���� ��� ������������ ∗���������∑�� �∑�� ���� (2) Observations are at the level of country ( _c_ ) and sector<sup>17</sup> ( _s_ ). Following the literature, we average all available data across several years to focus on the cross-sector aspects of trade specialization (Beck. 2003; Hur, Raj, and Riyanto, 2006; and Svaleryd and Vlachos, 2005). The dependent variable �� is the sector’s share in total exports, characterizing trade specialization. Full country and 2-digit ISIC industry controls are included to allow for an examination of within effects. The variable ��� is the error term. The coefficient on the country-sector interaction term is of principle interest.

Estimated coefficient estimates can only be interpreted as correlations, since no attempts have been made to control for simultaneity or endogeneity. Reverse causality cannot be ruled out; the possibility that governance and financial sector development can also be a consequence of trade cannot be dismissed. Using the proper econometric techniques, the role of governance has been found to have significant impact on growth and not the other way around.<sup>18</sup> However, the directionality between trade and governance is less clear although some research finds that openness to trade creates positive spillovers that promote better governance.<sup>19</sup>

# <mark>Box 1.</mark> <u><mark>Country Endowments and Sector Dependencies, Predictions from Theory</mark></u>

The impact of the interaction between external finance dependence on trade specialization onto trade is expected to be _positive_ . Theoretically, Kletzer and Bardhan (1987) argue that countries with better developed financial sectors have higher exports from sectors that rely more on external financing, holding all else constant. If financial sector development reduces the costs of external finance to firms, then countries with more developed financial institutions will specialize in sectors that rely more on external finance. Comparative advantage through financing can be important for trade by facilitating risk diversification, providing finance to sectors in need, or allowing the acquisition of improved technology to enhance productivity.

The impact of the interaction between asset tangibility and trade specialization is expected to be _negative_ . The higher a sector’s level of asset tangibility the more it facilitates collateralization and liquidity in markets where default risks are high or when contract enforcement is weak (Braun, 2003). If higher asset tangibility facilitates lending when contract enforcement is weak or when default risk is high, then countries with a more (less) developed governance or financial sector institutions should have lower (higher) export shares in industries that use more tangible assets.

|��������|�������|Predicted Effect onto<br>Trade Specialization|
|---|---|---|
|Financial Sector Development|External Finance Dependence|+|
|Financial Sector Development|Asset Tangibility|-|
|Governance|AssetTangibility|-|

> 17 Specifically, industries are identified by the 2-digit harmonized systems product classification code (http://www.foreigntrade.com/reference/hscode.htm).

> 18 For example, see La Porta et al 1999; Rodrik, Subramanian, Trebbi, 2002

> 19 See Berg and Kruegter, 2003; Islam and Montenegro, 2002; Wei, 2000

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