Abstract
AbstractInnovative production is driven by creative destruction. High turnover requires frequent reallocation of capital. Banks play a major role in capital reallocation by withdrawing funds from nonviable firms and redirecting credit to scale up the most productive firms. Structural parameters of the banking system thus affect a country’s comparative advantage in innovative sectors. Using a Heckscher–Ohlin model with banks, this paper shows how insolvency laws, investor protection, and bank capital regulation shape reallocation, specialization, and trade patterns.
Highlights
Innovation and trade are major sources of structural change
When capital and labor are locked into current uses, a country cannot reap the gains from trade and fails to exploit its comparative advantage
They aim at a lower cost of bank equity and more efficient bankruptcy procedures; and (iii) trade liberalization targeted at lower export costs in the innovative sector
Summary
Innovation and trade are major sources of structural change. Innovative firms with better products conquer world markets and drive the expansion of export industries, while declining sectors with less productive firms must shrink. We consider three policy interventions, namely, (i) bank regulation with higher capital standards, which capture the essence of recent banking reforms; (ii) institutional reforms relating to investor protection and bankruptcy law They aim at a lower cost of bank equity and more efficient bankruptcy procedures; and (iii) trade liberalization targeted at lower export costs in the innovative sector. Banks help shape comparative advantage by shifting investment and output to the innovative sector Institutional reforms such as better investor protection and more efficient bankruptcy laws make bank equity cheaper, and enable banks to extract more capital when liquidating non-performing loans. This induces more credit reallocation and shifts final investment and output to the expanding sector.
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