Financial Friction and Gains (Losses) from Trade

How does financial friction influence gains from trade? To answer this question, this paper develops a general equilibrium model of international trade with cross-country financial friction heterogeneity, as the source of comparative advantage. Although product markets are competitive, production of firms in finance-dependent sectors of a closed economy is supported by a markup over marginal cost, so that a higher profit prevents firms from strategically defaulting on loans. Trade liberalization reduces the price of the finance-dependent good, which benefits the consumers; however, economic rents of producing finance-dependent goods flow out to the financially less-frictional economy, which is welfare-reducing. In sum, gains/losses from trade is determined by the financing friction severity of the partner country. We test the empirical predictions of the model. In particular, while we show that financial development matters for the growth of finance-dependent industries in open economies, we do not find such an evidence for closed economies