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Financial Integration and International Risk Sharing

Author

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  • Yan Bai
  • Jing Zhang

    () (University of Michigan public)

Abstract

In the last two decades, financial integration has increased dramatically across the world. At the same time, the fraction of countries in default has more than doubled. Contrary to theory, however, there appears to have been no substantial improvement in the degree of international risk sharing. To account for this puzzle, we construct a general equilibrium model that features a continuum of countries and default choices on state-uncontingent bonds. We model increased financial integration as a decrease in the cost of borrowing. Our main finding is that as the cost of borrowing is lowered, financial integration and sovereign default increases substantially, but the degree of risk sharing as measured by cross section and panel regressions increases hardly at all. The explanation, we propose, is that international risk sharing is not sensitive to the increase in financial integration given the current magnitude of capital flows because countries can insure themselves through accumulation of domestic assets. To get better risk sharing, capital flows among countries need to be extremely large. In addition, although the ability to default on loans provides state contingency, it restricts international risk sharing in two ways: higher borrowing rates and future exclusion from international credit markets

Suggested Citation

  • Yan Bai & Jing Zhang, 2006. "Financial Integration and International Risk Sharing," 2006 Meeting Papers 371, Society for Economic Dynamics.
  • Handle: RePEc:red:sed006:371
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    More about this item

    Keywords

    Finanical Integration; Risk Sharing; Globalization; Sovereign Debt;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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