On the Social Costs of Financial Globalization without Financial Development∗

It is widely argued that countries can reap large gains from liberalizing their capital accounts if financial globalization is accompanied by the development of domestic institutions and financial markets. However, if liberalization does not lead to speedier financial development, globalization can result in adverse effects on distribution and welfare within and across countries. We use a multi-country model with heterogenous agents and non-insurable idiosyncratic risk to show that, if countries differ in the degree of asset market incompleteness, financial globalization hurts the poorer agents in countries with less developed financial markets. This is because in these countries liberalization leads to an increase in the borrowing cost, relative to financial autarky, and poorer agents are the ones that have larger liabilities relatively to their assets. Quantitative analysis shows that these welfare effects are sizable and can justify policy intervention. ∗This paper has been prepared for the International Seminar on Macroeconomics (ISOM), Instanbul, June 15-16, 2007. “...much of the Mexican banking system is now controlled by foreigners,... However, this influx of foreign capital has not led to cheaper banking. Fees remain high, producing bumper profits. Credit-card interest rates average over 30%... Banking in Mexico remains very profitable for banks, and intimidatingly expensive for the country’s poor.”. The Economist, Nov. 25, 2006