The Implications of Credit Markets on International Trade
By: Gregory Waltzer
After the collapse of the credit markets in 2008, many people have brought attention to the size of credit markets, the deterioration in credit covenants as well as the use of credit derivatives within financial markets. Although a controversial topic, credit markets are an essential part of economic growth, both domestic and international. The recent expansion in credit markets has resurfaced memories pertaining to 2008’s credit explosion, as debates over the source of recent credit market expansions have made individuals think about the appropriate use of credit instruments and the regulation of markets. As the United States is a leader in financial regulation and economic reform, the stability of both domestic and international credit markets and the respective derivatives that interlink global counterparties is a subject that all international trade industries need to pay close attention to. While various forms of credit are essential to funding corporate operations, the management of the credit market is necessary for long run economic stability. Past memories of 2008’s credit market have brought attention to the source of the current credit market expansion, examining variables from loan origination to the use of credit default swaps and everything in between. Although there are concerns regarding the lite covenants that structure credit agreements, the regulatory bodies governing the use of securitized debt instruments have redefined the appropriate standards of such credit derivatives. As a result, economists, investors, regulators, producers and consumers have shared concerns regarding whether expansions in credit markets are necessary for economic and international trade growth or rather a lesson we have failed to learn from 2008’s financial crisis. Although not a black and white subject in today’s world, studies from Stanford University as well as the National Bureau of Economic Research provide evidence that credit constraints constrict international trade flows, and more specifically, the pattern of foreign direct investments. Research on 91 countries over a 17-year horizon suggest that credit market liberalization increases exports at a disproportionate level between trade sectors that are more financially dependent on external sources of financing as well as employ fewer collateralized assets. With conclusions that impacts are independent of cross-country differences in factor endowments as well as simultaneous trade policy reforms, economic research has shown that liberal credit markets have more intense effects in economic environments exhibiting less active stock markets, suggesting that foreign investments may act as a support for underdeveloped domestic financial systems.
Implications on International Trade
Although the Heckscher-Olin Model suggests that countries abundant in labor resources have a comparative advantage in labor-intensive industries, research suggests that this model overlooks market friction arising from industry demand for external financing and the availability of collateralized assets. Ignoring barriers to entry, Heckscher-Olin may overlook the impacts of market friction stemming from credit constraints across industries and in domestic export sectors of various trade participants that are under capitalized. Research from Stanford University and the National Bureau of Economics concludes that countries, and more specifically, industries with access to external credit sources have an export advantage in international trade, which in turn, may stimulate domestic financial development in comparison to those countries and industries without similar access to external financing. Having determined the significance of credit access to international trade participants, the importance of understanding the underlying factors contributing to credit market expansions is essential in evaluating and promoting international economic welfare and stability. Although the covenants pertaining to recent credit contracts have shown signs of deterioration post financial crisis, new regulations such as the Volcker rule have put boundaries on the use of credit derivative such as credit default swaps. With the number of credit derivative contracts shrinking, hopes of decreased correlation concentration interlinking counterparty exposure must be weighed against the risk exposure taken by not entering into such contracts.
Food For Thought:
- What should determine the optimal size and regulations of credit markets?
- How will each country & industry benefit/suffer from credit access/restriction?
- What are the implications of U.S. credit markets on international trade?