Real Effects of Financial Market Integration: Does Lower Home Bias Lead to Welfare Benefits?

Abstract

This paper proposes equity home bias as a proxy for financial integration in the ongoing empirical debate on the impact of financial integration on economic growth. In integrated markets, investors are expected to take full advantage of the potential for international diversification. The extent of equity home bias (i.e. overinvesting in domestic stocks and foregoing gains from international diversification) gives therefore a relevant quantity-based measure of financial integration. Using different techniques to compute home bias, this paper investigates whether countries with lower home bias experience faster economic growth. Also, other possible real effects of (decreasing) home bias are analyzed, respectively regarding growth and consumption variability, as well as the degree of international risk sharing and on income inequality. The results suggest that financial integration, proxied by the decreasing equity home bias, has significant positive effects on economic growth and on international risk sharing. Moreover, these benefits do not come at the cost of higher variability in real variables. At the same time, it appears that higher financial integration is associated also with higher income inequality.