for external ...nance that comes from a country’s export pattern. We then use a comprehensive dataset on ...nancial development ...rst introduced by Beck, Demirguc-Kunt, and Levine (2000) to show that a country’s ...nancial development is strongly and robustly a¤ected by the external ...nance need of its exports. The e¤ect we ...nd is economically signi...cant. Our most conservative coe¢ cient estimates imply that moving from the 25th to the 75th percentile in the distribution of external ...nance need of exports is associated with an increase in ...nancial development of about 0.33 standard deviations, or a 12 percentage point increase in private credit to GDP.

A key feature of this paper is the way it addresses the simultaneity problem arising in this exercise. We require an instrument for a country’s export pattern. In order to construct it, we expand the geography-based methodology of Frankel and Romer (1999). These authors use the gravity model to predict bilateral trade volumes between each pair of countries based on a set of geographical variables, such as bilateral distance, common border, area, and population. Summing up across trading partners then yields, for each country, its “natural openness:”the overall trade to GDP as predicted by its geography. Because we need an instrument for trade patterns rather than total trade volumes, our point of departure is to estimate the Frankel and Romer gravity regressions in each industry. Following their methodology, we can then obtain the predicted trade volume as a share of GDP not just in each country, but also in each sector within each country.<sup>1</sup> Doing so allows us to construct each country’s predicted external ...nance need of exports, based on its predicted trade shares in each sector. We then use it as an instrument for the actual external ...nance need of exports. As a further extension of the Frankel and Romer approach, we perform this exercise for each ...ve-year period between 1970 and 1999, giving a time dimension to our instrument.

The model we use to illustrate our point has two sectors, one of which relies on external ...nance. The size of the ...nancial system, that is, the amount of borrowing and lending that occurs in the economy, is naturally a function of total output in the ...nancially intensive sector. An additional feature of our theoretical setup is that the quality of the ...nancial system is a function of its size. A larger ...nancial sector leads to the greater ease with which entrepreneurs are able to ful...ll the need for external ...nance. This is because when entrepreneurs start ...nancially intensive projects and engage the country’s ...nancial system, they add liquidity. They become potential providers of external ...nance for fellow entrepreneurs, reducing the likelihood of ...nancial distress. Each entrepreneur who invests in the ...nancially intensive sector hence generates a positive spillover by increasing ...nancial depth.<sup>2</sup> Opening to trade will a¤ect demand for external ...nance in both trading

> 1 This strategy is adapted from di Giovanni, Levchenko, and Ranciere (2005).

> 2 In modeling the market for external ...nance and the positive e¤ect of ...nancial system size on its quality, we abstract from the informational and enforcement frictions that are often invoked in this context. One can clearly adopt this approach as well, and think of the quality of the ...nancial system in terms of how well it can overcome

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