Financial Integration and International Business Cycle Co-Movement: The Role of Balance Sheets

Abstract This paper investigates the effect of international financial integration on international business cycle co-movement. We first show with a reduced form empirical approach how capital market integration (equity) has a negative effect on business cycle co-movement while credit market integration (debt) has a positive effect. We then construct a model that can replicate these empirical results. In the model, capital market integration is modeled as crossborder equity ownership and involves wealth effects. Credit market integration is modeled as cross-border borrowing and lending between credit constrained entrepreneurs and banks, and thus involves balance sheet effects. The wealth effect tends to reduce cross-country output correlation, but balance sheet effects serve to increase correlation as a negative shock in one country causes loan losses on the balance sheets of foreign banks. In versions of the model with a financial accelerator and balance sheet effects, credit market integration has a positive effect on cyclical correlation. However, in versions of the model without the financial accelerator and balance sheet effects, credit market integration has a negligible effect on cyclical correlation.