We study the effects of globalization on risk sharing and welfare. Like previous literature, we assume that countries cannot commit to repay their debts. Unlike previous literature, we assume that countries cannot discriminate between domestic and foreign creditors when repaying their debts. This creates novel interactions between domestic and international trade in assets. (i) Increases in domestic trade raise the bene.ts of enforcement and facilitate international trade. In fact, in our setup countries can obtain international risk sharing even in the absence of default penalties. (ii) Increases in foreign trade .i.e. globalization.raise the costs of enforcement and hamper domestic trade. As a result, globalization may worsen domestic risk sharing and lower welfare. We show how these e¤ects depend on various characteristics of tradable goods and explore the roles of borrowing limits, debt renegotiations, and trade policy.
Globalization, risk sharing, sovereign risk, domestic markets, international markets
This paper presents a theoretical study of the eÂ¤ects of globalization on risk sharing and welfare. We model globalization as a gradual and exogenous increase in the fraction of goods that are tradable. In the absence of frictions, globalization opens new goods markets and raises welfare. We assume, however, that countries cannot commit to pay their debts. Unlike the previous literature, and motivated by changes in the institutional setup of emerging-market borrowing, we also assume that countries cannot discriminate between domestic and foreign creditors when paying their debts. Although globalization still opens new goods markets, we find that it can also open or close some asset markets. The net eÂ¤ect on risk sharing and welfare of this process of creation and destruction of markets might be either positive or negative depending on a variety of factors that the theory highlights.
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