Financial Integration and International Risk Sharing

Yan Bai and Jing Zhang

No 594, Working Papers from Research Seminar in International Economics, University of Michigan

Abstract: Conventional wisdom suggests that financial liberalization can help countries insure against idiosyncratic risk. There is little evidence, however, that countries have increased risk sharing despite recent widespread financial liberalization. This work shows that the key to understanding this puzzling observation is that conventional wisdom assumes frictionless international financial markets, while actual international financial markets are far from frictionless. In particular, financial contracts are incomplete and enforceability of debt repayment is limited. Default risk of debt contracts constrains borrowing, and more importantly, it makes borrowing more difficult in bad times, precisely when countries need insurance the most. Thus, default risk of debt contracts hinders international risk sharing. When countries remove their official capital controls, default risk is still present as an implicit barrier to capital flows; the observed increase in capital flows under financial liberalization is in fact too limited to improve risk sharing. If default risk of debt contracts were eliminated, capital flows would be six times greater, and international risk sharing would increase substantially.

Keywords: international risk sharing; financial integration; financial liberalization; financial frictions; sovereign default; international capital flows (search for similar items in EconPapers)
JEL-codes: F02 F34 F36 F41 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2009-05
New Economics Papers: this item is included in nep-bec, nep-ias and nep-ifn
References: Add references at CitEc
Citations: View citations in EconPapers (18)

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http://www.fordschool.umich.edu/rsie/workingpapers/Papers576-600/r594.pdf

Related works:
Journal Article: Financial integration and international risk sharing (2012)
Working Paper: Financial Integration and International Risk Sharing (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:mie:wpaper:594

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