Optimal Financial Markets Liberalization

This paper examines the optimal financial markets liberalization policy for a large country in a two-country general equilibrium production economy. In our model, household’s portfolio choice is modeled separately from firm’s investment decision and financial markets play an important role in the allocation of capital between production technologies. We find that the type of production technology, specifically whether it exhibits decreasing returns to scale in capital, is an important factor in evaluating the welfare gains from financial markets liberalization, and hence the optimal financial structure for a country. As financial markets become liberalized, there is gain from efficient capital allocation as a result of improved sharing risk sharing. On the other hand, a less wealthy country will not be able to gain by borrowing at a lower risk-free rate and reinvesting in a more productive risky technology when financial markets are completely liberalized. When production technologies exhibit decreasing returns to scale, the gain from efficient capital allocation as a result of financial markets liberalization dominates the opportunity cost of higher borrowing rate for the less wealthy country. Consequently, complete financial markets liberalization is more likely to be optimal when production technologies exhibit decreasing returns to capital. JEL classification: F3, G0 © 2002 Khang Min Lee, Department of Economics, Faculty of Arts & Social Sciences, National University of Singapore, 1 Arts Link, Level 6, Singapore 117570. Office number: (65) 874 6625; Fax number: (65) 775 2646; Email: [email protected] or [email protected]. Views expressed herein are those of the author and do not necessarily reflect the views of the Department of Economics, National University of Singapore.