Medium and Long Run Implications of Financial Integration Without Financial Development

Abstract

The textbook neoclassical growth model predicts that countries with lower capital stock benefit from capital account liberalization since integration increases the speed of convergence through the equalization of returns on capital. In the present analysis we show that, in the medium term, financial integration can reduce capital accumulation in developing countries with poor financial institutions, because of a high risk premium in production activities. In the long run, however, integration brings higher capital than in the autarky steady state. The contrary happens for financially advanced economies: they enjoy a period of capital growth in the first years after integration, but in the long run they experience a reduction in capital compared to their autarky steady state. Two forces drive these results: precautionary saving and the propensity to move resources from risky capital to safe assets until the risk-adjusted return on capital equalizes the risk-free interest rate; under the maintained assumption of constant relative risk aversion (CRRA) utility function, those forces are both decreasing in wealth. Overall, financial integration is welfare improving for financially advanced economies and welfare decreasing for developing countries.

Keywords: Current Account, Incomplete Markets, International Capital Movements, Economic Growth

JEL Classification: F32, F43, G11, O16