Seminario CEDE - David Pérez-Reyna

We analyze the interaction of financial development and trade in a small open economy. In a benchmark economy with full financial development, there is no misallocation. When financial development is imperfect, access to borrowing in local currency is expensive. This causes misallocation to arise among the most productive firms. Productive firms with small initial capital access the international credit market by paying a fixed cost. By borrowing in foreign currency, they scale up close to their benchmark size. Larger firms borrow from domestic credit markets and are smaller than their benchmark counterparts. More expensive borrowing hinders firms to pay the fixed cost to export. Therefore, lower financial development causes firms to be worse off during devaluations, relative to the benchmark.