Finance and International Trade: A Review of the Literature

Terry Selb

January 5, 2024

Finance and international trade are two inseparable components of the global economy. In the increasingly interconnected world, the relationship between finance and international trade has become more significant than ever before. This article aims to provide a comprehensive review of the literature on the intricate linkages between finance and international trade, shedding light on the key concepts, theories, and empirical evidence that have emerged over the years.

The Theoretical Framework

One of the foundational theories in international trade is the comparative advantage theory, developed by David Ricardo in the 19th century. This theory asserts that countries should specialize in producing goods and services with a comparative advantage and then trade with other countries to maximize overall welfare. Finance is crucial in facilitating this trade by providing the necessary funds for businesses to expand their production and engage in cross-border commerce.

Exchange Rate Theories

Exchange rates are fundamental to international trade as they determine the relative prices of goods and services in different countries. Various exchange rate theories, such as the Purchasing Power Parity (PPP) theory and the Interest Rate Parity (IRP) theory, explain the relationship between exchange rates, interest rates, and inflation. Understanding these theories is essential for businesses engaged in international trade to manage currency risk effectively.

Empirical Evidence

Several empirical studies have examined the impact of finance on international trade. Research has shown that countries with well-developed financial systems tend to trade more internationally. The availability of credit, access to foreign exchange markets, and a stable banking sector are all factors that contribute to a country’s ability to participate in global trade. Empirical evidence also suggests that financial crises can harm international trade, as seen in the aftermath of the 2008 global financial crisis.

Financial Instruments and Trade Financing

Trade financing is a critical aspect of international trade, and financial instruments such as letters of credit, trade credit insurance, and export financing play a pivotal role in facilitating cross-border transactions. Letters of credit, for instance, provide a guarantee of payment to exporters, reducing the risk associated with international trade. Trade credit insurance protects businesses against non-payment by foreign buyers. The availability and efficiency of these financial instruments significantly influence the volume and scope of international trade.

Global Banking and Multinational Corporations

The role of global banks and multinational corporations in international trade cannot be overstated. Multinational corporations rely on global banks to provide various financial services, including trade financing, foreign exchange services, and risk management. These institutions serve as intermediaries, connecting businesses in different countries and enabling the smooth flow of goods and capital across borders. The presence of multinational corporations also fosters technology transfer and knowledge spillovers, which can have positive spillover effects on host countries’ economies.

Trade Finance and Developing Countries

Access to trade finance is often limited in developing countries, hindering their ability to engage in international trade. The literature highlights the importance of addressing the trade finance gap in these economies. International organizations, such as the World Bank and the International Finance Corporation (IFC), have initiated programs to promote trade finance in developing countries. These efforts aim to reduce barriers to trade expansion in low-income countries.

The Impact of Financial Liberalization

Financial liberalization, the process of opening up a country’s financial sector to foreign investment and competition, has been debated in the literature. Proponents argue that liberalization can stimulate economic growth and increase access to finance, which, in turn, promotes international trade. However, critics highlight the risks associated with financial liberalization, including increased vulnerability to financial crises. Striking a balance between economic openness and stability is a crucial challenge for policymakers.

Financial Crises and Trade

The literature extensively explores the link between financial crises and international trade. It is well-documented that financial crises can severely negatively impact trade, leading to a contraction in imports and exports. During economic uncertainty, businesses become more risk-averse, and financing becomes scarcer. Consequently, trade volumes decline, and the global economy experiences a downturn. Mitigating the effects of financial crises on international trade remains a significant challenge for policymakers worldwide.

The relationship between finance and international trade is intricate and multifaceted. Finance serves as the lifeblood of international trade, facilitating the movement of goods and services across borders. Theoretical frameworks such as comparative advantage and exchange rate theories provide the foundation for understanding the dynamics of international trade. Empirical evidence underscores the importance of financial development and the role of financial instruments in promoting international trade.

Global banking institutions and multinational corporations are pivotal in shaping the international trade landscape. While they facilitate cross-border transactions, they also bring about financial liberalization and crisis management challenges. For developing countries, access to trade finance remains a critical issue that requires targeted interventions.

As the global economy continues to evolve, the interplay between finance and international trade will continue to shape how nations conduct business and interact. The literature reviewed in this article provides valuable insights into this complex relationship. It underscores the importance of a well-functioning financial system in promoting international trade and fostering economic growth on a global scale.