Understanding the Causal Links between Financial Development and International Trade

This paper analyses the causal relationship between financial development and international trade using data of 21 developed and developing countries from 1961 to 2010 and appropriate time series techniques that allow us to decompose the source of causation according to the order of integration of the variables and the possible presence of a cointegrating relationship. We analyze in detail the issue of integration of our series in order to use the most appropriate stationarisation techniques on non-stationary series. We also account for the major problems encountered in empirical studies on issues of causality link between finance and the real economy. Our results provide little support to the view that financial development is a leading factor in the participation of countries in international trade. Mainly, we find a bi-directional relationship between the levels of finance and trade. Moreover, it appears that the causality pattern varies across countries with different levels of economic development. Overall, the development of the financial sector contributes more to the causal relationship in the developing countries than in the developed countries. These results are robust to the use of an alternative method of testing for causality and to the use of alternative indicators or financial development and international trade.