Financial Globalization, Portfolio Diversification, and the Pattern of International Trade

The paper provides a general equilibrium model to show how the incompleteness of international financial markets leads to insufficient industrial specialization and a depressed volume of goods trade. As international portfolio diversification is limited and productivity is uncertain, investors wish to maintain a diversified industrial structure, not specializing according to their comparative advantage. Financial globalization, modelled as an increase in the number of assets that can be traded internationally, then induces more specialization and more trade. The present framework yields explicit closed-form solutions for the pattern of specialization and the volume of trade. Empirical results on the structure and volume of trade support the implications of the theory. Trade in financially open countries is (i) higher, (ii) more dependent on productivity differences and (iii) less sensitive to industry risks.