Innovation and trade in the presence of credit constraints

This paper examines how trade liberalization affects investment in R&D at the firm level. We provide a model with entrepreneurs that differ in their wealth endowments, causing them to rely on external funds to different extents. In the presence of capital market imperfections, this implies heterogeneous access to external financing such that poor entrepreneurs run smaller firms, are less likely to invest in R&D and are 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 prior research emphasizes a positive impact of trade liberalization on firms’ productivity-enhancing activities, we provide novel evidence showing that financial constraints can impair the effect on R&D efforts. These results suggest that imperfect capital markets can prevent welfare gains from trade liberalization to materialize.