Sovereign Risk, Anonymous Markets, and the Effects of Globalization

Abstract

The goal of this paper is to study the effects of globalization on the workings of asset markets and welfare. To do this, we adopt a technological view of the globalization process. That is, we model this process as consisting of a gradual (and exogenous) reduction in the costs of shipping goods across different regions of the world. In the absence of market frictions, globalization creates foreign trade opportunities without affecting domestic ones and, as a result, unambiguously raises welfare. In the presence of sovereign risk, however, globalization can either create or destroy both domestic and foreign trade opportunities. The net effect on welfare of this process of creation and destruction of trade opportunities might be either positive or negative. We also find that asset bubbles moderate this welfare effect. When globalization is welfare reducing, asset bubbles grow creating a positive wealth effect, and vice versa. This might come at a cost though. Asset bubbles reduce the incentives to implement reforms aimed at reducing sovereign risk.

Keywords: Financial integration, anonymous markets, sovereign risk, domestic markets, international markets

JEL Classification: F34, F36, G15