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What Hinders Investment In The Aftermath Of Financial Crises: Insolvent Firms Or Illiquid Banks?

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Executive Summary

There are two leading views on how financial crises turn into recessions. The first view highlights the importance of a troubled banking sector that cannot provide credit to domestic firms. The second view stresses the relevance of short-term borrowing in foreign currency and the associated decline in net worth through a weak balance sheet. Both views underline the role of financial constraints as mechanisms that can lead to an aggregate investment collapse. This result only holds when the currency crisis is combined with a banking crisis, implying that the key factor that hinders investment and growth is the decline in the supply of credit.

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