Managing Financial Integration

The goal of this paper is to study the e¤ects of globalization on the workings of asset markets and welfare. To do this, we adopt a “technological”view of the globalization process. That is, we model this process as consisting of a gradual (and exogenous) reduction in the costs of shipping goods across di¤erent regions of the world. In the absence of market frictions, globalization creates foreign trade opportunities without a¤ecting domestic ones and, as a result, unambiguously raises welfare. In the presence of sovereign risk, however, globalization can either create or destroy both domestic and foreign trade opportunities. The net e¤ect on welfare of this process of creation and destruction of trade opportunities might be either positive or negative. We also …nd that asset bubbles moderate this welfare e¤ect. When globalization is welfare reducing, asset bubbles grow creating a positive wealth e¤ect, and vice versa. This might come at a cost though. Asset bubbles reduce the incentives to implement reforms aimed at reducing sovereign risk. Barcelona Economics WP no 201 The goal of this paper is to study the e¤ects of globalization on the workings of asset markets and welfare. To do this, we adopt a “technological”view of the globalization process. That is, we model this process as consisting of a gradual (and exogenous) reduction in the costs of shipping goods across di¤erent regions of the world. In the absence of market frictions, globalization creates foreign trade opportunities without a¤ecting domestic ones and, as a result, unambiguously raises welfare. In the presence of sovereign risk, however, globalization can either create or destroy both domestic and foreign trade opportunities. The net e¤ect on welfare of this process of creation and destruction of trade opportunities might be either positive or negative. We also …nd that asset bubbles moderate this welfare e¤ect. When globalization is welfare reducing, asset bubbles grow creating a positive wealth e¤ect, and vice versa. This might come at a cost though. Asset bubbles reduce the incentives to implement reforms aimed at reducing sovereign risk. We consider a simple world economy with two regions. Individuals experience income shocks and want to insure against them. They can do so by trading securities with other domestic and foreign residents. Importantly, we assume throughout that securities trade in anonymous markets. This means that individuals issue securities as opposed to signing contracts1. Initially, the costs of transporting goods between regions are high enough to make all trades between domestic and foreign residents prohibitively expensive. As a result, individuals insure their idiosyncratic risk with other domestic residents, but do not insure their region-wide aggregate risk. Globalization brings about a steady reduction in the costs of trading with foreigners allowing, in principle, to insure aggregate risk with foreign residents. We consider the implications of this reduction for risk-sharing and welfare in three di¤erent environments. In the …rst environment, we assume that markets are complete. Not surprisingly, globalization leads to an increase in trading opportunities as individuals now …nd it cheaper to trade with foreign residents. Equilibrium trade increases and this improves the distribution of consumption across states of nature. All individuals of the world gain from this and welfare unambiguously increases. In the second environment, we introduce sovereign risk. Namely, governments cannot commit “ex-ante” to enforce “ex-post”payments by their citizens. As a result, governments enforce payments only if this raises the welfare of domestic residents ex-post (even if this reduces the welfare of domestic residents ex-ante). Just as in the complete-markets model, globalization creates new trade opportunities by making it cheaper to trade with foreigners. But now there is an additional e¤ect. As trade with foreigners increases, so do the temptations for governments to skip enforcing Securities consist of obligations of the issuer towards the holder of the security, and can be traded freely. Contracts stipulate obligations between the signing parties that can not be traded freely.