NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

International Financial Integration and Crisis Contagion

Michael B. Devereux, Changhua Yu

NBER Working Paper No. 20526
Issued in September 2014
NBER Program(s):International Finance and Macroeconomics

International financial integration helps to diversify risk but also may increase the trans- mission of crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with endogenous portfolio choice and collateral con- straints. Collateral constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. The analysis allows for different degrees of financial integration, moving from financial autarky to bond market integration and equity market integration. Fi- nancial integration leads to a significant increase in global leverage, doubles the probability of balance sheet crises for any one country, and dramatically increases the degree of 'contagion' across countries. Outside of crises, the impact of financial integration on macro aggregates is relatively small. But the impact of a crisis with integrated international financial markets is much less severe than that under financial market autarky. Thus, a trade-off emerges between the 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 increased leverage resulting from financial integration can reduce welfare of investors.

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Document Object Identifier (DOI): 10.3386/w20526

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