International Trade and Capital Movement under
Financial Imperfection ∗Taiji Furusawa†

Noriyuki Yanagawa‡

Hitotsubashi University

University of Tokyo

Harvard University

December 2011

Abstract
The paper examines the impacts of trade and capital movement between the Northand the South under financial imperfection. We find that trade and capital movement
are complements, rather than substitutes as in the case of perfect financial institution,in the sense that when capital is perfectly mobile, trade in goods will induce further
capital movement and capital moves from the South to the North. We also find thatan international difference in financial development induces reciprocal foreign direct
investment.
JEL Classification: F12, F21, G20, G30
Keywords: Complementarity, financial institution, FDI∗

We are grateful for helpful comments to Martin Davies, Motonari Kurasawa, Yasuhiro Sato, Thierry
Verdier, participants of the Asia Pacific Trade Seminars 2008, the 2009 Far Eastern and South Asian Meetingof the Econometric Society, the European Trade Study Group meeting (2009), Hitotsubashi COE Conferenceon International Trade and FDI (2009), the IEFS China Inaugural Conference (2009), the 2008 annual
meeting of Japan Society of International Economics, Midwest International Economics Group Meeting (Fall2009), Second Keio/Kyoto International Conference on Market Quality Economics, and seminar participantsat Copenhagen Business School, GATE, Keio University, Kobe University, Kyoto University, Kyung-Hee
University, National Taiwan University, Paris School of Economics, Sogang University Universite de Caen
Basse-Normandie University of Tokyo, and Yokohama National University. Furusawa acknowledges financial
support from the Abe Fellowship.
†
Weatherhead Center for International Affairs, Harvard University. Email: tfurusawa@wcfia.harvard.edu‡
Faculty of Economics, University of Tokyo. Email: yanagawa@e.u-tokyo.ac.jp

1

Introduction

Recent financial turmoil reminded us of the importance of the high-quality credit market
on the economy. The subprime loan problem in the United States seriously hurt the financial systems in the United States and other countries in the world, which led to the global
economic downturn as banks and other financial intermediaries became cautious and reluctant to lend money that is necessary for firms to smoothly operate. The financial crisis had
spread very quickly and its impact was large worldwide because the financial market had
been globalized in the last decades.
The purpose of this paper is to examine the impacts of trade in goods and international
capital movement when the financial institution is not perfect. The impact of globalization of the financial market on the economy has been extensively analyzed.1 However, theliterature of international trade under financial imperfection is premature. Kletzer and Bardhan (1987), Beck (2002), Matsuyama (2005), Wynne (2005), Levchenko (2007), Ju and Wei(2008), and Antràs and Caballero (2009), for example, find that the cross-country differencesin the quality of financial institutions significantly affect the structure of countries’ comparative advantage and trade patterns. Chaney (2005), Manova (2008a), and Suwantaradon(2008) develop their models in which heterogeneous firms are faced with credit-constraints
when they finance trade costs. Their models predict that more-productive and wealthier firms engage in export, while others sell their products only domestically.2 Foellmi and1Henry (2007), for example, finds evidence that financial globalization contributes to economic growth.
Klein (2005) shows that countries with better (but not the best) institutions exhibit positive effects of capital
account liberalization on economic growth. Kose, Prasad, Rogoff, and Wei (2006) argue that countries thatmeet threshold conditions (about institutional quality and trade openness, for example) are better able toreap the growth and stability benefits of financial globalization. Financial development itself depends on
general institutional quality and political and economic environment. Chinn and Ito (2006) find evidence that
capital account liberalization leads to equity market development only if a threshold level of legal development
has been attained and that trade openness is a prerequisite for capital account liberalization. Rajan andZingales (2003) and Do and Levchenko (2007) find that trade and international capital movement induce
financial development. Indeed, the quality of financial institution has long been recognized to be critical tothe economic prosperity. McKinnon (1973, 1993), for example, emphasizes that less-developed countries andcountries in transition from socialism to democracy should develop reliable financial institution in order toachieve economic growth. He argues that countries should first improve their internal financial institutions
before opening to trade in goods. Rajan and Zingales (1998) find evidence that financial development
contributes positively to the economic growth. Kose, Prasad, Rogoff, and Wei (2006, 2009) provide excellent
surveys of the studies on the economic impacts of financial globalization.
2
Manova (2008b) and Chor and Manova (2009) find evidence that credit constraints are an important1

Oechslin (2010) also theoretically investigate the effect of international trade on exogenouslyheterogeneous firms within an industry and show that rich entrepreneurs win while poor ones
lose from opening to trade. Despite that these studies in the field of international trade reveal many important features and mechanisms that appear under financial imperfection, we
have yet to analyze many aspects of international trade and capital movement in the economy with imperfect financial institutions. Because financial imperfection is so pervasive,
it is important to re-establish the trade literature under the assumption that the financial
institution is not nearly perfect.
In this paper, we examine the impacts of trade and capital movement between the Northand the South under financial imperfection. We are especially interested in economic interaction between trade in goods and international capital movement. More specifically, we
examine how trade and capital movement affect the industry in individual countries withpossibly different qualities of financial institutions. We also allow countries to differ fromeach other in their wealth distributions (which can be considered as capital endowments
for now) in order to distinguish the effects caused by the difference in countries’ financial
development from those caused by a traditional difference in factor endowments.
The main result of the paper is that under financial imperfection, trade in goods andinternational capital movement are complements, rather than substitutes as in the case of
perfect financial institution, in the sense that when capital is perfectly mobile, trade in goods
will induce further capital movement and capital moves from the South to the North. Tradeand capital movement are substitutes, according to the traditional international trade theory
which assumes perfect financial institutions (Mundell 1957 and Krugman 1979). But we findthat they are complements under financial imperfection. Together with the observation(which is theoretically confirmed in this paper) that capital account liberalization by bothcountries induces capital flight from the South if countries are different in the quality offinancial institution (which is known as Lucas Paradox, Lucas 1990), trade liberalization
amplifies the capital flight under financial imperfection according to our result. This result
determinant of international trade flows.

2

is important because it is suggestive to policy makers in the South who attempt to assess the
economic impacts of liberalizing trade and capital account; they may naturally reconsider
opening to trade and international capital movement if they know our result.
Antràs and Caballero (2009) also theoretically examine the complementarity between
international trade in goods and capital movement under financial imperfection. They showamong others that trade in goods and capital movement are complements in the sense that
trade in goods induces capital to flow into a financially-less-developed country (i.e., theSouth). We share the complementarity result with them. But there is an important difference: they predict that trade in goods induces capital to flow into the South while we predict
the opposite direction of international capital flow. This difference is obviously important
especially for policy makers in the South. The key to the complementarity in the framework of Antràs and Caballero (2009) is that trade induces the South to specialize in thefinancially-unconstrained industry so that labor employed disproportionately in that sector
depresses (compared to the North) the wage rate in the South and raises the rental rate ofcapital that is mobile across countries. This traditional, general-equilibrium mechanism ofspecialization causes the complementarity between trade and capital inflow (to the South).
Trade and capital outflow (from the South) are complements in our model, on the other hand,because trade benefits firms in the financially-dependent industry in the North and harms
those in the South (the positive market expansion effect outweighs the negative competition
enhancement effect for firms in the North but not for firms in the South) so that trade pushes
up the interest rate (or rental rate) in the North but pushes down that in the South. Thatis, the key to our complementarity is the competition effect in the industry. Our competition
effect is relevant and important especially for contemporary trade because the proportion of
intra-industry trade to inter-industry trade is higher than ever before.3 In addition, our analysis applies better to trade among developed countries and emerging-market economies since
they tend to trade manufactures whose production operation depends heavily on externalfinance.
3
Our result can be considered to be in contrast to Krugman’s (1979) substitutability result, just as Antràs
and Caballero’s (2009) complementarity is in contrast to Mundell’s (1957) substitutability result.

3

Our study here is also related to the one in the companion paper (Furusawa and Yanagawa2012), which investigates the impacts of trade and capital-account liberalization on the
productivity distribution of the industry that depends on external finance. The main purposeof the companion paper is to explore the relationship between the financial development andfirm heterogeneity in their productivity (which is absent in this paper) and to show that
trade and capital-account liberalization leads to the global convergence in the productivity
distribution in. This paper, on the other hand, examines the substitutability between tradein goods and international capital movement, a traditional and fundamental question ininternational trade.
After setting out the model in the next section, we briefly examine trade equilibrium whenfinancial institution is perfect, and confirm that trade and capital movement are (almost)perfect substitutes. Section 4, which is the main section of the paper, examines the economy
with imperfect financial institutions. We first show that trade in goods alone will not affectthe size of the industry in either country and that capital movement, on the other hand,makes a significant impact on the industry. Finally in this section, we show that under perfectcapital mobility, trade induces capital movement from the South to the North, affecting thesize of the industry in both countries; trade affects the size of the industry in either country
only when it is accompanied by international capital movement.
Section 5 considers the possibility of foreign direct investment (FDI). We investigate FDI
flows between two countries with different financial development, and find that reciprocal
FDI may arise in such situations. On one hand, FDI from a (relatively) financially-developed
country (the North) to a financially-less-developed country (the South) arises since firms in
the North, which locally finance part of their FDI projects, attempt to exploit interest rate
differential. On the other hand, there also exists FDI from the South to the North aiming
to overcome financial constraints. Ju and Wei (2010) also establish a theoretical model thatreveals a mechanism of two-way capital flow. In their model, financial capital flows fromthe financially-less-developed South to the North, while FDI from the North in which the
expected return from the investment is low (due to the capital abundance) to the South.

4Unlike their model, ours naturally spotlights overcoming financial constraints as the main
motive for FDIs. Indeed, if both international portfolio investment and FDI are allowed in
our model, both financial and FDI-oriented capital move from the South to the North, which
is obviously different from their prediction. Southern firms’ FDIs driven by the motive ofovercoming financial constraints have not been stressed in the literature, but will become
practically important as more and more southern firms become competitive in the world
market.

2

Model

There are two countries, which we call North (N ) and South (S). In country k ∈ {N, S},
there is a mass mk of individuals; we normalize the population such that mN + mS = 1.
Each individual owns one unit of labor and a wealth of ω that is distributed according to the
cumulative distribution of Fk . The wealth distribution in North has first order stochastic
dominance over that in South, i.e., FN (ω) < FS (ω) for any ω, if the distributions are different
between the countries at all. All individuals share the same utility function over the twogoods, a differentiated good X and a numeraire good Y , which is characterized byu = log ux + y,
where
Z

ux =

σ−1

x(i) σ di

 σ

σ−1

; σ > 1,(1)

Ωkdenotes the subutility derived from the consumption of continuum varieties of good X,{x(i)}i∈Ωk (where Ωk denotes the set of all varieties available in country k), and y denotes
the consumption level of good Y . The numeraire good is competitively produced such that
one unit of labor produces one unit of the good, so the wage rate equals one.
Each individual chooses a consumption profile of good X to maximize ux subject toRΩk p(i)x(i)di ≤ E, where p(i) and E denote the price for variety i and the total expenditureon all varieties of good X, respectively. It is immediate to obtain x(i) = p(i)−σ E/Pk1−σ ,where Pk ≡

hR

1−σ
di
Ωk p(i)i 11−σdenotes the price index of good X. We substitute this result
5into (1) to obtain ux = E/Pk , so that an individual’s utility function can be written as
u = log E − log Pk + y. Maximizing the utility with the constraint E + y ≤ I, where I denotethe individual’s income (which is the sum of her labor income and the investment returnfrom her wealth), we obtain E = 1. That is, each individual spends E = 1 on good X, so
the country k’s aggregate expenditure on good X is mk .
The differentiated-good industry is characterized by the monopolistic competition withfree entry and free exit. When a firm enters, however, it incurs an R&D (or setup) investmentof g units of labor (or the numeraire good Y ). Each entrepreneur needs to raise capital ofg to finance this investment before the operation. Since there is a continuum of varieties,
each firm naturally ignores the impact of its pricing on the price index, so that firms selectprices that are σ/(σ − 1) times their individual marginal costs of c. Let nk denote the massof firms in country k. Then, it is easy to see that the profits for firm i in country k equal
πk = mk /σnk .

(2)

Individuals in country k decide whether or not they become entrepreneurs who can borrowmoney at a gross interest rate of Rk to finance their investments if necessary. If she decides
not to be an entrepreneur or if part of her wealth is left after the investment for her firm,
she will lend out her (remaining) wealth.
The critical feature of the model is that entrepreneurs are faced with a financial constraint.
We assume that entrepreneurs in country k can only pledge themselves to repay only afraction θk ∈ (0, 1] of the profits that they will earn, and hence entrepreneur i in country
k can borrow only up to the amount such that the repayment does not exceed θk πk . The
fraction θk represents the quality of the financial institution of the country. (Matsuyama
2000, for example, adopts this formulation of financial imperfection.4 ) A financial institution
is perfect if θk = 1; any entrepreneur with any wealth level can finance the investment
effectively without any constraint. A financial institution is imperfect if θk < 1; individuals
with small amounts of wealth may not be able to finance the investment in this case. We
4Matsuyama (2007) describes various economic implications of the credit market imperfection of this
type.

6

assume, without loss of generality, that θN ≥ θS .
We can list several reasons why θ (from which we drop the subscript k for the following
general argument) can be smaller than one. A natural cause of financial imperfection is theimperfection of legal enforcement.5 If the legal enforcement is perfect, as assumed in the
traditional literature, a court can enforce a borrowing contract as long as the repayment
under the contract does not exceed the profit from the project, which is denoted by π.
Empirical evidences show, however, the enforcement power is not perfect (La Porta, et al.,1998). Thus, in reality, a court may be able to force a borrower to pay only up to a fractionof the profits, i.e., θπ where θ < 1, even though the realized profit is π. Hence, unlessthe non-pecuniary penalty for the default is large enough, the borrower is likely to refuse
to pay more than θπ even if the promised payment exceeds this amount. This behavior iscalled the “strategic default.” A contract cannot be a perfect commitment device if the legal
enforcement is imperfect; it is difficult for a lender to expect that a borrower will sincerely
make the promised payment. Given that, lenders will not lend more than the amount suchthat the return from the lending equals θπ. Another cause of financial imperfection is theagency problem of the lender-borrower relationship, which is explained briefly in a simple
model in the Appendix.
In the economy that we consider, there are two types of the constraints that must be satisfied: the profitability constraint and the borrowing constraint. The profitability constraint(PC) πk − Rk g ≥ 0(3)

simply means that the net profits must be non-negative. The borrowing constraint, on theother hand, can be written as(BC) θk πk ≥ Rk (g − ω),(4)which mean that in country k, an entrepreneur with the wealth of ω can borrow money only
up to the amount such that the repayment does not exceed the fraction θk of the profits. It
is easy to see that the profitability constraint is tighter than the borrowing constraint if θk5

See for example Hart(1995).

7

is large, whereas the borrowing constraint is tighter if θk is small. The borrowing constraint
tends to be tighter for entrepreneurs with a small amount of wealth.
We investigate the effects of trade and international capital movement under an imperfectfinancial institution on the economy and establish the main result that trade and international capital movements are complement and only if the financial institution is not perfect.
To this end, we first analyze the case in which the financial institution is perfect.
We also emphasize here that the numeraire good is always tradable in all cases that we
consider, so “opening to trade in goods” here means opening to trade in the differentiatedgood as well as the numeraire good. We need this assumption in order to meaningfully
analyze the effect of capital movement. In this static model, the balance-of-payment consideration requires some goods be traded in order for capital to flow from one country to theother.

3

Equilibrium under a perfect financial institution

This section shows that if there is no financial constraint, trade in goods and international
capital movement will be substitutes in a sense that is made clear shortly. The constraintthat binds is the profitability constraint (3) because θk = 1 for k = N, S.
Let us begin with deriving the autarkic equilibrium. The equilibrium is characterized by
the capital market clearing condition and the profitability constraint.
Capital demands must be equal to capital supplies in each country k in autarky. Thatis, the total capital demands nk g must be equal to the total capital supplies mk ω̄k , where
ω̄ ≡

R∞
0

ωdFk (ω) denotes the average wealth of individuals in country k. It is immediatethat the equilibrium mass of firms is given bynk =mk ω̄k.
g(5)

We assume that ω̄k < g so that nk < mk .
Having derived the equilibrium mass of firms, we can now derive the equilibrium grossinterest rate. It follows from (2) and (5) that the profits are πk = g/σ ω̄k . Then, we have8from (PC), expressed in (3), that
Rk =

1
.
σ ω̄k

(6)

As expected, the gross interest rate is smaller in the capital-abundant country N if FN < FS
(so that ω̄N > ω̄S ). The capital-abundant country will have a greater mass of firms per
capita, which makes their profits smaller. The gross interest rate is also smaller than thecapital-scarce country because capital demands are relatively weak as a result.
Note that the decision as to whether or not an individual becomes an entrepreneur does
not depend on her wealth. This means that despite that the number of entrepreneurs isunambiguously determined, who become entrepreneurs is indeterminate. But if we supposethat only the wealthiest individuals become entrepreneurs, the wealth level of the poorest
entrepreneur ωk∗ must satisfy nk = mk [1 − Fk (ωk∗ )], which we rewrite asω̄k = g[1 − Fk (ωk∗ )],(7)

using the relationship given in (5).
Now, we turn to the examination of free trade, still assuming that there is no international
capital movement. We will show that the gross interest rates are the same between the twocountries, so free trade will eliminate the incentive for capital to move internationally.
In free trade, all firms compete in a level field regardless of their nationality, so eachfirm’s profits become πw = 1/σ(nN + nS ), where we have used mN + mS = 1. Individual
country’s capital market clearing condition still determines the mass of firms in each country
as in (5). Consequently, we can write the profits as
πw =

g
.
σ(mN ω̄N + mS ω̄S )(8)Then, it follows from (3) that
RN = RS =1.
σ(mN ω̄N + mS ω̄S )(9)

As (9) indicates, trade and capital movement are substitute in the sense that free tradeeliminates the interest rate differential between the countries.
9If capital is mobile between the two countries while goods are not, on the other hand, theinterest rates are equalized (i.e., RN = RS ≡ Rw ). Then, it follows from (3) that πN = πS
and hence mN /nN = mS /nS ; the profits are equalized between the countries as capital
movement will equate the mass of firms per capita.
Capital moves from the capital-abundant country to the capital-scarce country as the
traditional trade theory predicts. Let K denote the amount of capital that flows from North
to South. (It takes a negative value if capital moves from South to North.) Then, we
can write the capital market clearing condition in each country as nN g = mN ω̄N − K andnS g = mS ω̄S + K. We solve these equations for nN and nS , respectively, to obtainnN = (mN ω̄N − K)/g,(10)nS = (mS ω̄S + K)/g,(11)

and substitute them to πN = πS with the use of (2) to get the equilibrium capital flow from
North:
K = mN mS (ω̄N − ω̄S ).

(12)

Capital moves out of North to South if and only if ω̄N > ω̄S .
The profits and the gross interest rate are also the same in equilibrium as those in thefree trade equilibrium without capital mobility. Substituting the equilibrium capital flow
given in (12) to the expressions in (10) and (11), we obtainnN = mN [mN ω̄N + mS ω̄S ]/g,nS = mS [mN ω̄N + mS ω̄S ]/g.
Then, we find from (2) that the profits for any firm in any country are the same as those infree trade, given by (8), and so is the equilibrium interest rate, given by (9).
It is interesting that the equilibrium profits under capital movement are the same as
those under free trade in goods. Trade in goods effectively expands the market for firms in
North and shrinks the market for firms in South, which increases the profits for the firms in
North and decreases those in South. Capital movement (without trade), on the other hand,10decreases the mass of firms in North while increases the mass of firms in South, and thereby
changes their profits accordingly. Trade induces a net flow of the good from North to South,
while capital movement induces a flow of firms themselves from North to South. The profits
for the firms in North increase while those in South decrease as a result in both cases.
Proposition 1 Under a perfect financial institution, trade in goods and international capital movement are perfect substitutes in the sense that (i) trade will equalize the two countries’interest rates, eliminating an incentive for capital to move internationally, (ii) capital movement will also equalize the interest rate at the same level as the equilibrium interest rate infree trade, and (iii) the profits are equalized between the two countries at a common level ineither of the two regimes.
Although some important economic variables, such as the profits and interest rates, arethe same between the two regimes, consumers can enjoy more varieties in the case of free tradein goods than in the case of free capital mobility, as trade allows consumers in either country
to consume varieties produced in the foreign country as well as those produced domestically.
Trade in goods and capital movement are perfect substitutes from the perspective of the
production side of the economy. But trade in goods is a better alternative than capital
movement when the consumption side is taken into account.

4

Equilibrium under an imperfect financial institution

We have shown that under a perfect financial institution, an individual’s wealth is irrelevantin her decision as to whether or not she becomes an entrepreneur. As expected, individual’s
wealth will be an important factor under financial imperfection. Due to a financial constraint,
only wealthy individuals can borrow enough money to finance a project. We show in thissection that trade and capital movement are complement unlike in the case of a perfectfinancial institution where they are substitutes.
For the rest of the analysis, we focus on the case in which θk is small such that theborrowing constraint, given in (4), holds with equality, while profitability constraints, given11in (3), holds with strict inequality. If θk is small enough that the borrowing constraint isbinding, wealthiest individuals become entrepreneurs and the poorer individuals lend out
their wealth. We define a critical level of wealth, ωk , such that all individuals with ω ≥ ωkbecome entrepreneurs.
At the critical value of θk as to which constraint is the one that binds in equilibrium,
both (3) and (4) hold with equality at the threshold value ωk = ωk∗ , so we obtain the criticalvalue θ̂ = 1 − (ωk∗ /g). In this section, we focus on the case in which θk < θ̂ for k = N, S, sothat the relevant constraint is the binding (BC), which we write here as
Rk =

θk πk
.
g − ωk(13)

After we derive the autarkic equilibrium in the first subsection, we will turn to theanalysis of free trade without international capital mobility and that of the case of perfectinternational capital mobility in the absence of trade in the subsequent sections. We willshow that trade and international capital movement are complement in the sense that under
perfect capital mobility trade will induce further capital movement from South to North.

4.1

Autarkic Equilibrium

Since the profits for the firms are determined by the mass of firms, which is in turn determinedby the capital market clearing condition, the profits for the firms in this case are the same as
those under perfect financial institution. The mass of firms is given by (5) and the threshold
wealth for being an entrepreneur is characterized by (7). Then, it follows from (2) that the
profits are πk = g/σ ω̄k , which is the same as in autarky.
The equilibrium gross interest rate, however, is different from that under perfect financial
institution, since (BC), rather than (PC), determines the rate here. It is easy to see from(13) that the autarkic equilibrium interest rate is
Rk =

θk g
.
σ ω̄k (g − ωk∗ )(14)

As (14) indicates, any change in θk will induce offsetting change in Rk . In partial equilibrium analyses, financial development generally induces firms to enter the market because it
12becomes easier for entrepreneurs to finance the investment costs. But this seemingly obvious
causality breaks down in this general equilibrium model. The size of the industry hinges
critically on the total credit supply that is fixed in the autarkic economy. That is why financial development would increase the interest rate to offset enhanced demands in the credit
market.
Lemma 1 Under financial imperfection (such that both borrowing constraint (4) is binding),
financial development would only raise the interest rate, leaving the size of the industry
unchanged.
Which of RN and RS is greater than the other is important because it will determine thedirection of capital movement when capital is internationally mobile. We examine this issue
in two cases. The first case is that θN = θS but FN < FS . This case can be considered as the
traditional case because the countries are different in their factor endowments. The secondcase is that θN > θS while FN = FS . In this case, countries are different in their qualities offinancial institution.
If θN = θS but FN < FS , the question is reduced to the relative size of ω̄k (g −ωk∗ ) betweenm> ωSm , for example,
the two countries. If Fk is a uniform distribution on [0, ωkm ] such that ωN∗) > ω̄S (g − ωS∗ ). Then, it follows that RN < RS . But in general, whether
we have ω̄N (g − ωN

RN is smaller than RS depends on the specific shape of the distribution function of ω.
∗
If θN > θS and FN = FS , then ω̄N (g − ωN
) = ω̄S (g − ωS∗ ) and hence RN > RS . Under

imperfect financial institution, some (potential) entrepreneurs would not be able to borrowmoney merely because of the borrowing constraints; the poorer the financial institution,
the lower the effective capital demands. Consequently, the gross interest rate is smaller infinancially less-developed South.

4.2

Equilibrium with Free Trade in Goods

In this subsection, we show that opening to trade induces intra-industry trade so that consumers enjoy an increase in variety of the good, but it does not affect the size of the industry

13

in either country. Trade in goods, however, will lead to an increase in the interest rate inNorth and a decrease in that in South if the two countries differ in their capital endowments.
As in autarky, the capital market clearing condition gives us ωk = ωk∗ and nk = mk ω̄k /g.
That is, opening to trade will not affect the size of the industry in either country. But the
profits will change in general as expected. The effect of opening to trade is the same as in
the case of perfect financial institution, so the equilibrium profits are given by (8) for every
firm in either country. Then, the gross interest rate is determined by (BC), which is givenin (13):
Rk =

θk g
.
σ(mN ω̄N + mS ω̄S )(g − ωk∗ )If θN = θS but FN < FS , then ω̄S < ω̄N so that ω̄S < mN ω̄N + mS ω̄S < ω̄N . Therefore,
the profits for the firms in North increase while those for the firms in South decrease as aresult of trade liberalization. Then, it follows from (13) that trade liberalization leads to arise in RN and a fall in RS .
If θN > θS and FN = FS , trade liberalization does not change the profits for the firms nor
the gross interest rate in either country. If FN = FS , then ω̄N = ω̄S = mN ω̄N + mS ω̄S . An
increase in market competitiveness completely offsets the positive effect of market expansion.
Trade liberalization will not change the profits, so that the interest rates stay the same asneither profits nor the threshold wealth level change as a result of trade (see (13)).

4.3

Equilibrium with International Capital Movement

Since the interest rates are different in general between the two countries, capital moves
internationally if it is sufficiently mobile. In this section, we consider the case in which
capital is perfectly mobile between the countries and show that in equilibrium, the profits
are smaller for the firms in North than those in South. This difference in equilibrium profitsis the key to the complementarity between trade in goods and capital movement.
Interest rate differential between the countries in autarky induces international capital
movement, which changes the size of the industry in each country and hence the profits forthe firms through the changes in the market competitiveness. We use nk = mk [1 − Fk (ωk )]14

to write the profits as
1,
σ[1 − FN (ωN )]1πS =.
σ[1 − FS (ωS )]

πN =

(15)
(16)

Perfect capital mobility will equate the interest rates between the countries, so we have from(13) that
θNθS= Rw =.
σ[1 − FN (ωN )](g − ωN )σ[1 − FS (ωS )](g − ωS )(17)

If θN = θS and FN < FS , it follows from (17) that
[1 − FN (ωN )](g − ωN ) = [1 − FS (ωS )](g − ωS ).

(18)

Suppose temporarily that ωN = ωS . Then, our assumption of stochastic dominance implies
that FN (ωN ) < FS (ωS ) and hence the left-hand side of (18) is greater than the right-handside. To restore the equality, therefore, it must be the case that ωN > ωS and hence
1 − FN (ωN ) > 1 − FS (ωS ). This result immediately implies from (15) and (16) that πN < πS .
Because the proportion of rich individuals is greater in North than in South, the threshold
wealth for being an entrepreneur is greater in North. Then the profits in North must be
smaller than those in South in equilibrium with a common interest rate, for the thresholdentrepreneurs in North who have the higher wealth than those in South to find the borrowing
constraint to be biding.
If θN > θS and FN = FS , on the other hand, RN > RS in autarky so that capital flows
out of South. Thus, in equilibrium, ωN < ωS since they were the same in autarky. This
also implies 1 − FN (ωN ) > 1 − FS (ωS ) (note that FN = FS ), and hence πN < πS . North
attract capital because of the interest rate differential caused by the difference in the qualityof financial institution. Consequently, the market in North becomes more competitive thanthat in South.
Proposition 2 International capital movement will equate the interest rates between thetwo countries, but leave the profits differential between the firms in North and those in Southsuch that the profits are smaller in North than in South.
15

4.4

Equilibrium with Trade in Goods and Capital Movement

We have seen that the profits for the firms in North are smaller than those in South in theequilibrium with international capital movement. Thus, if trade is allowed (in addition tocapital movement) so that all firms compete in a level field, the profits rise in North anddrop in South, which will induce further capital movement and capital moves from South toNorth.
To see this more formally, we first note that the profits for any firm are the same as in
the case of free trade with no capital movement since the total mass of firms in the world
would not be affected by capital movement; the profits are given in (8). Then, it follows
from (BC) and equality of the interest rates between the countries that
θN g
θS g
= Rw =,σ(mN ω̄N + mS ω̄S )(g − ωN )σ(mN ω̄N + mS ω̄S )(g − ωS )and hence
θNθS=.
g − ωNg − ωS(19)

If θN = θS and FN < FS , it immediately follows from (19) that ωN = ωS . But there
are more firms in North than in South because 1 − FN (ωN ) > 1 − FS (ωS ) when ωN = ωS .
Recall that in this case, ωN > ωS in the equilibrium under perfect capital mobility without
international trade in goods. Thus, we find that capital moves out of South to North when
trade in goods is allowed in addition to capital movement. Figure 1 shows threshold wealthlevels in the two countries in every case that we have examined (the figure depicts the casein which the ranking of the thresholds accords with the case of the uniform distributionof wealth); Superscripts A, T , K, and KT are used to indicate the corresponding cases ofautarky, trade equilibrium, equilibrium with capital movement, and equilibrium with capital
movement and trade in goods, respectively. Figure 1 shows that trade in goods affects thethreshold wealth only when it is accompanied by international capital movement.
Next, we consider the case in which θN > θS and FN = FS . Recall that in the case of
perfect capital mobility without trade in goods, (17) holds with ωN < ωS , which implies
1 − FN (ωN ) > 1 − FS (ωS ). This means that compared with the threshold values in the case16

of perfect capital mobility without trade, ωN must be smaller and ωS must be greater for(19) to be satisfied. That is, trade induce further capital outflow from South to North. All
the thresholds in the case that θN > θS and FN = FS are shown in Figure 2; trade in goods
affect the threshold wealth only when it is accompanied by international capital movement
also in this case.
Proposition 3 Trade in goods and capital movement are complement such that trade ingoods induces further capital movement when capital has been mobile internationally. Trade
induces capital flight from South, expanding Northern industry and shrinking Southern.
International capital movement alone is not sufficient to equalize firms’ profits between
North and South; the market in the capital-abundant or financially-developed North is morecompetitive than the one in South. Opening to trade allows the firms in North to penetrate
the less-competitive market in South and induces the firms in South to penetrate the morecompetitive market in North, raising the profits for the firms in North while lowering thosein South. That is why opening to trade when capital has been internationally mobile induces
additional capital movement and capital moves from South to North. Proposition 3, which
expresses this complementarity of trade and capital movement, is the core result of the paper.

5

Foreign Direct Investment under Financial Imperfection

We have shown how financial imperfection affects international capital movement and theresulting adjustment of the industry. The type of capital movement that we have consideredis portfolio investment such that capital moves to the country in which borrowers utilize thecapital to establish their firms. In this section, we consider foreign direct investment (FDI)
such that it is entrepreneurs that move from one country to the other where they borrowmoney and invest to produce the good. We assume that goods are freely traded in thissection, so whether entrepreneurs themselves move from the FDI source country to the hostcountry or only their operations are relocated is not an issue.
17

FDI naturally arises if trade is prohibited. In such cases, entrepreneurs in the country
with a more-competitive market have an incentive to locate their firms in the foreign country
with a less-competitive market. Here, we consider a situation in which such incentives do notexist. We consider a free-trade situation in which profits are the same for all firms regardlessof their locations. To derive a sharp result, we also assume that FN = FS . We show that evenin such situations, some firms engage in FDI. Indeed, we find that two types of FDI co-exist
in equilibrium: one that firms engage in FDI to exploit interest rate differential between
the two countries, and the other that firms invest in the foreign country to overcome theirborrowing constraints. Under financial imperfection, reciprocal FDI arises: firms in North
invest in South to exploit interest rate differential whereas firms in South invest in North toovercome borrowing constraints.
Recall that in free trade, the interest rate is higher in North than in South, i.e., RN > RS ,reflecting the difference in financial development between the two countries, i.e., θN > θS . If
FDI is allowed, therefore, some firms in North invest in South, financing the investment at
smaller costs. Consequently, the interest rate tends to decrease in North and rise in South,
such that they become equal at the world interest rate, Rw in equilibrium with trade and
FDI. Faced with the same interest rate, some individuals in South are credit-constrained in
the South, but not in North, since the borrowing constraint is tighter in South; we have
ωN < ωS and hence all individuals with ω ∈ [ωN , ωS ) in South will invest in North toovercome their borrowing constraint for becoming entrepreneurs.
In the equilibrium with free trade and FDI, both the profits for the firms and the grossinterest rates must be the same between the two countries just as in the case of free tradeand perfect capital mobility. That is, we have the same relationship as shown in (19). Then,it follows from θN > θS that ωN < ωS , again just as in the case of free trade and perfectcapital mobility.
But an important difference is that in this case, the potential entrepreneurs in South,
whose wealth is less than ωS but is greater than or equal to ωN , have an incentive to moveto North to establish their firms. Indeed, as indicated in Figure 3, all entrepreneurs in South18

with ω ∈ [ωN , ωS ) move to North, since they can only run a business in North. At the sametime, some (and not necessarily all) entrepreneurs in North with ω ∈ [ωS , g) move to South,
contributing to the interest rate parity between the two countries.
We record these findings as the final proposition.
Proposition 4 Reciprocal FDI will arise even when the countries engage in free trade.
Firms in North engage in FDI to exploit interest rate differential, while firms in South
engage in FDI to overcome financial constraint.
If international portfolio investment is allowed in addition to trade and FDI, capital
may move from South to North in the form of portfolio investment, replacing the FDI from
North to South. Just as northern firms’ FDI, financial capital movement from South toNorth achieves the interest rate parity. In this case, capital moves out of South in the formsof both portfolio investment and FDI.

6

Concluding Remarks

We have examined the impact of international trade in goods and capital movement between
two countries. We have found that (i) trade in goods alone will not affect the size of theindustry in either country, (ii) capital tends to move from a country with a poorer financial
institution to the other, shrinking the industry in the source country and expanding theindustry in the host country, (iii) trade in goods affects the size of the industry in eachcountry only when it is accompanied by capital movement, (iv) when capital is also allowed
to move, trade in goods itself induces capital movement from South to North, and (v)reciprocal FDI arises even in free trade.
These findings regarding the impacts of financial imperfection on the differentiated-good
sector that depends on external finance (which can be thought of as a manufacture industry)
are in general quite different from the conventional wisdom in international trade theory
without any consideration of financial imperfection. Since no country has a perfect financial
institution in practice, it is important to know how the traditional theories should be modified
when we incorporate financial imperfection into the models.
19

This paper is one of the first attempts to investigate interactions between financial development and international trade. We have shown that trade in goods and international
capital movement are complements under financial imperfection such that trade induces capital flight from the South. There remain many important results in the trade literature yet
to be challenged in the environment of imperfect financial institutions.

20

Appendix
A

A Cause of Financial Imperfection

Here, we present a simple model to justify an imperfect financial institution. This model
setting is a simplified version of Tirole’s (2006).
Let us consider the situation in which an agent tries to borrow g from a lender to financea profitable project. This project potentially generates profits of π(> Rg) where R is theexogenous (gross) interest rate. In order to complete the project successfully with a highprobability, however, the agent must exert effort, which is unobservable to the lender. If
the agent exerts effort, the project generates π with the probability 1. If the agent shirks,
one the other hand, the project generates π with the probability pL (< 1) and 0 with theprobability 1 − pL . By shirking, however, the agent can get non-pecuniary benefits bπ, where0 < b < 1.
The agent unambiguously shirks if the entire π goes to the lender. In order to induce
the agent to exert effort, therefore, the lender must abandon some of π, giving a contingent
reward w to the agent; the reward is given to the agent if and only if the project has
successfully generated π. The reward w should satisfy the incentive condition, w ≥ pL w +bπ,
where the left-hand side is the agent’s payoff when she exerts effort, while the right-hand sideis her expected payoff when she shirks. We assume that negative rewards (i.e., penalties) are
not allowed perhaps because the asset held by the agent is limited. This incentive condition
can be written asw≥bπ.
1 − pLThe lender expects to obtain at most [1 − (b/(1 − pL ))]π if he induces the agent to exert
effort. Alternatively, he may set w = 0 so that he obtains the expected payoff of pL π.
Consequently, the lender obtains the returns at most θπ, where()

bθ ≡ max 1 −, pL .
1 − pL
Obviously, the lender will not lend g if Rg exceeds θπ. Note that if pL is small enough, θ is21

equal to 1 − (b/(1 − pL )). Under a developed financial institution with a solid legal system,
non-pecuniary benefits tend to be small. The parameter θ can be considered to represent
the quality of a financial institution because θ increases as b diminishes.

22

References
Antràs, Pol and Ricardo J. Caballero (2009), “Trade and Capital Flows: A Financial
Frictions Perspective,” Journal of Political Economy, 117, 701-744.
Beck, Thorsten (2002), “Financial Development and International Trade: Is There a Link?”
Journal of International Economics, 57, 107-131.
Chaney, Thomas (2005), “Liquidity Constrained Exporters,” unpublished manuscript, University of Chicago.
Chinn, Menzie D. and Hiro Ito (2006), “What Matters for Financial Development? Capital
Controls, Institutions, and Interactions,” Journal of Development Economics, 81, 163192.
Chor, Davin and Kalina Manova (2009), “Off the Cliff and Back? Credit Conditions and International Trade During the Global Financial Crisis,” unpublished manuscript, Stanford University.
Do, Quy-Toan and Andrei A. Levchenko (2007), “Comparative Advantage, Demand forExternal Finance, and Financial Development,” Journal of Financial Economics, 86,
796-834.
Foellmi, Reto and Manuel Oechslin (2010), “Market Imperfections, Wealth Inequality, andthe Distribution of Trade Gains,” Journal of International Economics, 81, 15-25.
Furusawa, Taiji and Noriyuki Yanagawa (2012), “Globalization under Financial Imperfection,” unpublished manuscript, Hitotsubashi University.
Hart, Oliver (1995), Firms, Contracts, and Financial Structure, Oxford University Press,
Oxford.
Henry, Peter Blair (2007), “Capital Account Liberalization: Theory, Evidence, and Specialization,” Journal of Economic Literature, 45, 887-935.
Ju, Jiandong and Shang-Jin Wei (2008), “When is Quality of Financial System a Source ofComparative Advantage?” NBER Working Paper 13984.
Ju, Jiandong and Shang-Jin Wei (2010), “Domestic Institutions and the Bypass Effect ofInternational Capital Flow,” American Economic Journal: Economic Policy, 2, 173204.
Kletzer, Kenneth and Pranab Bardhan (1987), “Credit Markets and Patterns of International Trade,” Journal of Development Economics, 27, 57-70.

23Klein, Michael W. (2005), “Capital Account Liberalization, Institutional Quality and Economic Growth: Theory and Evidence,” NBER Working Paper 11112.
Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei (2006), “Financial
Globalization: A Reappraisal,” IMF Working Paper WP/06/189.
Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei (2009), “Financial
Globalization and Economic Policies,” CEPR Discussion Paper No. 7117.
Krugman, Paul R. (1979), “Increasing Returns, Monopolistic Competition, and International Trade,” Journal of International Economics, 9, 469-479.
La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny(1998), “Law and Finance,” Journal of Political Economy, 106, 1113-1155.
Levchenko, Andrei A. (2007), “Institutional Quality and International Trade,” Review of
Economic Studies, 74, 791-819.
Lucas, Robert E., Jr. (1990), “Why Doesn’t Capital Flow from Rich to Poor Countries?”
American Economic Review, 80, 92-96.
Manova, Kalina (2008a), “Credit Constraints, Heterogeneous Firms, and International
Trade,” NBER Working Paper 14531.
Manova, Kalina (2008b), “Credit Constraints, Equity Market Liberalizations and International Trade,” Journal of International Trade, 76, 33-47.
Matsuyama, Kiminori (2000), “Endogenous Inequality,” Review of Economic Studies, 67,743-759.
Matsuyama, Kiminori (2005), “Credit Market Imperfections and Patterns of International
Trade and Capital Flows,” Journal of the European Economic Association, 3, 714-723.
Matsuyama, Kiminori (2007), “Aggregate Implications of Credit Market Imperfections,”
NBER Macroeconomic Annual, 22, 1-69.
McKinnon, Ronald I. (1973), Money and Capital in Economic Development, Brookings
Institution, Washington, D.C.
McKinnon, Ronald I. (1993), The Order of Economic Liberalization: Financial Control in
the Transition to a Market Economy, Johns Hopkins University Press, Baltimore.
Mundell, Robert A. (1957), “International Trade and Factor Mobility,” American Economic
Review, 47, 321-335.
Rajan, Raghuram G. and Luigi Zingales (1998), “Financial Dependence and Growth,”
American Economic Review, 88, 559-586.
24

Rajan, Raghuram G. and Luigi Zingales (2003), “The Great Reversals: the Politics ofFinancial Development in the Twentieth Century,” Journal of Financial Economics,
69, 5-50.
Suwantaradon, Ruanjai (2008), “Financial Frictions and International Trade,” unpublished
Manuscript, Singapore Management University.
Tirole, Jean (2006), The Theory of Corporate Finance, Princeton University Press, Princeton.
Wyne, Jose (2005), “Wealth as a Determinant of Comparative Advantage,” American Economic Review, 95, 226-254.

25

NT
NKT

NA
SK



NK


KT
S

A
S

g



ST
Figure 1: Threshold wealth levels: Case where  N   S , FN  FS

NT
NKT

NK

NA
SA

SK

SKT

g

ST
Figure 2: Threshold wealth levels: Case where  N   S , FN  FS



N
S

Figure 3. Reciprocal FDI Flowsg