Greenaway et al. (2007) suggests that the stronger financial health of exporters can be seen as ‘an outcome rather than a determinant of entry’ into exporting.

The importance of analyzing the interaction of trade and domestic financial sector reforms can be illustrated by observed patterns of policy indicators or by the joint presence of both reforms in many of the policy packages implemented by developing and emerging economies.<sup>4</sup> As an example of the association between the two reforms, Figure 1 plots five-year averages for the trade and banking sector transition indicators for Central and Eastern European countries compiled by the European Bank for Reconstruction and Development (EBRD).<sup>5</sup> As expected, the levels of the two policy indicators are positively associated with the second panel highlighting the often contemporaneous progress on both trade and financial sector reforms.<sup>6</sup> In addition, reforms in one sector can take place at a range of initial values for policies in the other sector. Indeed, based on a new IMF dataset of de jure reform indicators covering a wider sample of 91 countries over the period 1973-2005, Hauner & Prati (2008) find that trade reforms tend to lead domestic financial reforms. Thus analysis of trade reforms assuming perfect credit markets would appear to be often inappropriate. Whilst summary indicators of policy stance are clearly not perfect, for example due to the lack of information on enforcement or their aggregate nature, the above patterns serve to highlight the empirical importance of analyzing the potential trade-offs and complementarities in the effects of trade and financial sector reforms. Such analysis can provide insights into the appropriate design of reform packages in individual countries and can also shed light on the political economy implications of combinations of reforms.

# **2.2 Related literature**

This work is related to three main strands of literature. The first concerns the reallocative effects of trade reforms in the presence of heterogeneous productivity firms as analyzed in a growing theoretical literature (see, for example, the theoretical models of Melitz, 2003; Baldwin & Forslid, 2006). In such models trade liberalization increases investment and the demand for labor. With a fixed labor supply this leads to a rise in the minimum productivity of producers, shifts production towards higher productivity firms and results in an increase in average productivity. This reallocative process is supported in empirical studies such as Bernard et al. (2006) in relation to the US, Pavcnik (2002) for Chile and Fernandes (2007) for Colombia.

The second strand of related literature concerns the reallocative effects of financial sector reforms. Theoretical models, such as Almeida & Wolfenzon (2005) and Caselli & Gennaioli (2006), illustrate how domestic financial development (for example, contract enforcement or investor protection) can promote aggregate productivity through reallocating resources

> 4See, for example, the chronology provided by Henry (2000) of reforms across 12 major emerging markets in the 1980s and early 1990s or the analysis of IMF programme conditionalities provided in IMF (2001).

> 5The transition indicators represent an assessment of a country’s policies and institutions in each area against specific criteria with scores assigned from 1 to 4.33 such that higher values indicate improvements in the policy areas towards the levels in advanced economies. Appendix A provides further details on the transition indicators and the sample coverage.

> 6As shown in Appendix Figure 12, similar associations are present when controlling for country and period fixed effects.

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