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[ Journal of Political Economy, 2009, vol. 117, no. 3]
䉷 2009 by The University of Chicago. All rights reserved. 0022-3808/2009/11703-0001$10.00
Financial Integration, Financial Development,
and Global Imbalances
Enrique G. Mendoza
University of Maryland and National Bureau of Economic Research
Vincenzo Quadrini
University of Southern California, Centre for Economic Policy Research, and National Bureau of
Economic Research
Jose´ -Vı´ctor Rı´os-Rull
University of Minnesota, Federal Reserve Bank of Minneapolis, Centro de Ana´lysis y Estudios
Rı´os Pe´rez, Centre for Economic Policy Research, and National Bureau of Economic Research
Global financial imbalances can result from financial integration when
countries differ in financial markets development. Countries with
more advanced financial markets accumulate foreign liabilities in a
gradual, long-lasting process. Differences in financial development
also affect the composition of foreign portfolios: countries with neg-
ative net foreign asset positions maintain positive net holdings of non-
diversifiable equity and foreign direct investment. Three observations
motivate our analysis: (1) financial development varies widely even
among industrial countries, with the United States on top; (2) the
secular decline in the U.S. net foreign asset position started in the
early 1980s, together with a gradual process of international financial
We would like to thank Manuel Amador, David Backus, Luca Dedola, Linda Goldberg,
Pierre-Olivier Gourinchas, Gita Gopinath, Ayse I
˙
mrohorog˘lu, Patrick Kehoe, Kyungsoo
Kim, and Alessandro Rebucci for insightful comments and Gian Maria Milesi-Ferretti and
Philip Lane for sharing their cross-country data on foreign asset positions. We also thank
participants at several universities and conferences. Financial support from the National
Science Foundation is gratefully acknowledged: Quadrini with grant SES-0617937 and
Rı´os-Rull with grant SES-0079504. The views expressed herein are those of the authors
and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal
Reserve System.
372 journal of political economy
integration; (3) the portfolio composition of U.S. net foreign assets
features increased holdings of risky assets and a large increase in debt.
I. Introduction
At the end of 2006, the current account deficit of the United States
reached 1.6 percent of the world’s GDP, the largest in the country’s
history. Continuing a trend that started in the early 1980s, the U.S. net
foreign asset (NFA) position fell to ⫺5 percent of the world’s output.
During this period, the U.S. foreign asset portfolio also changed dra-
matically: net equity and foreign direct investment (FDI) climbed to
one-tenth of U.S. GDP, whereas net debt obligations increased sharply
to about one-third of U.S. GDP.
These unprecedented global imbalances are the focus of a large and
growing literature. Some studies argue that the imbalances resulted from
economic policy misalignments in the United States and abroad,
1
whereas others argue that they were caused by events such as differences
in productivity growth, business cycle volatility, demographic dynamics,
a “global savings glut,” or valuation effects.
2
To date, however, a quan-
titatively consistent explanation of both the unprecedented magnitude
of the changes in NFA positions and the striking changes in their port-
folio structure has proven elusive.
In this paper we show that both of these phenomena can be explained
as the equilibrium outcome of financial integration across countries
with heterogeneous domestic financial markets. This is a relevant hy-
pothesis because the reforms that integrated world capital markets start-
ing in the 1980s were predicated on their benefits for efficient resource
allocation and risk sharing across countries, ignoring the fact that do-
mestic financial systems differed substantially, and these differences per-
sist today despite the globalization of capital markets. In short, financial
integration was a global phenomenon, but financial development was
not.
The empirical motivation for our analysis derives from three key
observations.
1. There is a high degree of heterogeneity in domestic financial markets across
countries, and these differences remain largely unaltered despite financial glob-
1
See, e.g., Obstfeld and Rogoff (2004), Summers (2004), Blanchard, Giavazzi, and Sa
(2005), Roubini and Setser (2005), and Krugman (2006).
2
See Backus et al. (2005), Bernanke (2005), Croke, Kamin, and Leduc (2005), Haus-
mann and Sturzenegger (2005), Henriksen (2005), Attanasio, Kitao, and Violante (2006),
Cavallo and Tille (2006), Engel and Rogers (2006), Fogli and Perri (2006), Chakraborty
and Deckle (2007), Deckle, Eaton, and Kortum (2007), Ghironi, Lee, and Rebucci (2007),
Gourinchas and Rey (2007), Lane and Milesi-Ferretti (2007), Prades and Rabitsch (2007),
Caballero, Farhi, and Gourinchas (2008), and McGrattan and Prescott (2008).
financial integration 373
alization and financial development. Figure 1A plots the financial devel-
opment index constructed by the International Monetary Fund for in-
dustrial countries (see IMF 2006). The index shows that there are large
differences even among advanced economies, with the United States
ranked first. In addition, the gaps of other industrial countries relative
to the United States did not change significantly between 1995 and
2004. Similar features are evident in another index of financial devel-
opment constructed by Abiad, Detragiache, and Tressel (2008) for in-
dustrial and emerging economies for the 1973–2002 period. As shown
in figure 1B, while financial liberalization progressed in both OECD
and emerging economies over the last 30 years, the gap between the
two groups of countries has not changed.
2. The secular decline of the NFA position of the most financially developed
country—the United States—began roughly at the same time as the financial
globalization process, in the early 1980s. Figure 2A shows the Chinn-Ito
financial openness index for the United States, the industrial countries
excluding the United States, and all countries except the United States.
Capital markets in the United States have been relatively open to the
rest of the world throughout the last three decades. Most of the other
countries started opening their capital accounts gradually since the early
1980s. Figure 2B shows that this process of financial integration pro-
duced a worldwide surge in gross stocks of foreign assets and liabilities.
3. The decline in the U.S. NFA position was accompanied by a marked change
in the portfolio composition of foreign assets of all countries. Figure 3 plots the
two broad components of the total NFA positions: net debt instruments
(including international reserves) and net portfolio equity and FDI. The
plots show that the United States increased net holdings of risky assets
(portfolio equity and FDI) and reduced net holdings of riskless assets
into a very large negative position. Other industrial countries changed
net holdings of risky assets in a similar way but hardly changed holdings
of riskless assets. The emerging economies reduced net holdings of risky
assets and increased holdings of riskless assets. See also Gourinchas and
Rey (2007), Lane and Milesi-Ferretti (2007), and Curcuru, Dvorak, and
Warnock (2008).
We build a model suitable for empirical analysis in which we take as
given observations 1 and 2 to explain the facts highlighted in observation
3 (i.e., the changes in NFA positions and in their portfolio structure).
In our model, countries are inhabited by ex ante identical agents who
face two types of idiosyncratic shocks: endowment and investment
shocks. Financial development is defined by the extent to which a coun-
try’s legal system can enforce financial contracts among its residents so
that they can use these contracts to insure against idiosyncratic risks.
In our model, the state of development of a country’s legal system is
represented by the fraction of individual income that the country’s
374
Fig. 1.—Indices of financial markets heterogeneity. A, Financial index score for ad-
vanced economies (data from IMF [2006]). Open bars p 1995; black bars p 2004. B,
Index of financial liberalization (data from Abiad et al. [2008]). Solid line p OECD
countries; dashed line p emerging economies. See Appendix A for definitions of the
variables.
375
Fig. 2.—Indices of financial openness. A, Index of capital account openness (data from
Chinn and Ito [2005]). Solid line p United States; dashed line p OECD countries except
United States; dotted line p all countries except United States. B, Gross stock of foreign
assets and liabilities (data from Lane and Milesi-Ferretti [2007]). Solid line p United
States; dashed line p OECD countries except United States; dotted line p emerging
economies. See Appendix A for definitions of the variables.
