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Financial Integration and International Risk Sharing
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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 recent
widespread financial liberalization. This work shows that the key to understanding this puzzling observation
is that conventional wisdom assumes frictionless international financial markets, while actual
international financial markets are far from frictionless. In particular, financial contracts are incomplete
and enforceability of debt repayment is limited. Default risk of debt contracts constrains borrowing, and
more importantly, it makes borrowing more difficult in bad times, precisely when countries need insurance
the most. Thus, default risk of debt contracts hinders international risk sharing. When countries
remove their official capital controls, default risk is still present as an implicit barrier to capital flows;
the observed increase in capital flows under financial liberalization is in fact too limited to improve risk
sharing. If default risk of debt contracts were eliminated, capital flows would be six times greater, and
international risk sharing would increase substantially.international risk sharing, financial integration, financial liberalization, financial frictions, sovereign default, international capital flows