International financial integration and total factor productivity losses from underdeveloped domestic financial markets

Abstract

This paper explores the role of international financial integration in the association between total factor productivity (TFP) and domestic financial development. Using a heterogeneous-agent model with financial frictions, we compare TFP losses from underdeveloped domestic financial markets between a state of financial autarky and a state of financial integration. The model predicts that economies under integration are less affected by financial frictions than under autarky. The main mechanism is the role of integration in improving the efficacy of self-financing: even with an underdeveloped domestic financial system, agents under integration overcome financial frictions more easily by accumulating their internal capital and, thus, financial frictions translate into smaller distortions in resource allocation along the intensive and extensive margins than under autarky. Using data for 138 countries during 1970–2017, we estimate the role of integration in TFP effect of financial development. The empirical results are consistent with the model’s prediction.