Optimal Liberalization of Financial Markets

This paper shows that the type of production technology, specifically whether it exhibits decreasing returns to scale in capital, is an important factor in evaluating the welfare gain from liberalizing financial markets, and hence the optimal financial structure for a country. As financial markets become completely liberalized, countries gain from a better capital allocation as a result of improved risk sharing, but the less wealthy country can no longer profit from borrowing abroad at a lower rate and reinvesting at home in the technology with a higher expected rate of return. With decreasing (rather than constant) returns to capital, the gain from risk sharing is more likely to dominate the loss of the difference between the borrowing rate abroad and the decreasing (rather than constant) reinvestment rate at home. Our analysis suggests that complete liberalization is likely to be optimal for less wealthy countries unless their labor endowment is large, their mean productivity is large, or initial holdings by foreigners are small, as is currently the case in China.