Trade Liberalization and Capital Flows: a Perspective of Comparative Advantage and Heterogeneous Firms

Motivated by the non-linear and S-shaped pattern between trade liberalization and capital inflow observed in cross country data, this paper offers a new perspective in understanding the relation between these two. The static model nests Melitz style heterogenous firms with endogenous mark-up within a classical Heckscher-Ohlin style comparative advantage frame work. In this integrated model trade liberalization not only raises the productivity but also relocate more labor to the comparatively advantageous sector. These two effects are intertwined by themselves and work exactly the opposite direction in shaping the response of real rental rate after trade liberalization. Using a large panel of firm level data, we find that these two effects coexist during China’s trade liberalization around 2001. The static model is also extended to a dynamic setting that exhibits a S-shape response of current account after a once-for-all tariff reduction.