International Financial Integration and Crisis Contagion

Abstract

International financial integration helps to diversify risk but also may increase the trans- mission ofcrises across countries. We provide a quantitative analysis of this trade-off in a two-country generalequilibrium model with endogenous portfolio choice and collateral con- straints. Collateral constraintsbind occasionally, depending upon the state of the economy and levels of inherited debt. The analysisallows for different degrees of financial integration, moving from financial autarky to bond marketintegration and equity market integration. Fi- nancial integration leads to a significant increase in globalleverage, doubles the probability of balance sheet crises for any one country, and dramatically increasesthe degree of 'contagion' across countries. Outside of crises, the impact of financial integration onmacro aggregates is relatively small. But the impact of a crisis with integrated international financialmarkets is much less severe than that under financial market autarky. Thus, a trade-off emerges betweenthe probability of crises and the severity of crises. Financial integration can raise or lower welfare,depending on the scale of macroeconomic risk. In particular, in a low risk environment, the increasedleverage resulting from financial integration can reduce welfare of investors.