High domestic interest rates, which can result from monetary policy aimed at stemming rapid exchange rate depreciation, can directly squeeze corporate cash flow especially for corporations dependent on domestic bank financing. Nominal interest rates rose above 60 percent ahead of the crisis troughs in Chile, Mexico (1983 and 1995), Poland and Indonesia, although interest rate increases were much smaller for Hungary and Malaysia. Claessens et al. (1999) show that a large share of firms in east Asian countries could not cover interest rate expenses from operational cash flows by 1998.
Money market rates except for Indonesia (call money rate), Chile (lending rate), Mexico (bankers acceptances rate) and Hungary (treasury bill rate).
Increases in world interest rates and country risk premiums will also reduce the cash flow and net worth of firm with high levels of foreign debt. For example, an 8 percent increase in the country risk premium has been estimated to reduce the 1998 equity value of the Korean corporate sector by percent and that of the Indonesian corporate sector by percent again because of Indonesia's higher level of external debt (Gray, 1999).
A domestic "credit crunch" is an important link between bad banks, corporate leverage and output contraction. A credit crunch can be defined as the unavailability of financing to creditworthy borrowers at interest rates commensurate with their risk. Credit crunches are attributable to a combination of factors, including higher perceived risk due to a deterioration in the growth outlook, tight monetary policy, a poor risk evaluation culture, a cutoff of external financing and efforts by banks to shore up balance sheets weakened by nonperforming loans. The magnitude of bank distress is evidenced by the incidence of bank crises for all the countries examined here (Table 9). These factors can stall lending not only to heavily indebted corporations but also to viable firms. Real domestic credit (reported in the International Financial Statistics) fell sharply for most of the corporate crisis countries. However, the empirical evidence on the causes of the credit decline is decidedly mixed. Furman and Stiglitz (1998) attribute the credit decline to tight monetary policy. In contrast, Borensztein and Lee (2000) suggest that the credit crunch was more the result of structural changes in the financial sector whose impact on credit allocation may have been exacerbated by the crisis, and Ghosh and Ghosh (1999) conclude that the credit decline is explained mostly by lower credit demand.
2/ Countries other than those in East Asia from Caprio and Klingebiel (1996).
Finally, current account adjustment is a new and important channel that amplifies the impact of a cutoff of capital inflows to the corporate sector on the rest of the economy. In the model of Krugman (1999a), a loss of confidence leads to a cutoff of capital inflows and prompts a large upward swing in the current account balance. This upward swing requires a sharp depreciation of the exchange rate, which, given the onerous weigh of foreign debt, worsens corporate balance sheets, reduces investment, validates the loss of confidence, and triggers a recession. The increases in the current account during the crisis years for six of the nine episodes is the largest over the past twenty five years and the second largest for Chile (Table 10). For Hungary and Poland, the current account swings were smaller due to the smaller role played by external financing in the years of central planning. For the east Asian countries, current account adjustment took the form of remarkable contractions of import spending (Appendix).
(Percent of GDP)
Bankruptcy serves as a key channel between highly leveraged corporations and economic contraction that emerges during crisis. Bankruptcy introduces a crucial nonlinearity into the relationship between exchange rate depreciation and aggregate output. A crisis induced increase in debt servicing costs may not just lower marginal aggregate demand, but can push some firms over the edge into liquidation, thereby sharply reducing supply (Kim and Stone, 1999). Bankruptcy thus helps push currency or banking sector turbulence into a full fledged systemic financial crisis. The impact of bankruptcies is hard to gauge in the absence of comparable cross country bankruptcy data. However, two proxies are available for bankruptcies in East Asia.
First, the World Bank (1999) estimated the share of "nonviable" firms (estimated losses exceed equity) as of early 1998. These data, which cover only five east Asian countries, suggest a rough correspondence between corporate leverage and nonviability (Figure 8; top panel). Second, a comprehensive cross country microeconomic data set of nonfmancial firms shows that the share of corporations that filed for legal creditor protection during 1997-98 was much larger in the highly leveraged countries (Figure 8, bottom panel), with the exception of Indonesia, where the incomplete implementation of bankruptcy and judicial reform during 1997 and 1998 delayed bankruptcy procedures for nonviable firms. Analysis of this data set concluded that leverage was an important determinant of filing for legal credit on protection (Claessens et al., 1998s).