Trade shocks and credit reallocation

The effect of trade liberalization on welfare and economic activity remains one of the most important questions in economics. The literature identifies a number of key determinants that reduce the potential gains from trade, by focusing on frictions to labor mobility across regions or sectors. This paper contributes to this debate by exploring a novel channel, namely the reallocation of credit in the aftermath of a trade shock. We find that there are endogenous financial frictions that arise from trade liberalization and spillovers between losers and winners from trade that go through banks, as banks can be negatively affected by a trade shock through the portfolio of firms they lend to. Using data from the Italian credit registry, matched with bank and firm level data, we follow the evolution of bank and firm activities prior to and after the entry of China into the WTO. We identify the sectors most affected by import competition from China and estimate the transmission of this trade shock from firms to their lending banks, and the consequence of the shock on banks' lending to other firms. We find that, controlling for credit demand, banks exposed to the China shock decrease their lending relative to non-exposed banks. Importantly, this lending is reduced both for firms exposed to competition from China and to those that are not and that we should expect to expand. The main mechanism is related to the reduction of the core capital of banks, and their resulting funding capacity, through the rise of non-performing loans. We quantify the impact of this effect on real outcomes such as employment, investment, and output and we find relevant aggregate implications. These findings provide evidence that following a trade shock, bank lending has a key impact on the reallocation channel and on the potential gains from trade.