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Corporate Debt Structure, Precautionary Savings, and Investment Dynamics


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Working Paper

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Xiao, J. 

Abstract

Micro-level evidence indicates that firms which substituted bank loans with bond issues during the Great Recession did not experience a large contraction in their total borrowing, but they have been hoarding more cash and investing less than firms that did not substitute. This suggests that firms� balance sheet adjustment played a key role in the transmission of aggregate shocks. To evaluate the importance of this mechanism in the propagation of the Great Recession, I build a quantitative general equilibrium model of firm dynamics that jointly endogenizes the composition of borrowing on the liability-side, and the portfolio allocation between savings and investment on the asset-side. Bond issuances have lower intermediation costs than bank debt, but the latter can be restructured when firms are in financial distress. In response to a contraction in bank credit supply, firms substitute bank loans with bond issues and thus become more exposed to the risk of financial distress. This strengthens firms� precautionary incentive to increase cash holdings at the expense of investment, as they optimally trade-off growth against self-insurance via cash holdings. Model simulations suggest that this �precautionary savings� channel can account for 40 percent of the decline in aggregate investment in the first two years of the Great Recession, and more than one-half of the decline in the following five years.

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Faculty of Economics

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