Financial integration, capital misallocation and global imbalances

This paper shows that in a stylized model with two countries, characterized by different levels of financial development, the following facts can be replicated: 1) persistent current account surpluses and 2) high TFP growth in China. Under autarky, entrepreneurs in the emerging country overinvest in short-term projects and underinvest in long-term projects because short-term assets help them secure long-term investments in the presence of credit constraints. This creates an aggregate misallocation of capital. When financial markets integrate, entrepreneurs with long-term projects can have access to cheaper short-term assets abroad, which leaves them with more resources to invest in their projects. This both reduces capital misallocations and generates capital outflows. (C) 2012 Elsevier Ltd. All rights reserved.