Financial Integration and International Risk Sharing

Yan Bai

Arizona State University (ASU) - Economics Department

Jing Zhang

University of Michigan at Ann Arbor

May 1, 2009

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, sovereign default, international capital flows

JEL Classification: F02, F34, F36, F41

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Date posted: December 18, 2009  

Suggested Citation

Bai, Yan and Zhang, Jing, Financial Integration and International Risk Sharing (May 1, 2009). Available at SSRN: http://ssrn.com/abstract=1525505

Contact Information

Yan Bai
Arizona State University (ASU) - Economics Department ( email )
Tempe, AZ 85287-3806
United States
Jing Zhang (Contact Author)
University of Michigan at Ann Arbor ( email )
500 S. State Street
Ann Arbor, MI 48109
United States
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