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Narrator: One of the key challenges for a country in maintaining economic stability is managing credit booms, which are periods of rapid debt accumulation. The Great Recession highlights this issue. In the early 2000s, there was rapid debt accumulation that eventually became unsustainable, leading to a financial crisis. Similar boom cycles have occurred globally, as in Japan during the late 1980s, and currently in China. So how can countries find ways to protect themselves from these boom-bust cycles? (light music continues)
Yueran Ma: If the legal institutions are inefficient, then firms may need to liquidate, shut down their operations, lay off people, and that can be very costly for the economy, especially if the firms have good business but just end up with too much debt.
Narrator: That’s Chicago Booth’s Yueran Ma. She and her coauthors looked at how a country’s bankruptcy efficiency can have massive effects on businesses’ outcomes during a recession. (light music continues)
Yueran Ma: Conceptually, bankruptcy efficiency aims to capture how much economic loss is associated with resolving high debt burden of an otherwise viable company, namely a company with a good business but just too much debt. Practically, how do we measure this? It turns out that the World Bank has spent several decades to construct a measure, in particular, they interviewed legal professionals in over 100 countries and asked them what is most likely to happen in a standardized scenario. (light music continues)
Narrator: In this scenario, a company owes more than 100 units of debt, and its value is estimated at 100 if it keeps operating. If the company shuts down, sells its assets, and lays off workers, it will be worth only 70 units. The legal experts were asked to predict whether the company would survive or shut down. They also considered how long the bankruptcy process might take and how much it might cost, including things such as lawyers’ fees. The study looks at how well countries handle bankruptcy with efficient systems preserving close to the full 100 units of value. The researchers then combined the World Bank’s bankruptcy efficiency data with additional annual data on business credit-to-GDP for many countries, along with measures of economic output, investment, and consumption. (light music)
Yueran Ma: And with this annual, country-level dataset, we then looked at what happens to economic activities following a change in business credit-to-GDP, and we find that in countries with low bankruptcy efficiency, when there is a buildup in business credit-to-GDP, then that is followed by sharp reduction in output, as well as sharp reduction in investment and consumption. Whereas in countries with high bankruptcy efficiency following even a substantial buildup in business credit-to-GDP, the economic outcome after that is generally stable, with a slight decline in output and an insignificant decline in investment and a slight increase in unemployment, but not very much disruption.
Narrator: The researchers analyzed whether bankruptcy efficiency is linked to other country-specific factors that influence the credit cycle.
Yueran Ma: For example, what if more-developed countries have stronger bankruptcy institutions, but there are also other features that make their economies more stable? So we looked at, for example, development status, such as GDP per capita, and it turns out that that’s not what drives a country’s performance after credit booms. We also looked at other features like countries’ conduct of monetary and fiscal policy and other measures of their institutions, such as the amount of corruption, and so on so forth, and it turns out that this measure of bankruptcy efficiency really stands out in their explanatory power of how countries perform after business credit booms, whereas other measures do not seem to have as much explanatory power, if at all. (light music continues)
Narrator: And if you’re a country looking to improve your bankruptcy efficiency, there are economies you can look to for examples.
Yueran Ma: In Japan in the late 1980s, there was a substantial credit boom, which then ended in large-scale distress among Japanese firms and Japanese banks in the early 1990s. In light of that, the Japanese government launched a major reform of the bankruptcy system starting from the mid-1990s, which then finished in the early 2000s. And after that reform, Japanese firms did much better through the credit cycles of the early 2000s. They did not see the same amount of massive distress among Japanese firms and Japanese banks that occurred in the early 1990s. (light music continues)
