The Impact of Financial Openness on Economic Integration: Evidence from the Europe and the Cis

2.2 Financial openness and international trade

Assuming that internationally well integrated capital markets will effectively emerge
from it, financial openness can influence the extent of international trade in goods and
services through two main channels. The first operates through risk-sharing and
production specialization¹⁰. Consider a region where countries are affected by
idiosyncratic shocks. If such shocks are large and volatile, or alternatively if
households are risk averse to a sufficient degree, then incentives to diversify domestic
production will be stronger, thus leading to low specialization. Open and well
integrated financial markets facilitate the diversification of ownership. This in turn
has two effects. First, if economic agents in one country hold debt and equity claims
on the output of the other country, then the dividend, interest and rental income
derived from these holdings contributes to smoothing shocks across countries. This is
thus a form of ex-ante international insurance. Second, to achieve consumption
smoothing, households in each country will undertake ex-post adjustment of their
asset portfolios following the realization of idiosyncratic shocks in the region. Again,
this will lead to smoothing the income of all countries. Once insurance is available
through international trade in financial assets, each country will have stronger
incentive to specialize in one production (or technology) in order to fully exploit
economies of scale (or technological competitive advantage). Specialization in
production will then create greater scope for international trade in goods and services,
as predicted from a standard neo-classical trade theory.

The second channel relies on the ability of the financial sector to divert savings to the
private sector. When domestic financial intermediation is weak and inefficient, firms
in export-oriented sectors are burdened by significant liquidity constraints and hence
trade less. Financial openness can help overcome those constraints by making more
external finance available to domestic firms. An implication of this model is that
international trade will tend to increase particularly in those sectors that more heavily
rely on external finance, such as projects in the manufacturing sector. A related
argument is that financial openness, by eventually facilitating the development of

¹⁰ For a discussion of the theoretical and empirical link between capital markets, risk sharing and
production specialization see Kalemli-Ozcan et al. (2003). For more empirical evidence see Imbs
(2003).

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