Balance-Sheet Contagion

Abstract

Japan has been in a slump for the past decade. After GDP had been growing by on average 4 percent during the 1980’s, the growth rate dropped to 1 percent in the 1990’s. Asset prices also fluctuated significantly: capital gains on stocks and real estate in the 1980’s, followed by capital losses in the 1990’s, were both on the order of a few years’ worth of GDP, even after taking inflation into account. Together with production and asset prices, the fraction of nonperforming loans fluctuated substantially. These are by no means all bank loans. For the nonfinancial corporate sector in Japan, the ratio of financial assets to total assets is about 40 percent, much higher than in the United States. Such financial assets include loans to and securities of other private agents. That is, nonfinancial institutions simultaneously borrow from and lend to each other on a significant scale. Many nonperforming loans are interlocked, paralyzing the financial system. It is important to recognize that these swings have been experienced by almost all sectors of the Japanese economy. Yet in other countries, comparable movements in asset prices have had less widespread consequences. For example, the recent fluctuations in the NASDAQ index in the United States have been no smaller than those of asset prices in Japan, but the damage appears to be contained to closely related sectors. Although U.S. equity-holders, particularly pension funds, have lost value, the level of nonperforming loans is relatively limited up to now. The question is: Why does there appear to be more contagion in some countries than in others? Has contagion anything to do with the nature of financing or the extent to which there are inter-locking loans? In this theoretical paper, we examine two different mechanisms by which contagion may occur. In both cases, propagation is through balancesheet effects. First, through the indirect effects that fluctuations in asset prices have on collateral values. Second, through the direct effects that default on or postponement of debt repayments have when there are chains of credit.