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 bear the burden of the tax or other costs caused by the government subsidies. The model provides several predictions that may well be consistent with the recent experience of east Asian countries. First, a higher government subsidy generates higher investment and GDP growth rates, a higher level and growth of real estate price, and a higher level of current account deficits. Second, the rapid growth induced by 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.
Bibliographical noteFunding Information:
The authors would like to thank Ronald Findlay, Se-Jik Kim, Changyong Rhee and participants at the 57th Japan Society of International Economics Conference, the Korea Econometric Society Macroeconomics Workshop, and the University of Washington at Seattle Conference on the Asian Crisis for helpful comments on earlier versions of the paper. Part of this work was undertaken while Jong-Wha Lee was visiting the Center for International Development at Harvard University. This work was supported by Korea Research Foundation Grant.
- Asian financial crisis
- Bank run
- Capital market liberization
- Industrial policy
ASJC Scopus subject areas
- Economics and Econometrics
- Political Science and International Relations