We develop a simple model to study the interactions between a supplier’s financial constraints and contract incompleteness in a vertical relationship. Production complexity increases the extent of contract incompleteness and the hold-up problem, which generates a cost when the supplier needs financial participation from the downstream firm. Vertical integration alleviates the impact of financial constraints but reduces the supplier’s incentives. We apply the model to an analysis of multinational firms’ sourcing strategies and predict that (1) complex and specific inputs are more likely to be sourced from financially developed countries and (2) multinationals are more likely to integrate suppliers located in countries with poor financial institutions, especially when trade involves complex goods. We examine and validate these predictions using firm-level trade data on multinational firms with operations in France. We provide evidence that financial development generates a comparative advantage in the supply of complex goods. Moreover, we find higher shares of intra-firm imports of complex inputs from countries with a lower level of financial development. The findings are robust to different measures of complexity and specificity, and are not driven by industry differences in fixed costs or traditional measures of external financial dependence. Quantitatively, we find that financial development is as important as contract enforcement in alleviating hold-up problems.
