Financial Crises and the Role of Debt Maturity for Emerging Economies

This paper studies the role of debt maturity for small open economies subject to endogenous financial crises. It uses an off-the-shelf two-sector DSGE model featuring collateral constraints and endogenous financial crises but allows the duration of the bond in the economy to vary. This model generates a trade-off between the borrowing cost and insurance benefit of a long-term bond. On one hand, it is more costly for small open economies to borrow through the long-term bond than the short-term bond. On the other hand, a long-term bond also provides an insurance benefit against aggregate shocks and the probability of financial crises declines monotonically in the duration of the bond. As a result, the quantitative analysis shows that the ex-ante welfare is maximized when the duration of the bond in the economy is seven quarters and this result sheds some light on why emerging market economies adopt controls on short-term capital flows.