Financial Development and the Choice of Trade Partners

Man Lung Chan, Kalina Manova

NBER Working Paper No. 18867
Issued in March 2013
NBER Program(s):   DEV   IFM   ITI

What determines the choice of countries' trade partners? Is there an order that firms follow when entering foreign markets? We show theoretically and empirically that financial market imperfections affect the number and identity of exporters' destinations. Bigger economies with lower trade costs are relatively more attractive markets because they offer cross-border sellers higher profits. This generates a pecking order of destinations such that exporters serve all countries above a cut-off level of market potential. Credit constraints raise this cut-off and prevent firms from entering some markets that they could profitably service in the first-best. Financially advanced exporters thus have more trade partners and go further down the pecking order of importers, especially in sectors that rely more heavily on the financial system. Our results provide the first systematic evidence that countries follow a hierarchy of export destinations, that market size and trade costs determine this hierarchy, and that financial frictions interact importantly with it. Methodologically, we show how to construct a model-consistent ranking of countries by market potential, and derive model-consistent estimating equations to test the pecking order hypothesis. Our findings have implications for various economic effects of international trade linkages that depend crucially on the number and identity of countries' trade partners.

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Document Object Identifier (DOI): 10.3386/w18867

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