**Figure 1:** EBRD transition indicators, 5 year averages: levels and changes

<!-- Start of picture text --> (a) Levels (b) Change compared to previous period<br>MNGALBMDAKGZKGZBGRALBGEOMDAARMKGZAZEMNGMNEMKDARMROUGEOMKDROUMKDHRVSVKALBBIHMDAUKRLTULVASVNCZEKAZBGRPOLLTUROUSVKEST S PL V HOH N AUNRVL CZE POLLTUBGRSVKESTLVACZE HUN ESTRV MDAARMKAZ KGZ ESTLVAROULTU<br>MNGTJK HUNARMKAZRUSUKRTJKAZEBIHRUSSRBKAZ MNGTJKGEOAZE MNEUKRSVKGEOBGRALBCZERUSPOLBIH SVNMKDHRV<br>MKDHRV SVNMNEUKRRUSSVKGEPCZE O L TJK SRBUZBMNGMNEAZE SRB HUN<br>M R STB OURBUSJKNEALBIH BLRBIHBGRSRBUZBESTUZBBLRAZE KGZMKDHU TKM SVUZBROUBLR N MKDAZEBLRARMPOLMDAKGZPOLALBLTUSVNUKRESTGEOBIHCZEARMKAZLVAROUALBMDALVASVKMNGBLRLTUCZESVKESTHUNHRVBGRRUSUKRKAZHRVBGRTJK<br>BIH<br>MNGLTU LVA<br>ARMKGZMDABLR UZB RUS UZB<br>KAZ<br>GM T S U ABT KM RKEOLJKNE ZBR E MNESRB<br>1 2 3 4 −.5 0 .5 1 1.5<br>Banking transition indicator Change in banking transition indicator<br>3<br>4<br>2<br>3<br>1<br>2<br>0<br>Trade and FX transition indicator<br>1 −1<br>Change in trade and FX transition indicator<br><!-- End of picture text --> Note: Values of the transition indicators range from 1 to 4.33 with higher values representing standards moving towards those of advanced industrial economies. Averages taken over 1989-1993, 1994-1998, 1999-2003 and 2004-2007 (four year average). Lines represent lowess smoother (locally weighted regression) with 95% confidence intervals.

to more productive firms.<sup>7</sup> From an empirical perspective the beneficial impacts of financial sector reforms on allocative efficiency are supported in studies such as Wurgler (2000), Galindo et al. (2007) and Abiad et al. (2007). For example, the latter paper finds domestic financial sector liberalization to be associated with an improvement in the efficiency of the allocation of production (indicated by a fall in the dispersion of Tobin’s q) in a sample of emerging economies.<sup>8</sup> The third strand of related literature concerns the impact of financial frictions on trade. This work builds on the analysis of Kletzer & Bardhan (1987) which provides one of the earliest theoretical papers to emphasize the impact of financial institutions on patterns of comparative advantage. Subsequent empirical papers, most recently using sector-level data, such as Beck (2003), Hur et al. (2006) and Manova (2006), support the view that financial frictions are an important determinant of trade flows. As the trade literature has moved towards heterogeneous firm models such as Melitz (2003) so a number of recent papers have used such frameworks to analyze the role of financial frictions in determining export patterns, for example Chaney (2005), Manova (2006) and Suwantaradon (2008).<sup>9</sup> Chor et al. (2007) extend this approach to consider how financial frictions in host economies affect exporting and foreign direct investment patterns within a three-country model. Whilst based on a similar broad modeling framework, this paper differs from these related papers in a number of important features. First, the focus

> 7Also, in the context of international financial sector reforms, Aoki et al. (2006) emphasize that the impact of capital account liberalization in shifting production across high and low productivity entrepreneurs is dependent on the development of the domestic financial sector.

> 8Abiad et al. (2007) also find that trade openness improves the allocation of production across firms but the issue of the interaction of the two reforms is not addressed.

> 9Suwantaradon (2008) highlights how financial frictions lead to selection into exporting and production based on both a firm’s net worth and productivity, compared to solely productivity in the standard Melitz set-up.

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