Abstract:
This paper analyzes how trade integration may affect international financial flows in a world with heterogeneous financial development. In contrast to the findings of Antras and Caballero (2009, Journal of Political Economy), free trade may amplify the global imbalances (a phenomenon of large financial flows from developing to developed countries observed in the recent decades), if trade-driven sectoral shifts allow the more financially developed country (North) to fully abandon low return production activities and upgrade to high-return activities along the value chains. This way, I complement the findings of Antras and Caballero (2009) and discover a novel mechanism through which the boom in supply-chain trade may contribute to the global imbalances in the recent decades. Besides, I consider the income effect of trade for the less financially developed country (South). Trade triggers the investment reallocation from high-return to low-return activities in South, which worsens allocation efficiency. If this negative effect dominates the conventional gains from trade, the income level in South will be lower than under autarky. Taking this trade-off into account, South should be cautious in selecting its trade partners.
