Trade and Capital Flows: A Financial Frictions Perspective

The classical Heckscher-Ohlin-Mundell paradigm states that trade and capital mobility are substitutes, in the sense that trade integration reduces the incentives for capital to flow to capital-scarce countries. In this paper we show that in a world with heterogeneous financial development, the classic conclusion does not hold. In particular, in less financially developed economies (South), trade and capital mobility are complements. Within a dynamic framework, the complementarity carries over to (financial) capital flows. This interaction implies that deepening trade integration in South raises net capital inflows (or reduces net capital outflows). It also implies that, at the global level, protectionism may backfire if the goal is to rebalance capital flows, when these are already heading from South to North. Our perspective also has implications for the effects of trade integration on factor prices. In contrast to the Heckscher-Ohlin model, trade liberalization always decreases the wage-rental in South: an anti-Stolper-Samuelson result.