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Financial Integration and International Risk Sharing

  • Yan Bai

    (Arizona State University)

  • Jing Zhang

    (University of Michigan)

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.

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Paper provided by Research Seminar in International Economics, University of Michigan in its series Working Papers with number 594.

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Length: 31 pages
Date of creation: May 2009
Date of revision:
Handle: RePEc:mie:wpaper:594
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