Corporate Leverage, Bankruptcy, and Output Adjustment in Post-Crisis East Asia

Abstract

This paper posits that different levels of corporate leverage

help explain the very wide range of output adjustment across

East Asia in response to the 1997-98 crisis. A general

equilibrium model is presented where leverage and output are

linked by low investment and capital sales triggered by the

threat of bankruptcy. In the model developed here, highly

leveraged firms facing a cutoff of capital inflows, which are

threatened by bankruptcy, respond first by eliminating

investment and then by selling their capital goods - at a

discount - to try to stay afloat. Lower investment and wasteful

capital sales shrink the aggregate capital stock, trigger

deflationary pressures, and contract overall output. In contrast,

less leveraged firms, which are not threatened by bankruptcy,

would not have to respond by lowering investment and raising

costly capital sales. Therefore, a higher corporate leverage may

induce a greater output contraction during the crisis. The

available data are consistent with the assumptions and

predictions of the model.