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International Financial Integration and Crisis Contagion

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  • Michael B. Devereux
  • Changhua Yu

Abstract

International financial integration helps to diversify risk but also may increase the trans- mission of crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with endogenous portfolio choice and collateral con- straints. Collateral constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. The analysis allows for different degrees of financial integration, moving from financial autarky to bond market integration and equity market integration. Fi- nancial integration leads to a significant increase in global leverage, doubles the probability of balance sheet crises for any one country, and dramatically increases the degree of 'contagion' across countries. Outside of crises, the impact of financial integration on macro aggregates is relatively small. But the impact of a crisis with integrated international financial markets is much less severe than that under financial market autarky. Thus, a trade-off emerges between the probability of crises and the severity of crises. Financial integration can raise or lower welfare, depending on the scale of macroeconomic risk. In particular, in a low risk environment, the increased leverage resulting from financial integration can reduce welfare of investors.

Suggested Citation

  • Michael B. Devereux & Changhua Yu, 2014. "International Financial Integration and Crisis Contagion," NBER Working Papers 20526, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20526
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    Cited by:

    1. Scheubel, Beatrice & Stracca, Livio & Tille, Cédric, 2019. "The global financial cycle and capital flow episodes: a wobbly link?," Working Paper Series 2337, European Central Bank.
    2. Cesa-Bianchi, Ambrogio & Imbs, Jean & Saleheen, Jumana, 2019. "Finance and synchronization," Journal of International Economics, Elsevier, vol. 116(C), pages 74-87.
    3. Hao Jin & Hewei Shen, 2020. "Foreign Asset Accumulation among Emerging Market Economies: a Case for Coordination," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 35, pages 54-73, January.
    4. Beck, Thorsten & Chen, Tao & Lin, Chen & Song, Frank M., 2016. "Financial innovation: The bright and the dark sides," Journal of Banking & Finance, Elsevier, vol. 72(C), pages 28-51.
    5. Nina Karnaukh & Angelo Ranaldo & Paul Söderlind, 2015. "Understanding FX Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 28(11), pages 3073-3108.
    6. Damián Pierri & Kevin Reffett, 2021. "Memory, Multiple Equilibria and Emerging Market Crises," Working Papers 154, Universidad de San Andres, Departamento de Economia, revised Jun 2021.
    7. Hao Jin & Hewei Shen, 2020. "Foreign Asset Accumulation among Emerging Market Economies: a Case for Coordination," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 35, pages 54-73, January.
    8. Michael B. Devereux & Changhua Yu, 2017. "Exchange Rate Adjustment in Financial Crises," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 65(3), pages 528-562, August.
    9. Yuko Imura & Julia Thomas, 2015. "International Transmission of Credit Shocks in an Equilibrium Model with Production Heterogeneity," Staff Working Papers 15-19, Bank of Canada.
    10. Devereux, Michael B. & Young, Eric R. & Yu, Changhua, 2019. "Capital controls and monetary policy in sudden-stop economies," Journal of Monetary Economics, Elsevier, vol. 103(C), pages 52-74.
    11. Yu, Changhua, 2015. "Evaluating international financial integration in a center-periphery economy," Journal of International Economics, Elsevier, vol. 95(1), pages 129-144.
    12. Martin R. Goetz & Juan Carlos Gozzi, 2020. "Financial Integration and the Co-Movement of Economic Activity: Evidence from U.S. States," International Finance Discussion Papers 1305, Board of Governors of the Federal Reserve System (U.S.).
    13. Ong, Kian, 2020. "Net foreign assets dynamics: the persistence and sources of shocks to net foreign assets in 12 EU countries," MPRA Paper 100929, University Library of Munich, Germany.
    14. Devereux, Michael B. & Saito, Makoto & Yu, Changhua, 2020. "International capital flows, portfolio composition, and the stability of external imbalances," Journal of International Economics, Elsevier, vol. 127(C).

    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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