Corporate Leverage and Currency Crises

Currency crises can arise because it is optimal to bail out financially distressed exporting firms through a currency depreciation. Exporting firms will not undertake profitable investments when high leverage causes debt overhang problems. A currency depreciation increases the profitability of new investments when revenues are foreign-currency denominated and domestic-currency costs are nominally rigid. Ex ante, currency depreciation leads to excessive investment in risky projects even if safer, more valuable projects are available. However, currency depreciation is optimal ex ante if the risky projects have higher expected returns and if firms must rely on debt financing because of underdeveloped equity markets.