Financial Integration Without Financial Development

Abstract

This paper shows that, in a two-country model, where the two economies differ in their level of financial market development, financial integration has sizable short- and medium-term effects, even in the absence of aggregate risks. Consistent with the Lucas paradox, the present work establishes that financial integration can reduce the speed of capital accumulation and increase savings in a developing country still in the process of convergence toward the steady state and with domestic capital market distortions. The level of capital accumulation at the time of integration crucially affects agents’ welfare. The closer the economy is to its steady state, the lower are agents’ welfare gains in the financially less advanced economy, while they are always negative in the more developed country. 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 assumption of the constant relative-risk-aversion utility function, those forces are both decreasing in wealth.