Corporate Leverage and Currency Crises

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 an exchange rate and letting the currency depreciate. Currency depreciation always increases the profitability of new investments when revenues from that project are in foreign currency and costs denominated in the domestic currency are nominally rigid. Although currency depreciation is always ex-post optimal once risky projects have been taken and failed, it can be harmful ex-ante, because it leads to excessive investment in risky projects even if more valuable safe projects are available. However, currency depreciation is also ex-ante 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.

Keywords: currency depreciation, debt overhang, emerging markets, efficient investment policy, excessive risk taking

JEL Classification: F34, G15, G31, G32

Accepted Paper Series