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

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.