Overinvestment, Collateral Lending, and Economic Crisis

This paper presents a model in which a high growth economy becomes susceptible to a sudden financial crisis. In the model firms are motivated to over-invest because of government subsidies and then bear the burden of the inefficiencies caused by the government distortion. We assume that the firms compensate for their losses by obtaining bank loans and domestic banks will continuously lend money to the firms as long as the total amount of accumulated loans remain within the limit of the collateral value of real estate. Domestic banks borrow from foreign investors to provide loans for the firms. With these assumptions, we obtain the following results that may well be consistent with the recent experience of East Asian countries. First, a higher growth economy with a higher government subsidy shows higher investment and GDP growth rates, a higher level and growth rate of real estate prices, and a higher level of current account deficits. Second, the rapid growth caused by higher government subsidies makes the economy very vulnerable to adverse shocks. When adverse shocks hit the economy and the expected loan-to-collateral value ratio rapidly increases, foreign investors become suspicious about the safety of domestic banks and begin to withdraw their loans. Subsequently, financial panic and economic crisis suddenly occur. Third, capital market liberalization, by provoking huge foreign capital inflows and outflows, increases the possibility of crisis and amplifies the scale of crisis.