Evaluating international financial integration in a center-periphery economy☆

a r t i c l e i n f o JEL classification: F36 F44 F62 G15 Keywords: Financial integration International risk sharing Portfolio choice Market size Welfare analysis Does opening up capital markets facilitate risk diversification across borders? Are all countries gradually better off in the process of international financial integration? This paper explores welfare implications for various countries in a center-periphery framework with endogenous portfolio choice. Financial integration is divided into four stages: financial autarky, two-country integration, center-periphery integration and global integration. Two effects from financial integration emerge: diversification effects and financial terms of trade effects. Results show that financial integration between the center and a new periphery in center-periphery integration generates welfare losses for the peripheral country already integrated and welfare gains for the central country. Allowing for financial integration between peripheries in global integration leads the welfare in the center to deteriorate. From two-country integration directly to global integration, the large country gains, while the small one loses. One of the most noticeable features in international financial markets is the momentous rise of international capital flows over the past several decades (Lane and Milesi-Ferretti, 2001, 2007). This phenomenon has attracted an expanding volume of literature trying to evaluate welfare gains from international financial integration. 1 According to standard theory, financial integration helps countries efficiently allocate resources and diversify their income risks across borders. This argument mainly favors the case from financial autarky to perfect financial integration in which the allocation of resources is the first-best. Nonetheless, international financial integration in the real world seems to be somewhere in the middle. Over decades, policy makers and economists have been concerned with welfare benefits from removing barriers to international capital flows. Does opening up capital markets facilitate risk diversification? Are all countries gradually better off in the process of international financial integration? Tackling these questions requires a multiple-country model where international portfolio choice is endogenous. This paper examines welfare implications for various countries in the process of international financial integration in a parsimonious center-periphery dynamic stochastic general equilibrium (DSGE) model which is augmented to allow for endogenous international portfolio choice. International financial architectures are exogenously divided into four stages according to the degree of international financial integration. 2 Fig. 1 illustrates these four stages. The first stage is financial autarky, in which countries do not hold external assets. In the second stage, two-country financial integration , central country …