# **1 Introduction**

The efficient allocation of production across firms matters for aggregate total factor productivity (TFP). Distortions which shift resources from more to less productive firms can have a sizeable impact on TFP and hence on average output per worker and welfare. For example, it is estimated that removing such resource misallocations could increase TFP in China by 25-40% and in India by 50-60% (Hsieh & Klenow, 2007).<sup>1</sup> Improvements of such magnitudes are equivalent to substantial reductions in the relative productivity gaps compared to the US, moving relative TFP in both countries from around 40% to 60% of the US level (based on the 2004 aggregate TFP estimates of Jorgenson & Vu, 2007). Many of the wide-ranging structural reforms across developing and transition economies in recent decades have been focused on reducing distortions to the allocation of production. Although reforms to trade and domestic financial sectors are often both key elements of such policy packages, the respective related empirical and theoretical literatures have generally abstracted from the potentially important reallocative effects of contemporaneous reforms in the other sector. Thus, a fundamental policy question of how reforms interact in terms of their impact on aggregate productivity, wages and welfare cannot be addressed.

The objective of this paper is to develop a theoretical framework to analyze this issue through adding financial constraints to a two-country (non-symmetric) heterogeneous firm trade model. In order to do so I add a number of novel, empirically relevant, features to a baseline heterogeneous firm trade model adapted from Melitz (2003). The first is to consider intermediate production as owned and operated by heterogeneous entrepreneurs whose borrowing is subject to credit constraints due to agency problems. The second is to allow these agency problems to vary with the composition of the entrepreneur’s production between domestic output and exports. This introduces a two-way linkage between a firm’s export decision and its financial constraints as suggested by firm-level survey data. I then examine the steady state general equilibrium interactions of the reallocative impacts of trade and domestic financial sector reforms (considered as reductions in variable trade costs and relaxations in credit constraints respectively).

The interaction effects between trade reforms and domestic financial sector reforms appear qualitatively important. On the one hand, trade and domestic financial sector reforms can have complementary effects in increasing the average productivity and size of producing entrepreneurs. If entrepreneurs face less restrictive credit constraints as a result of financial sector reforms then investment can increase more in response to a lowering of variable export costs. With fixed factor supplies, a greater reallocation from low to high productivity entrepreneurs is thus required in order to maintain factor market equilibrium. As a result, the positive effects of trade liberalization on average productivity and producer size are enhanced if domestic financial sector reforms are more advanced. On the other hand, in such a case the marginal gains for wages and household utility as a result of trade liberalization are reduced. If credit constraints are less restrictive then effective borrowing costs are lower, intermediate prices are reduced and real wages

> 1These estimates are derived from a movement to ‘US efficiency’ based on the distribution of marginal products of capital for plants within sectors. In turn, in a model calibrated to US data, Restuccia & Rogerson (2007) find similar order aggregate TFP effects of distortions to prices faced by individual plants.

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