A Global Analysis of Financial Market Integration

Masaya Sakuragawa and Hiroto Takahashi#January 14, 2008
Preliminary

Abstract
We consider a global analysis of financial market integration by modeling a two-country
overlapping generations economy in the presence of financial market frictions, and find several
important features that have not been obtained from the local analysis around steady states.
There are a stable symmetric steady state with harmonized growth and stable asymmetric steadystates with capital flows from the poor to the rich, both of which may coexist, and out of steadystates, there are interesting non-monotone behavior of the pattern of capital movement anddevelopment. The timing of integration that attains harmonized growth depends on several
characteristics including the stage of economic and legal developments, income inequality, andglobal savings. The existence of a stable asymmetric steady state does not necessarily
recommend the poor to keep capital control indefinitely, but if the stable symmetric steady statecoexists, will guide the poor to open eventually capital accounts by delaying the timing ofliberalization until arriving at some development stage. Even the existence of the unique steadystate that is stable and symmetric may or may not recommend the poor to lift capital controls
promptly because the symmetric-breaking process will occur on integration. The concept ofoptimal timing for liberalization allows us to explore conditions for successful integration.

We are greatly thankful to Kyoji Fukao, Masahisa Fujita, Makoto Saito, Etsuro Shioji, Yukie
Sakuragawa, Tadashi Shigoka, Makoto Yano and participants in the conference held in Hitotsubashi
University and Kyoto University for helpful and valuable comments.
#Keio University, Japan, masaya@econ.keio.ac.jp, hirotot@gs.econ.keio.ac.jp

11. Introduction
The neoclassical theory on capital mobility predicts that capital should flow from rich countries
to poor countries. By capital account liberalization, poor countries should be able to attain faster
growth followed by the inflow of capital from abroad. The observed evidence on developing
countries for past two decades, however, seems inconsistent with and even more complicatedthan the prediction of the neoclassical theory. In fact, despite the globalization as a great trend in
the world economy, financial liberalization still does not appear to be progressed so fast; manyobservers and policymakers of poor countries are still skeptical on the effects of capital accountliberalization on the economic growth, and even now so many countries impose various kinds ofcapital controls.1
A number of approaches have attempted to answer the question why capital does not flowfrom the rich to the poor, and sometimes even flow from the poor to the rich. Among several
research lines, one research line emphasizes the role of frictions in international financial
markets, and focuses on the important role of legal and institutional infrastructure andasymmetric information for financial development (e.g., La Porta et al (1997, 1998), Levine(1998), Levine et al (2000), and others).2 Much theoretical literature has explained why andhow perverse capital movements and the divergence in income between the rich and the poorarise under financial market integration. The policy implication recommended there is that poor
countries should not open capital accounts, but the evidence is not necessarily consistent withthe theoretical prediction.
In fact, the integration of financial market has been progressed first among developed
countries, and later developed with the link of middle-income countries. Many observers and1

Braun and Raddatz (2007) report that in their sample of 108 countries for the 1970-2003, thenumber of those that allow for free capital mobility is 47, less than a half of all.
2
Another research line has emphasized the cost of the governments’ time inconsistency problem
associated with sovereign debt. The literature includes Bulow and Rogoff (1989), Eaton andFernandes (1995), Tirole (2003), and others. On the other hand, the research line supporting the“Lucas Paradox “(1990) has a negative stance to the financial-friction view, arguing that poor
countries also have lower endowments of factors complementary with physical capital, and hence
the large difference in capital-labor ratio will coexist with the equalization of marginal product ofcapital. Along this view, Caselli and Feyrer (2007) find that the cross-country difference in marginal
products of capital is not so large relative to the difference in capital-labor ratio, and support partially
Lucas’s argument.

2economists have addressed the important role of timing for financial liberalization for economicdevelopment in various ways. McKinnon (1991) addressed this question in terms of thesequence of liberalization between trade and capital markets.3 As a matter of fact, evenpolicymakers in poor countries will not intend to isolate their financial markets “indefinitely”
from the world. Therefore, the theoretical research is needed to provide a sufficientcharacterization on the long-run inequality of income between countries, the patterns of capital
movement, the timing of financial liberalization, and their relationship.
In this paper, we consider a two-country overlapping generations model in the presence offinancial market frictions. Two countries are assumed to be inherently identical in technologies
and institutions for contract enforcement, but may differ only in their initial levels of income.
Moreover, we assume that entrepreneurs have no initial wealth for financing productive
investment but can pledge up the future income (wage income in the model) as collateral. This
assumption is motivated to make the dynamical system a one-dimensional map of thecapital-labor ratio of either country, in contrast to the preceding literature which exhibits acomplicated dynamical system (e.g., Boyd and Smith (1997) and Matsuyama (2004)). This
assumption also enables us to preserve the non-monotone behavior of the interest rate in termsof the capital-labor ratio that is the source of multiple steady states and implicitly involved in
the preceding literature. We conduct the global analysis, finding interesting properties ofequilibria and the patter of capital movement that are not found in the steady state analysis. We
find that there are a stable symmetric and stable asymmetric steady states, both of which may
coexist, and that out of steady states, there are complicated but interesting non-monotone
behavior of the pattern of capital movement and development. We show that how the process ofdevelopment goes hand in hand with financial development, how the pattern of capital
movement and development evolves over time, and how and when the globalization magnifies
and lessens the divergence in per-capita income between the rich and the poor.
The timing of integration that attains harmonized growth depends on several characteristics
including the stage of economic and legal developments, income inequality, and global savings.
3Bartolini and Drazen (1997) emphasize the signaling role of capital account liberalization as acommitment to policy reforms to boost capital inflows.

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The existence of a stable asymmetric steady state does not necessarily recommend the poor

toisolate their capital markets indefinitely from the world, but if the stable symmetric steady statecoexists, will guide the poor to delay the timing of liberalization until arriving at somedevelopment stage. On the other hand, the existence of the unique steady state that is stable andsymmetric does not recommend the poor countries to lift capital controls promptly. An earlyride on “turnpike” on globalization may force the poor to be trapped into prolonged stagnation
with capital flight before exploiting gains of financial integration. The concept of optimal
timing for liberalization allows us to explore conditions for successful integration. This paper isorganized as follows. Section 2 reviews the related literature. Section 3 sets up the model.
Section 4 characterizes the autarkic economy and section 5 the world economy. Section 6analyzes the dynamic properties and provides policy implications for financial integration.

2. Related Literature
In answering the puzzle on why capital does not flow rich to poor countries, much literature
has emphasized the role of frictions in international financial markets. One important researchline of this view focuses on the role of legal and institutional infrastructure and asymmetric
information in developing financial markets (e.g., La Porta et al (1997, 1998), Levine (1998),Levine et al (2000), and others). The empirical literature includes Bekaert et al (2001), Reinhartand Rogoff (2004), Portes and Rey (2005), Chin and Ito (2006), Alfaro et al (2006), and Braunand Raddatz (2007).4 The theoretical literature includes Gertler and Rogoff (1990), Boyd andSmith (1997), Sakuragawa and Hamada (2001), and Matsuyama (2004), Caballerro andKrishnamurty (2001) (2006), Aghion et al (2004), and Aoki, Benigno and Kiyotaki (2006), andothers.5Gertler and Rogoff (1990) is a seminal work that explained the perverse capital movement
when the financial market imperfection arises from asymmetric information between creditors
4Bekaert et al(2001), Chin and Ito (2006) and Braun and Raddatz (2007) investigate the impact of
institutional factors that will affect financial development on capital account linearization.
5Caballerro and Krishnamurty (2001) (2006) and Aghion et al (2004), investigate thesmall-open-economy model of asymmetric information in order to identify perverse capital flows

4and debtors. In their static model, the difference in borrowers’ ability to rely on external financecauses capital flows to go from poor to rich. Boyd and Smith (1997) developed the idea ofGertler and Rogoff (1990) in the dynamic framework, showing that the financial market
integration causes the divergence in income between the poor and the rich, even with identicaltechnologies and institutions for contract enforcement. Matsuyama (2004) constructed moregeneral but tractable model than Boyd and Smith (1997), succeeding in characterizing all thesteady states, including those with binding borrowing constraint and the one without it. Boydand Smith (1997) and Matsuyama (2004) demonstrated how the integration of financial markets
magnifies inequality in income between the rich and the poor by relying on the poverty trap
argument that involves the multiplicity of steady states that arises from a feedback effectbetween the borrowers’ wealth and investment, reinforced by the so-called, “balance sheeteffect” (e.g., Bernanke and Gertler (1989)). But the introduction of the feedback effectcomplicates the dynamic system and hence their scope turns out to be limited to the local
analysis around steady states. Their complexity in principle arises from their application of theDiamond’s (1965) overlapping generations model in which agents work and earn labor incomeswhen young. Sakuragawa and Hamada (2001) are an exception that studied the wholedevelopment process, in and out of steady states. They constructed a two-country model withdifferent institutions for contract enforcement, and with technological externalities in production,
having policy implications on the timing of lifting capital account for successful development
Tornell and Velasco (1992) constructed a growth model with poorly established property
rights, showing that how the poorly established property rights make people appropriate others’
properties and lead to the slowdown of economic growth and capital flight. Acemoglu andZilibotti (1997) demonstrate how the market incompleteness, combined with technologicalnon-convexities, magnify the inequality of nations and becomes a reason for perverse capital
mobility. In theirs, rich countries provide more opportunities for diversification, and the better
financial market encourages more investment.

that happened in Asian emerging market countries.
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