Trade and Financial Development ∗

The differences in financial development between advanced and developing countries are pronounced. It has been observed, both theoretically and empirically, that these differences in countries’ financial systems are a source of comparative advantage and trade. This paper points out that to the extent a country’s financial development is endogenous, it will in turn be influenced by trade. We build a model in which a country’s financial development is an equilibrium outcome of the economy’s productive structure: in countries with large financially intensive sectors financial systems are more developed. When a wealthy and a poor country open to trade, the financially dependent sectors grow in the wealthy country, and so does the financial system. By contrast, as the financially intensive sectors shrink in the poor country, demand for external finance decreases and the domestic financial system deteriorates. We test our model using data on financial development for a sample of 77 countries. We find that the main predictions of the model are borne out in the data: trade openness is associated with faster financial development in wealthier countries, and with slower financial development in poorer ones. ∗We are grateful to Daron Acemoglu, Abhijit Banerjee, Thorsten Beck, Olivier Blanchard, Simon Johnson, Roberto Rigobon, and workshop participants at MIT for helpful comments. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily reflect the view of the World Bank, its Executive Directors, or the countries they represent. E-mail: [email protected], [email protected].