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Asset bubbles, Leverage and ýLifeboatsý: Elements of the East Asian crisis

Collapsing credit markets have been blamed for the depth and persistence of the Great Depression in the USA. Could similar mechanisms have played a role in ending the East Asian economic miracle - and in creating fragility in global financial markets? After a brief account of the nature of the East Asian crises of 1997/8, we use the framework of highly-leveraged, fully-collaterised firms due to Kiyotaki and Moore (1997) to explore the impact of a credit crunch. The paper emphasises the fragility of equilibrium and how rapidly boom can turn to bust. We highlight this by considering land-holding property companies and their vulnerability to adverse shocks - like the end of a property price bubble or a fall in the exchange rate. Even when substantial margins are held, the initial drop in net worth may be followed by powerful ‘knock on’ effects in the scramble for liquidity if companies are forced to sell land to satisfy collateral requirements - possibly leading to wholesale financial collapse.

Using the same framework, we show how crisis management can avert collapse: by a freeze which delays loan recalls, for example, and by financial reconstruction to reduce debt and encourage take-overs. These are among the drastic policy actions taken to protect financial systems in East Asia. We also consider how launching ‘lifeboats’ may help to contain contagion from highly-leveraged firms calling in loans after losses, cf. LTCM. But the vulnerability of highly-leveraged speculative investors to adverse shocks suggests that preventive measures are also required.



JEL Classification: E32, G21, G32, G33, and O54

Keywords: Credit market imperfections, financial leverage, asset price bubbles, financial crisis in East Asia, illiquidity and insolvency.