Financial Integration and External Sustainability

A stable net external position requires that the trade balance responds negatively to changes in the net external position. If financial integration makes financing external imbalances less costly, we expect slower external adjustment in more integrated economies. The study estimates theoretically founded trade balance reaction functions for a panel of seventy countries from 1970-2008. The empirical analysis finds that adjustment in integrated economies is slower. Consistent with the presented theory, the trade balance of integrated economies is more persistent, responds less strongly to net foreign assets, and is more sensitive to fluctuations in net output. Under high integration, the response to the net external position is weak and close to the minimum required to ensure external sustainability.