Financial Integration, Financial Deepness and Global Imbalances; Enrique G. Mendoza, Vincenzo Quadrini, and José-Víctor Ríos-Rull; November 9 and 10, 2006

Large global financial imbalances need not be the harbinger of a world financial crash as many authors believe. Instead, we show that large and persistent global imbalances can be the outcome of financial integration when countries have different financial markets characteristics. In particular, countries with more advanced financial markets accumulate foreign liabilities vis-a-vis countries with less developed financial systems in a gradual, long-lasting process. Moreover, differences in financial development affect the composition of foreign portfolios, so that a country with negative net foreign asset positions can receive positive factor payments. Three empirical observations support these arguments: (1) financial deepness varies widely even amongst industrial countries, with the United States ranking at the top; (2) the secular decline in the U.S. net foreign assets position started with a gradual process of financial markets liberalization; (3) net exports and current account balances are negatively correlated with indicators of financial markets development.