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| Default and Leverage Cycles: A Financial Accelerator Model with Bailouts |
| LU Lei, LIU Xue
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| State Administration of Foreign Exchange; PBC School of Finance, Tsinghua University |
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Abstract Following the 2008 global financial crisis, China adopted a series of stimulus policies to protect against external shocks. These have played a role in stabilizing economic growth but have also promoted increased levels of leverage in various sectors, especially the non-financial enterprise sector. While the leverage rate of the non-financial enterprise sector has risen, the non-performing loan ratio in the banking sector has not shown an upward trend. Intuitively, as leverage increases, the subsequent increase in the external financing premium will also raise borrowing costs and lead to a higher default rate. However, this is not consistent with the data for China during this period. To explain this puzzle, this paper develops a DSGE model that incorporates a bailout mechanism into the financial accelerator model of Bernanke et al. (1999). Our model helps us better understand the default and leverage cycles of the non-financial enterprise sector in China.
Our motivation in introducing a bailout mechanism is that in practice, local governments have incentives to provide direct or implicit bailouts to the enterprise sector to stimulate economic growth. There are two channels: first, the lower default rate resulting from bailouts can help commercial banks to relax constraints on the credit supply, thereby increasing credit to the enterprise sector; second, the lower external financing premiums due to a low default rate can stimulate the enterprise sector to invest more, leading to increased demand for credit and higher leverage. Consequently, bailouts play the dual role of leverage accelerator and default decelerator.
By computing the steady state, the results show that a higher degree of bailout of the nonfinancial enterprise sector leads to higher leverage and a lower default rate. We then simulate and analyze the impact of technology, risk, and bailout shocks on the economy. Technology shocks make leverage increase, and thus can partially explain the variation in leverage. Technology and risk shocks both lead to economic recession, and thus both make the default rate increase; only bailout shocks cause the default rate to fall. Therefore, it is necessary to incorporate the factor of default bailout to explain the characteristics of the non-performing loan ratio of the banking sector.
This paper also simulates a policy experiment on deleveraging and finds that asset prices fall sharply due to deleveraging, which leads to increased leverage. This implies that achieving the policy objective of deleveraging requires asset price stability; thus, financial stability is important for deleveraging policy. Accordingly, a dynamic bailout rule is proposed that considers expected asset prices. Through simulation, we show that when the bailout rule considers expected asset prices, asset prices fluctuate less under technological, risk, and bailout shocks. Reduced fluctuation in asset prices means that capital is more stable under external shocks, which ultimately stabilizes output and consumption and thus improves social welfare.
The main contributions of this paper are threefold. First, it develops a DSGE model with a bailout mechanism based on Bernanke et al. (1999), which provides a framework for understanding the formation mechanism behind the high leverage of the nonfinancial enterprise sector in China. Second, it provides a better understanding of the effects of deleveraging policy and the relationship between deleveraging and financial stability. If deleveraging policy ignores the need to stabilize asset prices or lacks the relevant policy tools, deleveraging will lead to the decline of asset prices, which will bring about recession and increased leverage. This study explains why China's previous deleveraging policies had undesirable outcomes. Third, the proposed model can be extended by introducing nominal rigidities to examine the role of monetary policy in supporting asset prices in the deleveraging process. It explains why the central bank's financial stability function and prudent monetary policy are necessary for the deleveraging process.
This paper's findings suggest that the two objectives of stabilizing economic growth and deleveraging are not necessarily contradictory if supported by a policy of financial stabilization. This conclusion differs from that reached in the previous literature. The model in this paper can also be extended to include both the state-owned and private-owned sectors when the government provides only an incomplete bailout to the former; such a model can be used to further analyze the impact of the bailout mechanism on resource misallocation.
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Received: 25 December 2017
Published: 10 June 2020
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