Trade‐induced sectoral upgrading and upstream financial flows

Abstract

AbstractThis paper shows that deepening trade integration may have non‐monotonic impacts on the direction of financial flows in a world with heterogeneous financial development. By inducing the more financially developed country (North) to specialize towards the financially constrained, high‐return sectors, trade integration reduces the return to capital in the unconstrained, low‐return sectors, which reverses the upstream financial flows, as predicted by Antras and Caballero (2009, Journal of Political Economy). However, if the cross‐country difference in financial development and the investment elasticity in North are sufficiently large, North may offshore the low‐return sectors and specialize fully in the high‐return sectors. In this case, upstream financial flows may not be dampened or reversed in the long run. My findings offer an alternative perspective of understanding the persistent current account imbalances between emerging Asia and the United States.