Financial integration and international risk sharing

Conventional wisdom suggests that countries that are more financially integrated can better insure against risk. Despite widespread deregulation and financial integration in recent history, there is little evidence that countries have increased risk sharing. This work shows financial integration does not necessarily lead to significant improvement in risk sharing if financial contracts are incomplete and enforceability of debt repayment is limited. We use a calibrated DSGE model featuring a continuum of countries and their default choices on sovereign debt, and we model increased financial integration with an exogenous reduction in transaction costs on foreign assets. The seemingly large increase in capital flows is too limited to significantly improve international risk sharing due to default risk; if the default risk was eliminated, capital flows would be six times greater than the observed flows in the data, and international risk sharing would increase substantially. In addition, consistent with the empirical evidence, the model exhibits a greater frequency of sovereign default in the more-integrated period. Equilibrium defaults overall reduce international risk sharing because countries are excluded from markets for some period after default though it provides some contingency in current repayments. JEL: F21, F34, F36, F41 Keyword: risk sharing, financial integration, capital flows, sovereign default ∗Email: [email protected] †Email: [email protected] ‡We are greatly indebted to Patrick Kehoe for his valuable advice and constant encouragement. We also thank Arellano Cristina, David Backus, Timothy Kehoe, Ellen McGrattan, Fabrizio Perri, Richard Rogerson, Linda Tesar and seminar participants at Arizona State University, Federal Reserve Bank of Minneapolis, Midwest Macro Conference 2006, the University of Minnesota, the University of Michigan, and SED 2006 for their helpful comments and suggestions. All errors remain our own.