WPS3889

# Comparative Advantage, Demand for External Finance, * and Financial Development

Quy-Toan Do Andrei A. Levchenko The World Bank International Monetary Fund

### **Abstract**

The differences in the levels of financial development between advanced and developing countries are large and persistent. Theoretical and empirical literature has argued that these differences are the source of comparative advantage and could therefore shape trade patterns. This paper points out the reverse link: financial development is influenced by comparative advantage. We illustrate this idea using a model in which a country’s financial development is an equilibrium outcome of the economy’s productive structure: financial systems are more developed in countries with large financially intensive sectors. After trade opening demand for external finance, and therefore financial development, are higher in a country that specializes in financially intensive goods. By contrast, financial development is lower in countries that primarily export goods which don’t rely on external finance. We demonstrate this effect empirically using data on financial development and export patterns in a panel of 96 countries over the period 1970-99. Using trade data, we construct a summary measure of a country’s external finance need of exports, and relate it to the level of financial development. In order to overcome the simultaneity problem, we adopt a strategy in the spirit of Frankel and Romer (1999). We exploit sector-level bilateral trade data to construct, for each country and time period, a predicted value of external finance need of exports based on the estimated effect of geography variables on trade volumes across sectors. Our results indicate that financial development is an equilibrium outcome that depends strongly on a country’s trade pattern.

JEL Classification Codes: F02, F14, O16, O19.

Keywords: trade patterns, demand for external finance, financial development, gravity model.

## World Bank Policy Research Working Paper 3889, April 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._

> We are grateful to Daron Acemoglu, Abhijit Banerjee, Thorsten Beck, Olivier Blanchard, Simon Johnson, Aart Kraay, Roberto Rigobon, Alan Winters and workshop participants at MIT and the World Bank for helpful comments. The views expressed in this paper are those of the authors and should not be attributed to the International Monetary Fund, the World Bank, their Executive Boards, or their respective managements. Correspondence: International Monetary Fund, 700 19th St. NW, Washington, DC 20431. Email: qdo@worldbank.org; alevchenko@imf.org.