Financial Development, Credit Rationing, and Informal Credit Markets: Implications for Pattern of Trade

ABSTRACT

Firms in developing countries often depend on informal credit due to bank credit rationing. Financial development reduces these structural barriers, expands access to credit, and improves trade and production outcomes. In this study, a theoretical model extending the Dixit–Stiglitz–Krugman (DSK) model of trade is developed to explore the interplay among financial development, credit rationing, and informal credit markets, and their effects on trade outcomes. We showed that financial development does not alter trade and production outcomes when firms have access to only formal credit markets with credit rationing. However, when informal credit markets co‐exist with credit rationing in formal markets, it leads to more varieties being produced but with lower output per variety. Furthermore, the marginal influence of financial development on trade and production outcomes would be stronger when the interest gap between the formal and informal credit markets is greater. A small motivational empirical exercise is also undertaken, providing suggestive evidence consistent with our theoretical model's predictions.