Financial Development, Credit Rationing and Informal Credit Markets: Implications for Pattern of Trade

Firms differ in the extent to which they get access to formal and informal credit sources in developing economies. In developing economies, banks ration credit due to higher perceived borrower risk, information asymmetry, lack of collateral, and market inefficiencies. Due to financial constraints in formal credit markets, firms often seek alternative funding from informal sources such as friends, family, and moneylenders, even though it comes at a higher borrowing cost. Financial development can help expand access to credit by reducing structural barriers and mitigating the effects of credit rationing. To analyze these dynamics, our paper developed a theoretical model that examines the relationships among credit rationing, financial development, and informal credit markets, and their impact on trade patterns. Financial capital is introduced into the standard workhorse of trade theory, i.e., Dixit-Stiglitz-Krugman (DSK) model of international trade under monopolistic competition. We showed that financial development does not affect trade and production outcomes when firms have access only to formal credit markets, whereas when firms gain access to informal credit markets alongside credit rationing, it increases the number of varieties produced but at the cost of lower output per variety. However, the higher the interest gap between the formal and informal credit markets, the higher will be the marginal impact of the degree of financial development on the pattern of trade. We have also conducted a small empirical motivational exercise to support our findings from theoretical model.