Financial Integration, Credit Market Imperfections and
North Carolina State University
June 22, 2008
Contrary to standard theoretical reasoning, recent empirical research shows that ﬁnancial
integration is associated with higher consumption volatility in developing countries. This paper
illustrates how domestic credit market imperfections can alter the standard predictions about
the consumption smoothing possibilities under ﬁnancial autarky and international ﬁnancial in-
tegration. I use a two country international real business cycle model where the non-traded
sector in the small country faces borrowing constraints due to contract enforceability problems.
If the international risk-sharing opportunities are nonexistent, households can secure themselves
against the shocks in the non-traded sector only by adjusting their labor eﬀort, which leads to
changes in sectorial output and terms of trade. The deterioration of the terms of trade acts as
a dampening eﬀect on consumption, causing it to be less volatile under ﬁnancial autarky rela-
tive to ﬁnancial integration. Under ﬁnancial integration, international ﬁnancial assets provide
the insurance against domestic productivity shocks without aﬀecting the relative prices, hence
allowing the consumption to react more.
Key Words: Financial integration, consumption smoothing, credit market frictions, emerging
markets, RBC models.
JEL Classiﬁcation: F41
Acknowledgement: I am grateful to Fabio Ghironi, Peter Ireland and Fabio Schiantarelli for
continuous help and advice. I would like to thank Matteo Iacoviello, Ayhan Kose, Luisa
Lambertini, Enrique Mendoza for helpful discussions and comments. Also I would like to
thank conference participants at SED 2006, seminar participants at Bogazici University,
Drexel University, North Carolina State University, UNC Chapel Hill, Sabanci University
for useful comments. All errors are mine.
∗Email: firstname.lastname@example.org. Correspondence: Department of Economics, North Carolina State University, Campus
Box 8110, Raleigh, NC 27695. Phone: 919-513-2867. Fax: 919-515-7873.
One of the perceived beneﬁts of ﬁnancial integration is international risk-sharing and consumption
smoothing. Financial integration provides access to a wider range of assets, which act as cushion
against domestic shocks. Theoretical studies (Mendoza (1994), Baxter and Crucini (1995), and
Sutherland (1998)) have shown that the diversiﬁcation of assets generates a lower consumption
volatility compared to a ﬁnancially less integrated system or a ﬁnancial autarky. Empirical studies,
on the other hand, have not robustly established a negative relationship between ﬁnancial openness
and consumption volatility for a large set of countries. While some evidence suggests that lower
consumption volatility is associated with greater ﬁnancial openness in developed economies, the
results for developing countries are less optimistic. In their empirical study, Kose, Prasad and
Terrones (2003) show that higher levels of ﬁnancial integration in the 1990s are associated with
higher consumption volatility relative to output volatility for developing countries. For a similar
group of emerging markets, Bekaert, Harvey and Lundblad (2006) demonstrate that there is a weak
positive correlation between the ratio of consumption growth volatility to income growth volatility
and some forms of capital account openness.1
The purpose of this paper is to analyze how credit market imperfections in developing economies
can alter the regular consumption-smoothing mechanisms provided by ﬁnancial integration, and
ask whether they are able to provide an explanation for the absence of a signiﬁcant decrease, or
an increase, in consumption volatility in the case of ﬁnancial integration. The theoretical exercise
shows that given the frictions, aggregate consumption and consumption relative to output can
be more volatile under ﬁnancial integration for certain parametrizations. The mechanism works
through diﬀerent relative price dynamics generated endogenously under ﬁnancial integration and
The model I develop in the paper is a two country real business cycle model, where one of the
countries represents an emerging market economy. This smaller economy features two credit market
imperfections that are characteristic of developing countries as shown by Tornell and Westermann
(2003). First, I assume that the non-traded sector ﬁrms cannot borrow internationally; they are
1See the next section for a more detailed summary of the evidence in these studies.
bound to the domestic ﬁnancial system for any borrowing requirements.
I assume, moreover,
that when they borrow from the domestic ﬁnancial system, they face collateral constraints due
to contract enforcement problems. As in Tornell and Westermann (2003), their borrowing cannot
exceed a given proportion of their existing capital stock. These frictions make the non-traded sector
inherently more volatile. Financial integration aﬀects how the households respond to this volatility.
I analyze the impact of ﬁnancial integration on the emerging market country by comparing two
scenarios. The ﬁrst setup depicts a ﬁnancial autarky where the economy is closed to trading of
any international assets. The second scenario involves ﬁnancial integration, where the households
are allowed to hold international state contingent portfolios, and hence are able to fully insure
themselves against domestic risks that are ampliﬁed by the ﬁnancial imperfections.2 In the autarky
scenario, however, where the international risk-sharing opportunities are nonexistent, households
can secure themselves only by adjusting their labor eﬀort, which leads to changes in sectorial output
and relative prices (e.g. terms of trade).
The mechanism following a productivity shock in the non-traded sector is as follows. Due to
the credit markets imperfections, the non-traded sector ﬁrms are required to pledge existing capital
stock, which is denominated in the relative price of the non-traded goods, as collateral. Therefore,
when faced with a productivity shock, value of the collateral decreases causing the ﬁrms to be
more constrained. A stricter constraint implies that loans and demand for labor in the non-traded
sector decrease. Under ﬁnancial autarky households have no assets, so the only sources of income
they have are from loans and labor supplied to the two sectors. When the demand for loans
and for labor in the non-traded sector decrease, households insure themselves by supplying more
labor to the traded sector. Higher labor supply in the traded sector leads to more output, and
to terms of trade deterioration.3 As a result of the terms of trade deterioration, the consumption
bundle becomes more expensive, dampening the reaction of consumption to productivity shocks.
Under ﬁnancial integration, however, households have international assets to insure themselves
with. Therefore, they do not react to the changes in the non-traded sector, and the terms of trade
2In either of these scenarios, the non-traded sector ﬁrm owners are not allowed to hold the international portfolios.
3The terms of trade is deﬁned as the ratio of the imported foreign good price to the exported home good price.
Hence, terms of trade deterioration means an increase in this ratio.
do not move. Without the dampening eﬀect of the terms of trade, reaction of consumption to
productivity changes can be higher, causing aggregate consumption to be more volatile. Higher
consumption volatility under ﬁnancial integration is associated with lower levels of welfare in the
aggregate, due to big welfare losses of the non-traded good ﬁrm owners, even though the households
are still better oﬀ under ﬁnancial integration.4
The higher consumption volatility under ﬁnancial integration results depend on the degree of
risk-aversion of the households, as well as the elasticity of their labor supply. As the households be-
come more risk-averse, the insurance international ﬁnancial assets provide becomes more valuable.
Moreover, as their total labor supply becomes more inelastic, adjusting labor eﬀort becomes more
costly in terms of welfare. In these two cases, the consumption and labor smoothing beneﬁts of
ﬁnancial integration outweigh the dampening eﬀects of relative prices observed in ﬁnancial autarky.
Credit market frictions, similar to the ones depicted in this paper, have widely been used in
explaining ﬁnancial crises and instability of small open economies. Aghion, Bacchetta and Banerjee
(2004), Tornell and Westermann (2002), and Arellano and Mendoza (2002) are a few examples that
focus on such imperfections in the context of small open economies. Because the main goal of this
strand of literature is to understand ﬁnancial crises, most of these studies do not look at the role
of domestic ﬁnancial frictions in the context of international ﬁnancial integration. One exception
is Aghion, Bacchetta and Banerjee (2004), who show how capital account liberalization might
destabilize a small country that has an intermediate level of ﬁnancial development. In their analysis,
they mainly focus on the volatility of investment and output, and do not discuss the implications for
consumption. Levchenko (2005), on the other hand, focuses on the impact of ﬁnancial liberalization
on consumption volatility. He shows that in the countries with underdeveloped ﬁnancial markets,
domestic risk-sharing arrangements might deteriorate in the face of ﬁnancial integration. As a
results, individual consumptions might become more volatile, but aggregate consumption volatility
will nevertheless decrease.
The rest of the paper is organized as follows: next section summarizes some of the empirical
4The result that ﬁnancial integration is not necessarily welfare improving to all parties is also discussed by Tille
(2005). He shows that when the goods markets are characterized by rigidities and exchange rate pass-through is
partial, the country with less volatile monetary shocks will lose from integration.
evidence on ﬁnancial openness and consumption volatility. Section 3 presents the model economy.
Section 4 discusses the model parametrization. Section 5 analyzes the frictions in the model and
presents the results. Section 6 looks at sensitivity analysis. Section 7 describes the welfare results.
Finally, section 8 concludes.
Review of Empirical Evidence on Financial Integration and Con-
There are alternative ways to evaluate the extent of international risk-sharing and beneﬁts of ﬁnan-
cial integration.5 Financial openness facilitates borrowing and lending opportunities that can help
the consumers smooth domestic shocks, and hence can help the economies achieve lower consump-
tion growth volatilities. Therefore, a direct way to assess the beneﬁts of ﬁnancial integration is
to analyze the relationship between consumption growth volatility and ﬁnancial integration. Since
ﬁnancial openness can also aﬀect the volatility of income growth, it is also important to examine the
ratio of consumption growth volatility to GDP growth volatility. This ratio captures an economy’s
ability to smooth shocks.
Allowing for an extensive set of control variables, and using data from both the developed
and developing countries, Kose, Prasad and Terrones (2003) investigate the relationship between
ﬁnancial integration and consumption growth volatility, in addition to the ratio of consumption
growth volatility to GDP growth volatility. As proxies for ﬁnancial integration, the authors use
both gross capital ﬂows (as a percentage of GDP) and an indicator of restrictions on capital account
transactions. One of the interesting results they obtain is that the consumption growth volatility
relative to output growth volatility is higher for more ﬁnancially integrated developing economies
during the 1990s–the decade during which they were ﬁnancially more open. Moreover, their results
show that increasing ﬁnancial openness is signiﬁcantly associated with rising relative volatility of
consumption upto a threshold. Their results imply that smoothing of shocks, and hence reductions
in the ratio of consumption volatility to GDP volatility occur in economies with gross capital ﬂows
5See Kose, Prasad and Terrones (2007) for a detailed discussion, and the references within.
higher than 49%. On the other hand, their results display no signiﬁcant relationship between the
volatility of consumption growth and ﬁnancial openness.
In a similar set-up, Bekaert, Harvey and Lundblad (2006) investigate the impact of ﬁnancial
liberalization on consumption growth volatility, and on the ratio of consumption growth volatility
to GDP growth volatility. As measures of ﬁnancial liberalization, they use both the equity market
liberalization measures (oﬃcial liberalization indicator and intensity measure), and capital account
liberalization measures (International Monetary Fund’s measure for restrictions on payments for
the capital account transactions and Quinn’s openness measure). They ﬁnd that the ﬁnancial
liberalization is associated with lower consumption growth variability in a large cross-section, and
that the eﬀect of equity market liberalization is larger for countries with relatively more open
capital accounts. When looking at emerging markets only, they do not ﬁnd a signiﬁcant relationship
between ﬁnancial liberalization and consumption growth variability. However, their results show a
reduction in the ratio of consumption growth volatility to GDP growth volatility after equity market
liberalizations in developing countries. The result for the enhanced ability to smooth shocks does
not carry over to other types of capital account liberalizations, as the authors ﬁnd a higher ratio
associated with IMF’s capital account openness measure.
As illustrated in these two studies, whether consumption growth (in absolute and relative terms)
becomes less volatile with ﬁnancial openness depends on the type and intensity of capital ﬂows, as
well as certain country characteristics. One of the country characteristics that might play a crucial
role in facilitating consumption smoothing after liberalizations is the level of ﬁnancial development.
If the domestic ﬁnancial frictions are too prevalent, then the countries might not be able to reap
the beneﬁts of ﬁnancial openness. The model I present below incorporates some of the domestic
ﬁnancial frictions that are present in the developing countries (as documented by Tornell and
Westermann (2002)), and investigates whether these frictions can hamper consumption smoothing
in the case of ﬁnancial integration.
This section presents the model for ﬁnancial autarky and ﬁnancial integration. It is a two-country
model with inﬁnitely lived agents. The world is populated with a continuum of agents on the
interval [0,1]. A mass n of households belongs to country H (home), while 1 − n belongs to F
(foreign). I assume that home is an emerging market economy with an underdeveloped ﬁnancial
system, and foreign is a large economy with perfect ﬁnancial markets. Each country produces a
traded and a non-traded good. In the home country, there are two types of consumers: households
and the owners of the non-traded sector ﬁrms (from here on NT owners). Households make up
fraction κ of the population, own the home traded goods ﬁrms, and provide labor to both the
traded and the non-traded goods sectors. NT owners make up fraction 1 − κ of the population, and
they borrow from the households to be able to ﬁnance the investment and production of non-traded
Consumption Baskets and Price Indices
Both the households and the NT owners consume the same consumption basket, Ct, which is a
composite index of traded and non-traded consumption goods, CT and CN , respectively:
t = [γ ξ C
+ (1 − γ) ξ C
where ξ ≥ 0 is the elasticity of substitution between traded and non-traded goods, and γ is the
share of traded goods in the consumption basket. Consumption of the traded goods, CT , is a
composite of home and foreign traded goods, CH and CF , respectively:
T ,t = [n θ C
+ (1 − n) θ C
where θ ≥ 0 is the elasticity of substitution between home and foreign traded goods. The general
price index for consumption, Pt, the price index for the traded goods, PT,t, and the price index for
the non-traded goods, PN,t, are denominated in units of domestic currency.6 Pt and PT,t are given
Pt = [γP 1−ξ + (1 − γ)P 1−ξ] 1−ξ
PT,t = [nP 1−θ + (1 − n)P 1−θ] 1−θ .
Households consume the consumption basket, own the traded sector ﬁrms, provide labor to the
production of traded and non-traded goods, and lend to the non-traded goods ﬁrms. The objective
of a household is to maximize:
t = Et
t ) − τN LN,t − τH LH,t]
t is the consumption of the household, LN,t and LH,t denote labor supply in the non-traded
and traded sectors, respectively.
Under ﬁnancial autarky, home households are not allowed to trade any assets with foreign house-
holds. The budget constraint in this case is
t + Z h
WN,tLN,t + WH,tLH,t + Rt−1Zh
t−1 + Πt,
t is the amount loans given to the non-traded sector, and Rt−1 is the gross interest rate on
the loans, paid in period t. WN,t and WH,t are the wage rates in the traded and non-traded goods
sectors, respectively. Πt denotes the proﬁts from owning the traded goods ﬁrms. The households
t , Z h
t , LN,t, LH,t to maximize (5) subject to (6).
The ﬁrst order conditions give us the
6It must be noted that the model economy is a cashless economy, as in Woodford (2003), where currency only
plays the role of convenient unit of account.
Euler equation and the labor supply equations in the two sectors:
WN,t = τNCh
WH,t = τHCh
When the home country is ﬁnancially integrated with the foreign country, households can fully
insure themselves against domestic shocks. They are able to do so by holding an international state
contingent portfolio, which yield a return in terms of the foreign country’s currency.7,8 The budget
constraint for the household in this case becomes:
t + Z h
t + εt
Q(st+1 | st)B(st+1) ≤ WN,tLN,t + WH,tLH,t + Rt−1Zh
t−1 + Πt + εtB(st)
where st denotes the state of the nature, εt is the nominal exchange rate, B(st) is the market
value of (in units of foreign currency) a portfolio of the state contingent securities held at the end
of period t, and Q(st+1 | st) is the pricing kernel of the state contingent portfolio. In this case,
in addition to the choice variables under ﬁnancial autarky, the household also chooses B(st+1) in
maximizing (5) subject to (10). The ﬁrst order conditions in this case are:
7The assumption of an international state contingent portfolio allows us to analyze the most favorable form of
ﬁnancial integration. The mechanism and the results presented hold when I consider a single non-contingent bond.
Results available upon request.
8Having bonds denominated in currency is convenient particularly here, since denomination in units of consumption
would imply implicit trading of foreign non-traded goods.
Q(st+1 | st) = β Pr(st+1|st)
WN,t = τNCh
WH,t = τHCh
Combining (11) and (12), I get the no-arbitrage condition between the returns on the loans and
the international portfolio:
Q(st+1 | st) =
The no-arbitrage condition implies that households are indiﬀerent between giving out loans to the
non-traded sector ﬁrms and holding the international portfolio. The equilibrium amount of loans is
then pinned down by the demand for loans of the NT owners, which is always positive in equilibrium
as discussed in section 3.4.
Traded Goods Sector
Firms in the traded sector are perfectly competitive, and for simplicity I assume that they produce
the home traded good using only labor. The typical competitive ﬁrm maximizes its proﬁts choosing
max PH,tYH,t + εtP ∗
YH,t + Y ∗
H,t = AH,tLH,t