The Distorted Effect of Financial Development on International Trade Flows

This paper investigates the effects of financial development on the intensive and extensive margins of countries exports, at different stages of economic development. The paper develops a partial equilibrium model with monopolistic competition. In this model, firms are heterogeneous in terms of productivity and have access to external liquidity. The effect of financial development on the intensive and extensive margins of countries exports is predicted to be positive, especially in sectors with a higher demand for external finance. In countries with poor financial institutions though, only the most productive firms benefit from an increased access to financial resources and start exporting, with little effect on aggregate exports. The effect of financial development on exports is therefore higher for a better initial development of financial institutions. The empirical analysis confirms that financial development promotes both the intensive and extensive margins of countries’ exports. This is more the case in industries with a higher demand for external finance. Though, more than 60% of the effect of financial development channels through the intensive margin. In industries where the demand for external finance is high, the effect of financial development is the highest in economies characterized by an intermediate development of financial institutions, and the lowest in countries with poor or advanced financial institutions. This contradicts the traditional expectation that financial development benefits more in terms of exports to countries where financial constraints are the most binding.