Trade Liberalization and Credit Constraints: Reallocations at the Firm Level

Following the idea of heterogeneous firms we examine responses to trade liberalization at the firm level in the presence of capital market imperfections. In our model, entrepreneurs differ in their wealth endowment, causing them to rely differently on external funds. With an imperfect capital market, we show that poor entrepreneurs run smaller firms, are less likely to invest in R&D, and more likely to exit the market. Decreasing trade costs resulting from tariff reductions exacerbate these characteristics. Using firm-level panel data on seven Latin American countries for 2006 and 2010, we find support for our theoretical predictions. While recent studies show a positive effect
of trade liberalization on firms' productivity-enhancing activities, we provide novel evidence showing that financial constraints can impair this market size effect on R&D. Furthermore our results suggest that imperfect capital markets can prevent welfare gains from trade liberalization to materialize.