Long-Term Finance and Economic Development

What are the linkages between the maturity of corporate debt, the liquidity of financial markets and the real economy? Relative to developed countries, firms on emerging economies borrow at shorter maturities and assets are traded in markets with larger frictions. This paper studies how firms choose and finance long-term investment projects in a production economy subject to an over-the-counter trading friction in financial markets. We show that the liquidity spread increases with the maturity of the asset, generating an upward sloping yield curve. As a result, improvements in the liquidity of financial markets flatten the yield curve, improve borrowing terms for long-term projects, and induce firms to invest at longer horizons. The model is calibrated to match the US corporate debt market and counterfactual exercises show that the liquidity of the secondary market can account for a significant fraction of the variations in maturity choices across countries. Finally, we propose a new policy designed to improve the liquidity of financial markets. The intervention is effective to improve the liquidity, and as a result, firms extend the maturity of projects which generate substantial welfare gains. JEL Classifications: E44, G30, O16.