SSE/EFI Working Paper Series in Economics and Finance
No 367:
Corporate Leverage and Currency Crises
Arturo Bris ()
and Yrjö Koskinen ()
Abstract: This paper provides an explanation of currency crises
based on an argument that bailing out financially distressed exporting
firms through a currency depreciation is ex-post optimal. Exporting firms
have profitable investment opportunities, but they will not invest because
high leverage causes debt overhang problems. The government can make
investments feasible by not defending a fixed exchange rate and letting the
currency depreciate. Currency depreciation always increases the
profitability of new investments when revenues are in a foreign currency
and costs are at least partially in domestic. Interestingly, foreign
borrowing by exporting firms doesn't change the qualitative results: if
firms' debt is denominated in foreign currency, a larger depreciation is
needed to restore incentives to invest. An important feature in our model
is that in general exporting firms choose to finance investments with debt
instead of equity. Currency depreciation is socially optimal if risky
projects have a higher expected return than safe projects and if firms are
forced to rely on debt financing because of underdeveloped equity markets.
Although currency depreciation is always ex-post optimal, it can be harmful
ex-ante. Exporting firms know that the government will let the currency
depreciate, if their risky investments have failed. This leads to excessive
investment in risky projects even if more valuable safe projects are
available.
Keywords: Currency depreciation; debt overhang; emerging markets; efficient investment policy; excessive risk taking; (follow links to similar papers)
JEL-Codes: F34; G15; G31; G32; (follow links to similar papers)
33 pages, March 17, 2000, Revised July 2, 2001
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- This paper is published as:
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Bris, Arturo and Yrjö Koskinen, (2002), 'Corporate Leverage and Currency Crises', Journal of Financial Economics, Vol. 63, No. 2, pages 275-310
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