The effect of trade liberalisation on economic activity remains one of the most important questions in economics. While prominent theories of international trade show that free trade improves the allocation of resources and welfare within countries (the so called “reallocation channel”), trade scepticism is at a historical high in many policy circles around the world.

It is well understood that in the short run trade liberalisation generates winners and losers. However, given the long-term benefits of free trade and the backlash that may arise before these gains materialise for everyone, it is crucial to understand better the frictions that prevent factors of production from moving across firms, sectors and regions, according to the changing patterns of comparative advantage.

In a recent paper, we contribute to this debate by analysing a novel friction that affects gains from trade: the reallocation of credit across firms and sectors in the aftermath of a trade shock. Credit matters for working capital and investments, so it contributes to the reallocation of both labour and physical capital. Looking at banks and credit is key to better understand short-medium term frictions that may harm gains from trade.

Our main finding is that there are negative spillovers between losers and winners from trade that go through banks, as banks can be adversely affected by a trade shock through the portfolio of firms to which they lend money. If a bank has a high volume of outstanding loans to firms that turn out to be subject to import competition, this is going to affect its overall lending activity, including to firms that could gain from the trade shock. This novel result reveals the presence of endogenous financial frictions that arise from trade liberalisation itself. These frictions hinder the reallocation of resources towards the firms that should expand after trade liberalisation, reducing the potential gains from trade, at least in the medium run.

In the paper, we look at China’s entrance in the WTO at the end of 2001, as an exogenous trade liberalisation shock and we focus on Italy as a case study. Using data from the Italian credit registry, matched with bank and firm level data, we follow the evolution of bank and firm activities prior to and after the entry of China into the WTO. We identify the sectors most affected by import competition from China and estimate the transmission of this trade shock from firms to their lending banks, and the consequence of the shock on banks’ lending to other firms. Then, we analyse the patterns of credit supply across banks with different degrees of exposure to the trade shock.

We find that, controlling for credit demand, banks exposed to the China shock decrease their lending relative to non-exposed banks. Importantly, the supply of credit is reduced not only to the expected losers of this shock (firms exposed to competition from China), but also to the expected winners from trade liberalisation. We use several alternative definitions of “winners”. We look at firms in sectors that have low exposure to competition from China, firms in sectors where Italy has a revealed comparative advantage to export, the more productive firms within sectors and firms in the service sector. Importantly firms that receive less credit from more exposed banks are not able to fully offset it with more credit coming from other banks, so the total supply of credit they get goes down relative to other firms.

The lower credit supply has real effects on firms’ employment, investments and revenues, so the firms that should expand are absorbing fewer resources than they could have otherwise. We compute some back-of-the-envelope estimates on how relevant these effects are in aggregate. We find that, over the period 2002-2007, employment would have been about 2.2 percentage points higher if the bank lending channel of the trade shock had been less binding. This is a non-trivial number and it comes on top of the direct trade effect of the China shock. The employment loss of the expected winners from trade liberalisation accounts for a third of this aggregate effect. This result is due to more exposed banks suffering losses from higher non-performing loans and reducing their core capital to cover such losses, which makes banks more fund-constrained in their lending activity.

Our study shows that credit allocation in the aftermath of a trade shock is a novel and relevant channel that can affect gains from trade. We believe that there is more to understand about the role of banks and credit for their impact on gains from trade. We hope to motivate further theoretical and empirical research on these issues, as we still need to understand better the interaction of this channel with other frictions in the economy and find policy solutions that may mitigate its impact.

♣♣♣

Notes:

  • This blog post is based on the author’s paper “Trade Shocks and Credit Reallocation”, with Stefano Federico and Veronica Rappoport, CEP Discussion Paper 1649.
  • The post gives the views of its author(s), not the position of the Bank of Italy, LSE Business Review or the London School of Economics.
  • Featured image by PublicDomainPictures, under a Pixabay licence
  • Before commenting, please read our Comment Policy

Fadi Hassan is a senior economist at the Bank of Italy and a research associate at LSE’s Centre for Economic Performance (CEP). His research interests are in the fields of international economics, finance, and development. He has been an assistant professor of economics at Trinity College Dublin, a visiting scholar at Harvard University, an advisor to UniCredit Research as well as a consultant for the European Central Bank, the European Commission, and the World Bank. He obtained his PhD from LSE and won the Young Economist Award from the European Economic Association.