Trade Liberalization and Financial Leverage

This paper argues that trade liberalization has a potentially significant impact on financial leverage. We compare the predictions of the trade-off model of capital structure with the pecking order model. In the first case, we suggest that trade liberalization affects the trade-off between the tax advantages of debt and expected bankruptcy costs. This implies that a reduction in domestic tariffs would tend to reduce financial leverage for domestic firms, while a trading partner’s reduced tariffs would tend to increase the level of leverage selected by domestic firms. The pecking order model suggests an opposing scenario. By altering the profits of domestic firms, trade liberalization moves firms along their pecking order of preferences for financing. We suggest that declining domestic tariffs reduce the profits of domestic firms and accordingly increase leverage, while falling foreign tariffs increase profits leading to lower leverage. Using data on Canadian firms in the period immediately following implementation of the Canada-U.S. Free Trade Agreement, these predictions are tested empirically and the results are broadly consistent with the predictions of the pecking order model of capital structure.