Financial Frictions, Product Quality, and International Trade

Product quality plays a key role in economics, but differs markedly across countries and industries. What are the determinants and implications of this pattern? In this paper, we test an explanation for the large heterogeneity in product quality that rests on the interplay between cross-country differences in financial frictions and cross-industry differences in financial vulnerability. To guide the empirical analysis, we rely on a simple trade model featuring heterogeneous firms, endogenous output quality, country heterogeneity in financial frictions, and industry heterogeneity in financial vulnerability. The model clearly illustrates how the interaction of financial frictions and financial vulnerability shapes the geographical and sectoral variation in product quality. We estimate the model using a novel data set, which contains proxies for export quality, financial development, and financial vulnerability for virtually all manufacturing industries and countries in the world, over a period that spans the last three decades. Our results show that the interplay between financial frictions and financial vulnerability is a main driver of the observed variation in product quality across countries and industries. The model also suggests that quality adjustments are an important mechanism through which financial development affects international trade and shapes countries’ export structure. We find strong evidence consistent with this implication.