Industrial specialization, financial integration and international consumption risk sharing

Standard models of international asset trade lack mechanisms linking an economy’s financial openness and industrial specialization. This paper presents a simple model of global portfolio diversification in which a link between financial liberalization and production specialization emerges very naturally. Within that model, an economy that liberalizes its financial markets is able to share its consumption risks, which in turn would allow the country to take extra risks in production by specializing in the good it produces more efficiently, resulting in higher output volatility and less correlated business cycles. The model provides insights about the effects of cross-country and cross-sector productivity shock correlations on portfolio choice, industrial specialization and consumption smoothing. Output volatility will increase as countries get more financially open, whereas consumption smoothing will depend on both the actual level of financial openness and on the productivity shock correlations between sectors and between countries. Higher integration induces greater production specialization, whereas the effect of productivity correlations on production diversification is ambiguous and depends on the degree of financial frictions.