Does the Degree of Development Matter in the Impact of Banking Crises on International Trade?

• Date: 01 August 2017
• Author: Rafael Llorca‐Vivero,José Antonio Martínez‐Serrano,Salvador Gil‐Pareja
• DOI: http://doi.org/10.1111/rode.12284
• Published date: 01 August 2017

Does the Degree of Development Matter in the

Impact of Banking Crises on International Trade?

Salvador Gil-Pareja, Rafael Llorca-Vivero, and Jos

e Antonio

Mart

ınez-Serrano*

Abstract

This paper analyzes how a country’s degree of economic development affects the impact of banking

crises on international trade. To this end, we estimate a gravity model of trade using a sample of 139

countries over the period 1975–2012. Our results show that middle income countries are generally the

most negatively affected. In contrast, financial turmoil appears to have less impact on bilateral trade

flows among high income countries and, more specially, among low income nations. The level of financial

development, contract enforcement, as well as the extent of the use of banking credit within international

trade all help to explain our findings.

1. Introduction

From a theoretical perspective, financial crises impact foreign sales to a greater

extent than domestic ones. Compared with those firms selling exclusively to

national markets, exporters face higher operational risks (as longer time lags in

international trade are required to recover the initial investment, which increases

the need for working capital). Furthermore, exporters face greater difficulty in

evaluating the probability of default by the foreign partner. The importer is also

concerned about the reception of goods in the agreed conditions. This uncertainty

is sometimes transferred to banks through the implementation of a “letter of

credit” or a “documentary collection,” which implicates both the importer’s and the

exporter’s financial institutions. Unfortunately, data about the use of these

instruments are almost non-existent. According to Niepmann and Schmidt-

Eisenlohr (2014), “letters of credit”—in which the importer bank assumes the risk

—are much more prevalent in US international trade finance than “documentary

collection” and their use is quite dependent on the level of risk in the destination

country.

Bank-intermediated trade finance is only one way of financing international trade.

Antr

as and Foley (2015) show how the degree of contractual enforcement and

institutional development determine the use of one or another type of trade finance

instrument: “bank-intermediated,” “open account” and “cash in advance.”

Additionally, Beck (2002) demonstrates that countries with relatively better

financial development (which is empirically measured through credit to the private

*Llorca-Vivero (Corresponding author), Gil-Pareja, Jos

e Antonio Mart

ınez-Serrano: Departamento de

Estructura Econ

omica, Facultad de Econom

ıa, University of Valencia, Av. de los Naranjos s/n, C.P.

46022, Valencia, Spain. Tel. +34-96-38-28349; Fax 34-96-38-28354; E-mail: Rafael.llorca@uv.es. This study

is part of a research project financed by Ministerio de Econom

ıa y Competitividad (ECO2012-38040,

partially funded by the European Regional Development Fund—ERDF) and Generalitat Valenciana

(PROMETEO II/2014-053).

Review of Development Economics, 21(3), 829–848, 2017

DOI:10.1111/rode.12284

©2016 John Wiley & Sons Ltd

sector provided by financial institutions as a percentage of gross domestic product

(GDP)) also perform better in the manufacturing exporting sector.

If we combine these views, an interesting question arises: “Has the degree of

development (related also to financial and institutional development as well as to

contractual enforcement) any influence on the assumed negative impact of banking

crises on international trade?” However, the answer is not so straightforward. For

instance, for high-risk importing countries bank intermediation (mainly “letters of

credit”) can be prohibitively costly and “cash in advance” is probably the best

alternative, whereas exporters may prefer to assume the risk (“open account”) in

low-risk destinations (Niepmann and Schmidt-Eisenlohr, 2014).

1

Therefore, the

differences across countries regarding their firms’ dependence on direct bank

intermediation for international transactions can be a determinant factor in the

magnitude of the transmission of financial difficulties to foreign trade. Additionally,

bank credit can also be used in the “cash in advance” or “open account” options by

the importer and the exporter, respectively, in order to obtain the required funds.

Such a scenario clearly implies that the health and degree of development of the

financial sector may also affect trade by these channels.

The recent subprime crisis (2007–2012) has led to the emergence of new research

on this topic. In essence, research has essentially focused on determining the impact

of demand (drop in income) and financial factors (credit restrictions) on the trade

collapse of 2008–2009. Some papers give more relevance to the former explanation

(for instance, Levchenko at al., 2010; Eaton et al., 2011) while others recognize the

responsibility of the latter (Amiti and Weinstein, 2011; Chor and Manova, 2012,

among others). The general consensus would appear to be that banking crises

impact negatively upon international trade, albeit in a moderate manner. However,

to our knowledge, no research has yet been conducted analyzing the question posed

here: “Which types of countries are more affected by financial turmoil in their

foreign trade relationships: developed or developing?”

To preview our results, the estimations suggest that banking crises affect

countries in a different manner depending on their degree of economic

development. In particular, the impact of financial turbulence seems to be relatively

strong for middle income countries and, to a lesser extent, for high income

countries (for which even no impact is detected when global crises take place).

When the crisis is not global, the explanation of this outcome seems to rely mainly

on the relatively weak stability of the financial system. However, when the crisis is

indeed global, both the depth and efficiency of the financial sector seem to matter.

Finally, trade is not affected when the crises occur in a pair of low income

countries, most probably because they are high risk destinations and, as outlined

before, banking financing is marginal.

The structure of the paper is the following. In the next section, we provide a

review of the literature. Section 3 describes the methodology used. Section 4 offers

the data sources. Section 5 presents the results and section 6 concludes.

2. Banking Crises and Trade: Background

The analysis regarding the impact of banking crises on world trade flows has been

conducted at the aggregated, sectorial and firm level. At the aggregated level, it is

generally accepted that the evolution of international trade strongly depends on

GDP. Moreover, the connection between these two variables has become narrower

in recent years because of the fragmentation of production at the international

830 S. Gil-Pareja et al.

©2016 John Wiley & Sons Ltd