Complementarity between Bilateral Trade and Financial Integration

This paper explores the complementarities between bilateral trade in goods and financial assets. By utilizing a gravity model specification with an extended dataset in terms of time span and asset classification as well as alternative instrumental variables, we confirm the existence of positive evidence for complementarities. We find that common factors such as bilateral distance and other economic size variables that determine both cross-border trade and financial flows contribute to complementarity. However, the fact that the estimated coefficients of distance for financial transactions are about half the size of those for trade in goods suggests that physical distance is less important for financial transactions. Furthermore, the significance of distance in explaining bilateral transactions disappears when trade is added as an additional explanatory variable, indicating that distance may not directly influence financial flows. Finally, we also find that there exists another important factor that is responsible for the complementarities that exist between trade and financial integration. This additional factor is a direct causal relationship that acts from both directions between trade in goods and financial transactions, while the directional effects from trade in goods to financial transactions are much stronger.