Credit constraints, quality, and export prices: Theory and evidence from China

•Examine the effect of credit constraints on export quality and export prices.•Build a heterogeneous-firm trade model with credit constraints and quality choice.•Tighter credit constrains force firms to produce lower quality in quality sorting.•Verify quality adjustment in support of quality sorting using Chinese data.•Find evidence on efficiency sorting with net-quality prices and quality variations.

This paper presents theory and evidence from highly disaggregated Chinese data that tighter credit constrains force firms to produce lower quality. The paper modifies Melitz's (2003) model of trade with heterogeneous firms by introducing quality choice and credit constraints. The quality sorting model predicts that tighter credit constraints faced by a firm reduce its optimal prices due to its choice of lower-quality products. However, when quality cannot be chosen by a firm in an efficiency sorting model, there is an opposite prediction that prices increase as firms face tighter credit constraints. An empirical analysis using Chinese bank loans data and a merged sample of large trading firms based on Chinese firm-level data from the National Bureau of Statistics of China (NBSC) and Chinese customs data strongly supports quality sorting and confirms the mechanism of quality adjustment: firms optimally choose to produce lower-quality products when facing tighter credit constraints. Moreover, the predictions of the efficiency sorting model are supported by using quality-adjusted prices in regression analysis and by using quality variation across firms within the same product.