The production of high-quality goods influences key aspects of countries’ economic performance, including growth and development (e.g. Aghion and Howitt 2005, Gancia and Zilibotti 2005), export success (Verhoogen 2008), and employment and wages (Khandelwal 2010). However, not all countries are able to manufacture high-quality products. Product quality varies markedly both across countries and across industries (Schott 2004, Feenstra and Romalis 2014). What determines this variation? Part of it certainly reflects the large differences in economic development and factor endowments that exist across countries (Schott 2004, Hummels and Klenow 2005, Hallak 2010). However, these explanations do not account for the entire variation in quality observed in the data. Other forces must be at play.
Financial imperfections and product quality
In recent work, we provide evidence for one such force – the interplay between cross-country differences in financial frictions and cross-industry differences in financial vulnerability (Crinò and Ogliari 2015). To summarise our evidence, in Figure 1 we start by showing the simple cross-country relationship between financial development (private credit over GDP) and Khandelwal’s (2010) proxy for product quality. The correlation is strong and positive (black circles), and remains so even after controlling for per-capita GDP – a proxy for economic development – and skill and capital endowments (red circles). This suggests that cross-country differences in financial frictions play an important role in explaining quality variation around the world.
Figure 1. Financial development and product quality across countries
In Table 1, we provide direct evidence on the interplay between financial frictions and cross-industry differences in financial vulnerability. The table assigns countries to two groups, with high and low levels of financial development (private credit above or below the sample median). Similarly, it classifies manufacturing industries into two groups, with high and low levels of financial vulnerability, proxied by external finance dependence (Rajan and Zingales 1998) and asset tangibility (Claessens and Laeven 2003). Each cell in the table reports the (standardised) average quality across all countries and industries belonging to that cell. The main message of the table is that, while financial frictions lower product quality across the board, their effect is stronger in financially more vulnerable industries, where firms are more sensitive to financial frictions because they depend more on outside capital and have fewer collateralisable assets.
Table 1. Financial development, financial vulnerability, and product quality
The effect of financial imperfections is quantitatively large. For instance, we find that a one-standard-deviation reduction in private credit would lower product quality by 12% more in the industry at the third quartile of the distribution by external finance dependence (relative to the industry at the first quartile) and by 11% more in the industry at the first quartile of the asset tangibility distribution (relative to the industry at the third quartile). A commensurate reduction in skill (resp. capital) endowment would lower product quality by 9% (resp. 23%) more in the industry at the third quartile of the skill (resp. capital) intensity distribution. Hence, financial imperfections are empirically no less relevant than economic development and factor endowments when it comes to explaining the observed variation in product quality across countries and industries.
Margins of adjustment
Our results potentially reflect two margins of adjustment – an intensive and an extensive margin. On the one hand, financial frictions affect the quality choice of incumbent firms in a given destination market (intensive margin). Intuitively, worse credit conditions tighten the liquidity constraints of these firms, preventing them from financing higher costs of quality upgrading. This happens especially in financially more vulnerable industries. On the other hand, worse credit conditions affect the selection of firms in a given market (extensive margin). This effect may strengthen or weaken the contribution of the intensive margin, depending on the quality choice of the marginal firm. We formalise these intuitions in a simple trade model, which introduces an endogenous choice of output quality into the workhorse multi-country, multi-industry, model of trade and finance with heterogeneous firms (Manova 2013). Our empirical results show that the intensive margin explains more than 75% of the overall effect of financial imperfections on product quality. Arguably this implies that, by removing financial frictions, governments could weaken an important source of within-firm distortions in the decision to upgrade technology.
Implications for trade flows
It is well known that more financially developed countries export relatively more in more financially vulnerable industries (Manova 2013). In other words, financial frictions shape the industrial composition of countries’ exports and strongly influence the pattern of comparative advantage. The mechanisms behind this evidence are still little understood. In this respect, adjustments in product quality may play a key role. The intuition is simple. If financial frictions are more detrimental to quality in financially more vulnerable industries, credit market imperfections may end up lowering the relative exports of such industries. Indeed, we find quality adjustments to explain the bulk of the overall impact of financial frictions on exports across sectors. We also document that the cross-industry response of prices to financial frictions is difficult to reconcile with existing models of trade and finance, which abstract from firm-level quality decisions. Instead, the way prices respond to financial frictions across industries lines up closely with our model of endogenous quality. Again, the intuition is clear. The observed variation in prices largely reflects variation in product quality, and the latter is strongly influenced by the interplay of financial frictions and financial vulnerability. All in all, this evidence suggests that, in order to fully understand the implications of financial imperfections for trade flows, product quality should be placed at centre stage.
Removing credit market imperfections may help countries transition from the production of low-quality to high-quality goods, especially in industries that are more sensitive to financial frictions. Thus, policies that improve the functioning of credit markets and facilitate firms’ access to credit may be effective tools for raising the sophistication of countries’ production and exports, with potentially beneficial consequences for their economic performance.
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 Khandelwal’s (2010) estimation procedure assigns higher quality to products displaying larger market shares in a given market, conditional on prices. We apply the procedure to highly detailed product-level data (roughly 6,000 8-digit manufacturing goods) on the exports of 171 countries to 26 EU members. In Figure 1, private credit and product quality are averaged over 1988-2011 and standardised.
 External finance dependence is the share of capital expenditure not financed through cash flow. Asset tangibility is the share of tangible assets in total assets. Both variables are computed for 273 manufacturing industries, as the median value across all US firms in Compustat in each industry between 1988 and 2012.
 Similar to the heterogeneous-firms literature with quality differentiation and, in particular, to Crinò and Epifani (2012).
 See Ciani and Bartoli (2013) and Fan et al. (2015) for related models of credit constraints and endogenous quality.
 We untangle the two margins by extending an estimation procedure developed by Helpman et al. (2008) and Manova (2013).