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Financial integration and international risk sharing

  • Bai, Yan
  • Zhang, Jing

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 widespread financial liberalization. We show that the key to understanding this puzzling observation is that conventional wisdom assumes frictionless international financial markets, while actual markets are far from frictionless: financial contracts are incomplete and contract enforceability is limited. When countries remove official capital controls, default risk is still present as an implicit barrier to capital flows. If default risk were eliminated, capital flows would be six times greater, and international risk sharing would increase substantially.

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File URL: http://www.sciencedirect.com/science/article/pii/S002219961100105X
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Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 86 (2012)
Issue (Month): 1 ()
Pages: 17-32

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Handle: RePEc:eee:inecon:v:86:y:2012:i:1:p:17-32
DOI: 10.1016/j.jinteco.2011.08.009
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505552

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