NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

What Hinders Investment in the Aftermath of Financial Crises?

The key factor that hinders investment and growth [following a financial crisis] is the decline in the supply of credit.

There are two leading views on how financial crises can lead to recessions, both of which underline the role of financial constraints. The "illiquidity" view highlights the importance of a troubled banking sector: if it cannot provide credit to domestic firms, it forces them to decrease investment and output, and this potentially leads to recession. The "insolvency" view revolves around the firm's weak balance sheets and the associated declined in firm net worth. A weakened currency increases the competitiveness of domestic firms, whose products become relatively cheaper in export markets, thereby supporting growth. However, if firms' short-term borrowing is held in foreign currency, then the depreciating domestic currency weakens their balance sheet position, can lead to insolvency, and prevents them from increasing investment and production.

In What Hinders Investment in the Aftermath of Financial Crises: Insolvent Firms or Illiquid Banks? (NBER Working Paper No. 16528), co-authors Sebnem Kalemli-Ozcan, Herman Kamil, and Carolina Villegas-Sanchez sort through the two theories and try to determine which causes financial crises to turn into recessions. They use a new firm-level database from six Latin American countries between 1990 and 2005 to test the importance of each view.

Their main hypothesis is that foreign owned exporting firms should perform better than domestic exporters during a twin crisis, when there is both a weakened currency and a banking crisis, but not during a currency crisis alone. During a currency crisis, both foreign and domestic firms are affected by the weakened currency. A twin crisis adds an illiquidity problem for domestic firms because of problems in the banking sector, which foreign firms can avoid since they have access to foreign credit sources. In other words, given two firms with the same level of short-term dollar debt and exports, only the foreign firm would increase investment during twin crises. This hypothesis assumes, and the authors confirm in the data, that liquidity constraints are binding for domestic firms during banking crises and not during currency crises.

The researchers find that when there is only a currency crisis, domestic firms perform just as well as foreign firms. This implies that during a currency crisis, domestic firms are able to match their short-term debt losses with increased export revenues flowing from their increased competitiveness. When there is a twin crisis, however, foreign exporters who hold short-term foreign-currency denominated debt actually increase investment by 13 percentage points compared to domestic exporters with foreign-currency denominated debt. The latter group presumably faces liquidity constraints. The authors conclude that the key factor that hinders investment and growth is the decline in the supply of credit. Therefore, they point out the importance of providing liquidity to the banking sector during banking crises, especially if the domestic sector is the main source of financing for firms.

-- Claire Brunel

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