Investment During the Korean Financial Crisis: A Structural Econometric Approach

Without capital market imperfections, the capital structure of a firm, including the size, the maturity and the currency composition of debts, should not matter for investment decisions. The Asian financial crises provide a good opportunity to test this hypothesis. We approach the problem in two ways: First, we apply a conventional reduced-form analysis to a panel data of Korean manufacturing firms, argueing that the devaluation that occurred during the crisis provides a natural experiment in which to assess the effect of balance sheet shocks to investment. Second, we use indirect inference to estimate a structural dynamic programming problem of a firm with foreign debts and financial constraints. Both reduced-form evidence and structural parameter estimates imply an important role for finance in investment at the firm level. Counterfactual simulations imply that balance sheet effects may account for 50% to 80% of the drop in investment during the crisis period. Although our estimates suggest that foreigndenominated debt had relatively little effect on aggregate investment spending for the Korean economy during this crisis episode, counterfactual experiments imply sizeable contractions in investment through this mechanism for economies that are more heavily dependent on foreign-denominated debt. We thank Kevin Cowan, Philippe Bachetta, seminar participants at the Bank of Canada, the Bank of Japan, the Federal Reserve Bank of San Francisco, the Board of Governors of the Federal Reserve, Boston University, Brandeis University, the IIE at Stockholm University, the LSE, MIT, the University of Pennsylvania, and conference participants at the CEPR/Bank of Finland, the NBER Summer Institute, and Pennsylvania State University.