paul, 998, Wha Happened sia? mime., M.I.T. Lee, J.-W., 996, Gvenmen Inevenins and Pduciviy Gwh, Junal Ecnmic Gwh, vl., pp Radele Seve and Jeey Sachs, 998, On he Onse he Eas sian Financial Cisis, develpmen discussin pape, Havad Insiue Inenainal Develpmen. Schneide Main and an Tnell, 998, Lending Bms and sse Pice Bubbles, Mime., Sand Univesiy. Wld Ban, 998, Eas sia: The Rad Recvey. 27

30 ppendix Table : Cmpaisn beween an Ecnmy Chaaceized by Ove-invesmen and a Nmal Ecnmy Ove-invesing Ecnmy Nmal Ecnmy Gwh Rae GNP and Real Esae Pices ( s) Cnsumpin / GNP ( )( s) Invesmen / GNP ( s) Land Value / GNP θ ( s) θ Cuen ccun Deicis/ GNP s 0 Nainal Deb / GNP Less han s ( s ) ( s ) 0 Inees Raes ( s) 28

31 Table 2: Cmpaisn beween Tw Ecnmies- Wih and Wihu Capial Mae Libealizain N Libealizain Libealizain GDP ( ) GNP ( ) Cuen ccun Deici Inees Rae s s ( ) ( s) Gwh Rae ( s) ( s) Real Esae Pices P h P h = P h ( ) ( s) ( s)( ( s) ) 29