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Long-Term Finance and Economic Development: The Role of Liquidity in Corporate Debt Markets

Julian Kozlowski ()

No 699, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: What are the linkages between maturity of corporate debt, liquidity of financial markets and the real economy? Firms in developing countries borrow at shorter maturities and those assets are traded in less liquid markets, relative to advance economies. To understand these facts, this paper studies how firms choose and finance investment projects in a production economy subject to an over-the-counter trading friction in financial markets and a time-to-build constraint on investment. Long-term assets rely on the possibility of being traded in secondary markets. Hence, the credit spread due to liquidity increases with the maturity of the asset, which generates an upward sloping yield curve. As a result, an improvement in market liquidity flattens the yield curve and benefits long-term borrowing. On the other hand, investment choices depend on financial costs. The time-to-build constraint implies that in order to produce a more profitable firm, an entrepreneur needs borrowing for a longer period of time. Hence, when borrowing costs at longer horizons decline, firms invest in more profitable longer-term projects. To evaluate the quantitative importance of this mechanism, I calibrate the model to match the US corporate debt market. Counterfactual exercises show that the liquidity of the secondary market can account for variations in maturity choices of 30.

New Economics Papers: this item is included in nep-dge, nep-fdg and nep-mac
Date: 2017
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