## _wp06263

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---

### Introduction — research question and motivation
- Core question: Why do countries experience systemic banking failures, and what can be done to avoid these failures, or at least to mitigate their negative consequences?
- Context: Financial and exchange rate crises (notably East Asia mid-1997 spreading to Russia, Brazil, and others) motivate analysis of conditions under which banking crises arise.
- Focus: Develop a formal macroeconomic framework to analyze contagion phenomena in a country with no apparent macroeconomic instabilities at the outset, a solvent banking system at the beginning of the period, and apparent economic progress (e.g., increases in employment or a strong currency).

### Stylized scenarios that can generate endogenous banking failures
- Mechanisms described:
  - Lending to support rapid economic expansion can induce borrowers to take loans based on anticipated high future returns and low current interest rates; later falls in returns cause defaults.
  - Rapid increase in the work force (urbanization) lowers the cost of capital, raises investment and FDI, reduces returns to existing capital, and can cause future insolvencies.
  - Shift from monetized budget deficits to greater debt financing raises interest rates, making short-term borrowers unable to service loans and causing insolvencies.
- Key insight: Apparently healthy economic developments (rapid growth, revaluation, increased borrowing) can nonetheless produce endogenous banking failures.

### Policy focus and main contribution
- Aim: Develop a model that generates the above outcomes and use numerical simulation to derive fiscal policies that can avoid these failures.
- Principal policy insight: Shifting the burden of taxation from capital to labor (raising labor income tax and lowering capital income tax) can prevent failures; these policies can be implemented within a balanced budget.
- Important constraint: Policy prescriptions do not require reversal of earlier policies that may have led to failures (for example, revaluation need not be reversed).

### Modeling approach, agents, and equilibrium structure
- Time and expectations:
  - Discrete time periods; agents optimize over a two-period perfect foresight horizon and revise expectations every two periods (adaptive expectation updating).
- Production and factors:
  - κ capital types across nonagricultural sectors; two labor types (urban and rural); land.
  - Sectoral value added: va_ij = va_ij(y_jKi, y_jLi, Y_Gi).
  - Firms face input taxes t_Kij, t_Lij; effective input prices ̃P_Lij = (1 + t_Lij) P_Lij, ̃P_Kij = (1 + t_Kij) P_Kij.
  - Investment cost / present value relation:
    - C_H1(1 − k_1 − d_1) = sum_{i=2}^n [(1 − t_Ki) P_Ki (1 − δ)^(i−2) H_1 ∏_{j=1}^{i−1} (1 + r_j)].
  - Borrowing is short-term and rolled over; insolvency occurs if present value of investment falls below debt service.
- Banking sector:
  - One bank per nonagricultural sector; each bank holds 50 percent of its sector’s outstanding debt and equal percent of the debt of other κ − 1 sectors.
  - Bank default exposure: DEF_ik percent of total assets in default in period i.
  - Loans: L_ij = sum_{k=1}^κ β_jk (1 − δ_k DEF_ik) C_Hij.
  - Solvency trigger: if α percent of assets are in default, bank is insolvent and fraction ω_k DEF_ik of deposits are seized.
  - Benchmark: bank solvency requirement set at 8 percent (if nonperforming assets > 8 percent of total assets, portion of deposits seized).
- Consumers, migration, and assets:
  - Two consumer types (urban, rural) with Cobb-Douglas demands; migration responds to relative wages.
  - Consumers hold money, domestic bank deposits, foreign currency; money demand sensitive to interest rates and perceived bank solvency.
  - Representative relations include migration equation, money demand log relation, and savings rate relation for period 2.
- Government budget and financing:
  - Period 1 deficit: D_1 = G_1 + S_1 + r_1 B_0 + r_F1 e_1 B_F0 − T_1.
  - Period 2 deficit: D_2 = G_2 + S_2 + r_2(∆y_BG1 + B_0) + e_2 r_F2 (C_F1 + B_F0) − T_2.
  - Financing identity: D_i = P_Bi ∆y_BGi + P_Mi ∆y_Mi + e_i C_Fi.
  - Foreign borrowing C_Fi exogenously determined by foreign lender; government sets face value of domestic bond sales ∆y_BGi; remainder monetized.
- Foreign sector and FDI:
  - Exports: ∆X_no = σ_1 [ π_i ∆e_i + π_Fi ] + σ_2 ∆y_wi.
  - Reserves: y_FGi = y_FG(i−1) + X_i − M_i + x_F(i−1) − x_Fi + C_Fi + C_FPi.
  - Private capital inflows C_FPi are assumed to be entirely FDI and are a function of relative domestic and foreign interest rates deflated by expected exchange rate change.
  - Simulation specification: ∆FDI = [ (1 + r_Fi) / (1 + r_i) * (e_{i+1} / e_i) ]_{≤FDI} − 1, with ≤FDI = 1 in simulations; FDI_i = FDI_o (1 + ∆FDI_i), treated as new capital not financed by domestic borrowing.
- Money supply:
  - ∆M_Si = ∆y_Mi + ∆OMO_i + e_i y_FGi − e_{i−1} y_FG(i−1).

### Calibration, numerical solution, and Chinese stylized example
- Numerical method: fixed-point solution to obtain intertemporal equilibrium with market clearing prices each period.
- Calibration notes:
  - ≤FDI = 1 (ad hoc) used in simulations.
  - Chinese calibration uses 1995 Chinese input-output matrix (17 sectors, aggregated into κ = 5 groups and five banks).
- Key calibration parameters and initial allocations:
  - Effective direct taxation on inputs of capital and labor: 4.8 percent (applied to all nonagricultural sectors).
  - Government expenditures (percent of GDP): capital expenditures 2.9 percent of GDP; current expenditures on goods and services 8.6 percent of GDP.
  - Initial money: M1 for 1994 (IFS). Bank deposits: 1994 quasi-money (IFS).
  - No domestic households hold foreign currency; foreign consumer initial foreign currency equals 1994 value of exports.
  - Benchmark run length: eight periods; exchange rate fixed for entire simulation.

### Benchmark simulation — key dynamics (Table 1)
- Indices normalized for base simulation.
- Exact aggregated outcomes:
  - Average annual real growth rate over eight periods: 7.3 percent.
  - Average inflation rate over the eight periods: 12.8 percent.
- Qualitative dynamics:
  - Trade surplus slowly declines (fixed exchange rate + inflation).
  - Budget deficit rises and domestic interest rate rises.
  - FDI increase over initial 1995 value slows over time due to rising domestic interest rates.
  - No bank failures in benchmark.
  - Domestic capital formation normalized to 100.

### Shock simulations — specifications and outcomes
- Shock 1: 10 percent annual increase in the workforce (Table 2)
  - Specification: Workforce increases by 10 percent per year; other parameters as Table 1.
  - Key outcomes:
    - Average annual real GDP growth rises to 11.1 percent.
    - Significant deflation observed.
    - Budget surplus increases slightly.
    - Nominal interest rates decline due to lower factor costs.
    - Domestic capital formation and FDI rise.
    - By period 8, banks hold large quantities of nonperforming assets and failures occur due to a dramatic decline in the return to capital.
  - Interpretation: Rapid downward pressure on wages can precipitate insolvency-driven banking collapse even without exogenous macro policy changes.
- Shock 2: 10 percent annual revaluation of the exchange rate (Table 3)
  - Specification: Exchange rate revalued by 10 percent each year for eight periods.
  - Key outcomes:
    - Sharp decrease in FDI compared to base case.
    - Trade balance moves to a deficit by the end period.
    - Nearly 50 percent decline in the price level by final period compared with Table 1.
    - Nominal interest rates lower but real interest rates higher in all periods; real rates rise dramatically in last two periods.
    - Borrowers unable to repay loans; banks fail by final period.
    - Overall decline in capital formation relative to benchmark.
  - Interpretation: Revaluation discourages FDI and investment; rising real rates trigger solvency problems and bank defaults.
- Shock 3: Increase in debt financing of the budget deficit (Table 4)
  - Specification: Financing composition shifts from 90 percent monetization / 10 percent domestic debt to 80 percent monetization / 20 percent domestic debt.
  - Key outcomes:
    - Interest rate increases rapidly over last four periods.
    - Government budget deficit increases due to higher interest obligations.
    - FDI growth slows and becomes negative relative to steady state.
    - Banks fail by period 6; sharp deflation in period 7.
    - Capital formation slowed; moderate decline in real GDP.
  - Interpretation: Increased domestic debt issuance has highly negative consequences for banking sector and macro stability.

### Fiscal countermeasures analyzed (Section IV.A) — tax shift as crisis prevention
- Policy tested:
  - Lower tax on capital income to 0 percent.
  - Raise tax on wage income to 35 percent.
  - Change implemented within a balanced-budget constraint.
- Rationale:
  - Relative factor price change raises return to capital, preserving investor solvency and reducing pressure on banks under a fixed exchange rate where monetary policy is constrained.
- Revaluation + tax change (Table 5) — key effects:
  - Nominal interest rates drop (capital tax lower).
  - Budget deficit decreases after wage tax implementation → less public borrowing and reduced banking-system pressure.
  - Trade balance improves (wage tax lowers consumption).
  - GDP slightly lower than revaluation-alone scenario.
  - FDI increases as cost of capital declines.
  - Failures eliminated in this scenario (tax shift prevents bank defaults).
- Workforce increase + tax change (Table 6) — key effects:
  - Compared with workforce-only scenario, GDP approximately constant; price levels decreased after wage tax.
  - Budget deficit decreased (higher government revenues).
  - Trade balance improved.
  - Average of interest rates in last two periods is lower.
  - Slight increase in FDI.
  - Bank failures observed in workforce-only scenario are prevented under the tax change.
- Caveats:
  - The 35 percent wage tax is illustrated as implausibly high; the example is illustrative.
  - Increased returns to capital and higher investment/FDI may eventually lead back to insolvency — tax shift likely only a temporary stabilizing measure.

### Welfare implications (Section IV.B; utility levels normalized to base = 100; Table 7)
- Normalization: utility levels at equilibrium in base case (Table 1) set to 100 for each consumer.
- Exact utility outcomes:
  - Simulation 1 - Base case: urban 100.0; rural 100.0; foreign 100.0
  - Simulation 2 - Workforce increase: urban 161.9; rural 159.7; foreign 168.3
  - Simulation 3 - Revaluation: urban 83.1; rural 101.2; foreign 70.0
  - Simulation 5 - Revaluation + tax: urban 71.7; rural 104.3; foreign 83.1
  - Simulation 6 - Workforce increase + tax: urban 110.4; rural 122.9; foreign 281.9
- Key welfare insights:
  - Workforce increase benefits all consumers (output increase outweighs wage decline).
  - Revaluation harms urban consumers (sharp real interest rate increase; urban consumers hold most domestic debt; manufactured exports decline); rural consumers see slight welfare improvement.
  - Revaluation + tax shift further lowers urban welfare (lower capital tax increases FDI; over time increased FDI depresses returns to existing capital owners).
  - Workforce increase + tax shift: domestic consumers experience mixed welfare effects; foreign consumer gains substantially.
- Policy trade-off:
  - Tax shift can prevent bank failures but imposes welfare costs on domestic consumers (notably urban consumers).
  - Policymakers might consider taxes and transfers to mitigate distributional welfare losses.
  - Long-run welfare costs of bank failures (not explicitly modeled) could exceed short-run welfare losses from tax changes.

### Conclusion (Section V)
- Main findings:
  - In the model calibrated to stylized Chinese data, bank failures can be triggered by:
    - Increase in growth rate of labor force.
    - Revaluation of exchange rate.
    - Increase in public debt issuance.
  - Failures can arise from apparently beneficial trends or reasonable policy actions.
- Policy implication:
  - Fiscal policy that lowers capital income tax and raises labor income tax increases returns to capital and can prevent or dampen banking crises under a fixed exchange rate regime.
  - Such fiscal measures can also improve trade balance and encourage FDI in economies with government-induced capital market distortions, high savings, export-led growth, and a large unemployed pool.
- Caveats and distributional considerations:
  - Tax changes carry welfare costs (urban sector losses, downward pressure on returns to existing capital from higher FDI).
  - Tax shifts should be considered temporary stabilizers; transfers and targeted policies may be needed to address welfare losses and distributional impacts.

*Source: _wp06263 (IMF working paper content unit)*

### References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### _wp06263 - References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### Tables (listed in source)
- 1. Base Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
- 2. 10 Percent Annual Increase in the Workforce. . . . . . . . . . . . . . . . . . . . . . . . . . 17
- 3. 10 Percent Annual Revaluation (Compared to Benchmark). . . . . . . . . . . . . . . . 18
- 4. Increase in Debt Financing of Budget Deficit . . . . . . . . . . . . . . . . . . . . . . . . . 19
- 5. Combination of Revaluation and Wage Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
- 6. Increase in Work Force Growth and Wage Tax . . . . . . . . . . . . . . . . . . . . . . . . . 22
- 7. Utility Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

### Introduction — research question and motivation
- Core question: Why do countries experience systemic banking failures, and what can be done to avoid these failures, or at least to mitigate their negative consequences?
- Context: Past and recent crises, notably the financial and exchange rate crises that erupted in East Asia in mid-1997 and spread to Russia, Brazil, and many other emerging and developed countries, intensified the need to understand conditions under which banking crises are likely to arise.
- Focus: Develop a formal macroeconomic framework to analyze contagion phenomena in a country with no apparent macroeconomic instabilities at the outset, a solvent banking system at the beginning of the period, and apparent economic progress (e.g., increases in employment or a strong currency).

### Stylized scenarios that can generate endogenous banking failures
- Lending to support rapid economic expansion can lead borrowers to take loans based on anticipated high future returns and currently low interest rates; increased FDI due to an undervalued exchange rate can lower returns to existing capital and lead to borrower defaults.
- Rapid increase in the work force (attracted from rural labor) can lower the cost of capital, increase domestic investment and FDI, reduce returns to capital, and cause future insolvencies.
- Shift from monetized budget deficits to debt financing can raise interest rates, making short-term borrowers unable to service suddenly more expensive loans, causing insolvencies.
- These are types of apparently healthy economic situations that can nonetheless produce endogenous failures.

### Policy focus and main contribution
- Aim: Develop a model that generates the above outcomes and use numerical simulation to derive fiscal policies that can avoid these failures.
- Key policy insight: Shifting the burden of taxation from capital to labor can prevent failures; these policies can be implemented within a balanced budget.
- Important constraint: The policy prescriptions do not require reversal of earlier policies that may have led to failures (for example, a revaluation need not be reversed).

### Modeling approach and empirical design
- The paper presents an intuitive outline of the model (next section in source) and then gives model details in Section II.
- Section III discusses parameterization of the model, gives a benchmark calibration, and demonstrates how failures can be generated.
- Simulations use stylized Chinese data for calibration, with the explicit caveat that the authors do not claim to have created an accurate model of China or that the simulations offer concrete policy advice for that country.
- Note: The source states there have been no recent bank failures of any significance in China, nor evidence that any are imminent.

*Source: _wp06263 - References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*

### Section IV derives fiscal counter measures and analyzes the welfare implications.

### _wp06263 - Section IV derives fiscal counter measures and analyzes the welfare implications.

### Model intuition and crisis mechanism
- Economy features:
  - Fixed nominal exchange rate that tends to be undervalued, reflected in large current account surpluses and rapid reserve accumulation.
  - Low cost of capital for foreign investors and high foreign direct investments (FDI).
  - Large pool of unemployed labor that puts downward pressure on wages, increasing the marginal productivity of capital.
  - High price of consumption (due to the undervalued exchange rate) → high savings, high investment, low interest rates.
- Sequence that can produce crisis:
  - Exogenous increase in labor supply → decrease in unemployment → falling wages → deflation.
  - Deflation increases relative return to capital → overinvestment.
  - Return to capital eventually falls → borrowers become insolvent as debt obligations surpass incomes.
  - Possible outcomes: bank failures (interest rates increase, investment decreases), monetization of bad debt and exchange rate collapse, or a halt to capital inflows driven by fear of default.
- FDI modeling:
  - FDI is endogenous and specified as an increasing function of the ratio of foreign to domestic interest rates, deflated by expected exchange rate changes.
  - Initial inflow may be driven by interest rate differentials; later, falling returns to capital reduce FDI.
- Key behavioral assumption:
  - Agents optimize over two-period perfect foresight horizons with adaptive expectation updates every two periods; this allows for unpredictable crisis timing and permits bank failures/defaults to occur.
- Comparative literature placement:
  - Paper links crises to banking-sector dynamics and endogenous investment behavior rather than to bailout guarantees or purely self-fulfilling runs in the government-fiscal literature.

### Simulated scenarios and main numerical experiments
- Benchmark simulation:
  - Generates a solvent banking system (baseline equilibrium).
- Simulation 1:
  - Assumes a 10 percent per year increase in the work force as compared to the benchmark.
  - Outcome: rapid increase in investment, eventual falling rate of return to capital, defaults on loans and bank failures by the final period of the simulation.
- Simulation 2:
  - Assumes government revalues the exchange rate by 10 percent per year.
  - Outcome: similar path with bank failures.
- Simulation 3:
  - Assumes an increase in debt issue to finance the government budget deficit.
  - Outcome: bank failures driven by interest rate increases causing borrower defaults.
- Fiscal countermeasure analyzed:
  - Increase in the tax rate on labor income combined with a decrease in the corporate tax rate.
  - Outcome: eliminates or dampens bank failures and endogenous runs on the banking system at the expense of domestic consumer welfare.

### Model structure — agents, markets, and key equations (high-level)
- Time and expectations:
  - Discrete time periods with agents optimizing over a two-period horizon and revising after two periods (adaptive expectations).
- Production:
  - κ capital types (κ aggregate nonagricultural productive sectors), two types of labor (urban and rural), and land.
  - Sector-specific value added: va_ij = va_ij(y_jKi, y_jLi, Y_Gi).
  - Firms face input taxes t_Kij, t_Lij; effective input prices ̃P_Lij = (1 + t_Lij) P_Lij, ̃P_Kij = (1 + t_Kij) P_Kij.
  - Price vector: P_i = va(P, Y_Gi)(1 + t)(I − A_i)^(−1).
  - Investment cost / present value relation:
    - C_H1(1 − k_1 − d_1) = sum_{i=2}^n [(1 − t_Ki) P_Ki (1 − δ)^(i−2) H_1 ∏_{j=1}^{i−1} (1 + r_j)].
  - Investment insolvency rule: if present value of investment falls below debt service in some period, borrower defaults; borrowing is short-term and rolled over each period.
- Banking:
  - One bank per nonagricultural sector; each bank holds 50 percent of the outstanding debt of its associated sector and an equal percent of the debt of each of the other κ − 1 sectors.
  - Bank-specific default holding: DEF_ik percent of its total assets in default in period i.
  - Bank risk parameter δ_k and sectoral borrowing shares β_jk.
  - Loans to sector j in period i:
    - L_ij = sum_{k=1}^κ β_jk (1 − δ_k DEF_ik) C_Hij.
  - Solvency trigger: if α percent of a bank’s assets are in default, bank is insolvent and a fraction ω_k DEF_ik of the bank’s deposits are seized by the government.
  - Loan supply is constrained by bank capital and by perceived borrower risk; deposits determined by consumer saving behavior and perceptions of bank solvency.
- Consumption and labor migration:
  - Two consumer types (urban, rural) with Cobb-Douglas demands and specific initial allocations.
  - Consumer optimization over two periods; migration responds to relative urban vs rural wages.
  - Consumers hold money, domestic bank deposits, foreign currency; money demand sensitive to interest rates; deposit demand depends on perceived banking solvency.
  - Representative consumer conditions include:
    - Aggregate consumption equals aggregate income: C_i = N_i.
    - Allocation across domestic and foreign interest-bearing assets depends on relative domestic and foreign interest rates deflated by expected exchange rate changes.
    - Migration: log(L_ui / L_ri) = a_1 + a_2 log( P_Lui − P_Lri / (P_Lui + P_Lri) ) (with condition P_Lui ≥ P_Lri; otherwise log(L_ui / L_ri) = 0).
    - Money demand: log P_Mi x_Mi = a + b log(1 + t_i) P_i x_i − c log π_i, with c = c(DEF/ASSET) and c negatively related to DEF/ASSET.
    - Savings rate relation for period 2: P_B2 x_B2 = d_0 + d_1 (1 + t_2) P_2 x_2 + d_2( (r_2 − π_2) / (1 + π_2) ).
- Government budget and financing:
  - Period 1 deficit: D_1 = G_1 + S_1 + r_1 B_0 + r_F1 e_1 B_F0 − T_1.
  - Period 2 deficit: D_2 = G_2 + S_2 + r_2(∆y_BG1 + B_0) + e_2 r_F2 (C_F1 + B_F0) − T_2.
  - Financing identity in period i:
    - D_i = P_Bi ∆y_BGi + P_Mi ∆y_Mi + e_i C_Fi.
  - Foreign borrowing C_Fi is exogenously determined by the lender; government sets face value of domestic bond sales ∆y_BGi; remainder financed by monetization.
- Foreign sector and FDI:
  - Export change: ∆X_no = σ_1 [ π_i ∆e_i + π_Fi ] + σ_2 ∆y_wi.
  - Supply of foreign reserves in period i:
    - y_FGi = y_FG(i−1) + X_i − M_i + x_F(i−1) − x_Fi + C_Fi + C_FPi.
  - Private capital inflows C_FPi are assumed to be entirely FDI and are a function of relative domestic and foreign interest rates deflated by expected exchange rate change.
  - FDI change specification used in simulations:
    - ∆FDI = [ (1 + r_Fi) / (1 + r_i) * (e_{i+1} / e_i) ]_{≤FDI} − 1, with ≤FDI the elasticity of FDI (taken equal to 1 in simulations).
  - New period FDI: FDI_i = FDI_o (1 + ∆FDI_i), distributed across capital types proportionally to nominal capital shares; FDI treated as new capital not financed by borrowing (no direct domestic interest-rate effect).
- Money supply:
  - ∆M_Si = ∆y_Mi + ∆OMO_i + e_i y_FGi − e_{i−1} y_FG(i−1).

### Calibration, numerical solution, and Chinese example
- Solution method:
  - Numerical fixed-point solution to obtain an intertemporal equilibrium (prices each period such that goods and financial markets clear).
- Calibration choices cited:
  - In simulations, ≤FDI = 1 (ad hoc specification).
- Chinese calibration:
  - Uses 1995 Chinese input-output matrix (from the 1998 China Statistical Yearbook) representing 1995 technology.
  - The matrix has 17 sectors (sectoral details not reproduced here).

### Policy insight and welfare implications
- Temporary fiscal policy examined:
  - Increasing tax on labor income and decreasing corporate tax rate:
    - Eliminates or dampens bank failures and endogenous banking runs.
    - Comes at the expense of domestic consumer welfare (domestic consumers lose welfare under this policy).
- Trade-offs highlighted:
  - Policies that stabilize the banking system and prevent runs may reduce domestic consumption welfare.
  - Revaluation, rapid labor inflows, or increased government borrowing can each precipitate banking-sector distress via different channels (interest rates, returns to capital, borrower insolvency).

*Source: _wp06263 - Section IV derives fiscal counter measures and analyzes the welfare implications.*

### 1. Agriculture10. Metal Products

### _wp06263 - 1. Agriculture10. Metal Products

### Sectors listed in the content unit

- 1. Agriculture10. Metal Products
- 2. Mining11. Machinery and Equipment
- 3. Foodstuff12. Construction
- 4. Textiles13. Transport and Telecom
- 5. Other Manufacturing14. Commerce
- 6. Production of electricity15. Public Utilities
- 7. Gas, Coal, and Petroleum16. Banking and Insurance
- 8. Chemicals17. Other Services

*Source: _wp06263 - 1. Agriculture10. Metal Products*

### 9. Building materials and nonmetallic minerals

### 9. Building materials and nonmetallic minerals

### Data, model setup, and calibration
- 17 sectors grouped into 5 aggregate groups (κ = 5) and hence five banks.
- Indirect taxes derived from the input-output matrix; import coefficients and import tariff rates derived following Feltenstein and Nsouli (2003).
- Effective direct taxation: tax rate of 4.8 percent levied upon inputs of capital and labor to all nonagricultural sectors (derived from China Statistical Yearbook).
- Government expenditures (percent of GDP):
  - Capital expenditures: 2.9 percent of GDP (nominal government expenditure divided by nominal GDP).
  - Current expenditures on goods and services: 8.6 percent of GDP.
- Initial allocations and parameters:
  - Consumers’ utility weights derived from final part of IO matrix (expenditures on each of the 17 sectors by agricultural and nonagricultural households).
  - Initial allocations of capital from sectoral operation surpluses (returns to capital) in IO matrix; labor from “compensation of laborers” across sectors. Physical unit of capital and labor defined as that which earned one yuan in 1995.
  - Initial money: M1 for 1994 (IFS). Bank deposits: 1994 quasi-money (IFS). No domestic households hold foreign currency; foreign consumer’s initial foreign currency equals 1994 value of exports (Yearbook).
- Benchmark equilibrium:
  - Exchange rate fixed for the entire simulation.
  - Model run for eight periods to determine endogenous outcomes.
  - Bank solvency requirement: 8 percent (if nonperforming assets > 8 percent of total assets, portion of deposits seized and depositors lose access to that share).
  - ωk = 1 for each bank; banks do not optimize and do not ration credit when borrowers default (benchmark assumption).

### Baseline simulation (Table 1 — key outcomes)
- All indices normalized for base simulation.
- The simulation generates:
  - Average annual real growth rate over eight periods: 7.3 percent.
  - Average inflation rate over the eight periods: 12.8 percent.
- Other baseline dynamics (qualitative):
  - Trade surplus slowly declines (fixed exchange rate + inflation).
  - Budget deficit rises and domestic interest rate rises correspondingly.
  - Increase in FDI over initial 1995 value slows over time due to rising domestic interest rates.
  - No bank failures in benchmark.
  - Domestic capital formation normalized to 100.

### Shock scenario 1 — 10 percent annual increase in the workforce (Table 2)
- Shock specification:
  - Workforce increases by 10 percent per year (intended to reflect rapid urbanization); all other parameters as in Table 1.
- Key outcomes:
  - Average annual real GDP growth rises to 11.1 percent.
  - Significant deflation observed (caused by workforce increase).
  - Budget surplus increases slightly (exports cheaper than base case).
  - Nominal interest rates decline due to lower factor costs.
  - Domestic capital formation and FDI rise.
  - By period 8, banks hold large quantities of nonperforming assets and failures occur.
    - Cause: dramatic decline in return to capital; firms cannot service debts despite lower interest rates.
- Interpretation:
  - Rapid downward pressure on wages can precipitate economic collapse via solvency failures even without exogenous macro policy changes.
  - Outcome depends on two-period perfect foresight assumption (firms surprised by rapid decline in returns to capital).

### Shock scenario 2 — 10 percent annual revaluation of exchange rate (Table 3)
- Shock specification:
  - Exchange rate revalued by 10 percent every year for eight periods (example: RNB 8 per USD → 7.2 in next period); all other parameters as in Table 1.
- Key outcomes:
  - Sharp decrease in FDI compared to base case.
  - Trade balance moves to a deficit by the end period (revaluation reduces export revenues).
  - Nearly 50 percent decline in the price level by final period compared with Table 1.
  - Nominal interest rates lower but real interest rates higher in all periods; real rates rise dramatically in last two periods.
  - Borrowers unable to repay loans; banks fail by final period.
  - Overall decline in capital formation relative to benchmark (real interest rate increase).
- Interpretation:
  - Revaluation makes domestic assets more expensive, discouraging FDI and investment; higher real rates trigger solvency problems and bank defaults.

### Shock scenario 3 — Increase in debt financing of budget deficit (Table 4)
- Shock specification:
  - Financing composition changed from 90 percent monetization / 10 percent domestic debt to 80 percent monetization / 20 percent domestic debt.
  - All other parameters as in Table 1.
- Key outcomes:
  - Interest rate increases rapidly over last four periods (sharp rise in interest obligations).
  - Government budget deficit increases due to higher interest obligations.
  - FDI growth slows and becomes negative relative to steady state.
  - Banks fail by period 6; sharp deflation in period 7.
  - Capital formation slowed; moderate decline in real GDP.
- Interpretation:
  - Increased domestic debt issuance has highly negative consequences for banking sector and macro stability.

### Fiscal policy response (Section IV.A — tax shift as crisis prevention)
- Policy tested:
  - Lower tax on capital income to 0 percent.
  - Raise tax on wage income to 35 percent.
  - Change implemented within a balanced-budget constraint; illustrative, not prescriptive.
- Rationale:
  - Relative factor price change raises return to capital, preserving investor solvency and reducing pressure on banks.
  - Fiscal policy effective under fixed exchange rate where monetary policy is constrained.
- Revaluation + tax change (Table 5) — key effects:
  - Nominal interest rates drop (capital tax lower).
  - Budget deficit decreases after wage tax implementation → less public borrowing and reduced banking-system pressure.
  - Trade balance improves (wage tax lowers consumption).
  - GDP slightly lower than revaluation-alone scenario.
  - FDI increases as cost of capital declines.
  - Failures eliminated in this scenario (tax shift prevents bank defaults).
- Caveats:
  - Tax on labor (35 percent) is implausibly high; example is illustrative.
  - Increased returns to capital and higher investment/FDI may eventually lead back to insolvency — tax shift likely only temporary stabilizing measure.

- Workforce increase + tax change (Table 6) — key effects:
  - Compared with workforce-only scenario (Table 2), GDP approximately constant; price levels decreased after wage tax.
  - Budget deficit decreased (higher government revenues).
  - Trade balance improved.
  - Average of interest rates in last two periods is lower.
  - Slight increase in FDI (real exchange rate decline).
  - Bank failures observed in Table 2 are prevented under the tax change.
- Interpretation:
  - Increasing labor income tax and decreasing capital tax helps prevent failures caused by rising workforce and declining returns to capital.

### Welfare implications (Section IV.B; Table 7 utility levels normalized to base = 100)
- Normalization: utility levels at equilibrium in base case (Table 1) set to 100 for each consumer.
- Utility outcomes (exact values from Table 7):
  - Simulation 1 - Base case: urban 100.0; rural 100.0; foreign 100.0
  - Simulation 2 - Workforce increase: urban 161.9; rural 159.7; foreign 168.3
  - Simulation 3 - Revaluation: urban 83.1; rural 101.2; foreign 70.0
  - Simulation 5 - Revaluation + tax: urban 71.7; rural 104.3; foreign 83.1
  - Simulation 6 - Workforce increase + tax: urban 110.4; rural 122.9; foreign 281.9
- Key welfare insights:
  - Workforce increase benefits all consumers (output increase outweighs wage decline).
  - Revaluation harms urban consumer (sharp real interest rate increase; urban consumer holds most domestic debt; manufactured exports decline); rural consumer sees slight welfare improvement (relative return to land rises).
  - Revaluation + tax shift further lowers urban welfare (lowering capital tax increases FDI; over time increased FDI depresses returns to existing capital owners).
  - Workforce increase + tax shift: both domestic consumers experience net welfare declines; foreign consumer gains substantially.
- Policy trade-off:
  - Tax shift prevents bank failures but imposes welfare costs on at least part of society (notably urban consumers).
  - Policymakers might consider taxes and transfer payments to mitigate distributional welfare losses.
  - Long-run welfare costs of bank failures (not explicitly modeled here) could exceed short-run welfare losses from tax changes.

### Conclusion (Section V)
- Main findings:
  - In the model calibrated to stylized Chinese data, bank failures can be triggered by:
    - Increase in growth rate of labor force.
    - Revaluation of exchange rate.
    - Increase in public debt issuance.
  - These failures can arise from apparently beneficial trends or reasonable policy actions.
- Policy implication:
  - Fiscal policy that lowers capital income tax and raises labor income tax increases returns to capital and can prevent or dampen banking crises under a fixed exchange rate regime.
  - Such fiscal measures can also improve trade balance and encourage FDI in economies with government-induced capital market distortions, high savings, export-led growth, and a large unemployed pool.
- Caveats and distributional considerations:
  - Tax changes carry welfare costs (urban sector losses, downward pressure on returns to existing capital from higher FDI).
  - Tax shifts should be considered temporary stabilizers; transfers and targeted policies may be needed to address welfare losses and distributional impacts.

*Source: _wp06263 - 9. Building materials and nonmetallic minerals*

### REFERENCES

### REFERENCES

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### Banking, Financial Intermediation, and Monetary Policy in General Equilibrium
- Altig, D., C. Carlstom, and K. Lansing, 1995, “Computable General Equilibrium Models and Monetary Policy Advice,”Journal of Money, Credit and Banking, Vol. 27, pp. 1472-1493.
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### Fiscal Policy, Bank Failures, and Development
- Ball, S., and A. Feltenstein, 2001, “Bank Failures and Fiscal Austerity: Policy Prescriptions for a Developing Country,”Journal of Public Economics, Vol. 82, pp. 247-270.
- Feltenstein, A., 1992, “Oil Prices and Rural Migration: The Dutch Disease Goes South,”Journal of International Money and Finance, Vol. 11, pp. 273-291.
- Feltenstein, A., and S. Nsouli, 2003, “Big Bang versus Gradualism in Economic Reforms: an Intertemporal Analysis with an Application to China,” IMF Staff Papers Vol.50, pp. 458-480.

### Methodology, Time Inconsistency, and Dynamic Behavior
- Strotz, R., 1956, “Myopia and Inconsistency in Dynamic Utility Maximization,” Review of Economic Studies, Vol. 23, pp. 165-180.

*Source: _wp06263 - REFERENCES*

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