Are Financial Development and Trade Openness Complements or Substitutes?

This article studies the long- and short-run relationships between financial development and trade openness. Using the pooled mean group estimator of Pesaran, Shin, and Smith (1999) for unbalanced panel data for 87 countries over the 1960-2005 period, our empirical results indicate that long-run complementarity between financial development and trade openness coexists with short-run substitutionarity between the two policy variables. But when splitting the data into OECD and non-OECD country groups, this finding can be observed only in non-OECD countries. For OECD countries, financial development has negligible effects on trade. In addition, we find nonlinearity in the relationship in that long-run responses of trade decrease with financial development. The article further finds coexistence of negative trade effects of financial fragility and positive trade impacts of financial depth.