Financial Integration and International Risk Sharing Bai, Yan; Zhang, Jing

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Bai, Yan ; Zhang, Jing
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Journal of International Economics
Financial markets; International finance; Financial risk
To link to full-text access for this article, visit this link: Byline: Yan Bai, Jing Zhang Keywords: Sovereign default; Financial liberalization; Financial frictions; International capital flows Abstract: Conventional wisdom suggests that financial liberalization can help countries insure against idiosyncratic risk. There is little evidence, however, that countries have increased risk sharing despite widespread financial liberalization. We show that the key to understanding this puzzling observation is that conventional wisdom assumes frictionless international financial markets, while actual markets are far from frictionless: financial contracts are incomplete and contract enforceability is limited. When countries remove official capital controls, default risk is still present as an implicit barrier to capital flows. If default risk were eliminated, capital flows would be six times greater, and international risk sharing would increase substantially. Article History: Received 19 September 2010; Revised 13 August 2011; Accepted 15 August 2011 Article Note: (footnote) [star] We thank Patrick Kehoe, Timothy Kehoe, Ellen McGrattan, Richard Rogerson, Linda Tesar and seminar participants at Arizona State University, Federal Reserve Bank of Minneapolis, Midwest Macro Conference 2006, the University of Minnesota, the University of Michigan, the Ohio State University, SED 2006, and the University of Wisconsin for their helpful comments and suggestions. All errors remain our own.
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