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 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.