Savings Gluts and Asset Price Booms: The Impact of Domestic Imperfect Enforcement and Global Financial Integration

Abstract

This paper shows that capital outflows from emerging economies after financial integration can lead to simultaneous increases in the savings rate and in domestic asset prices. Under autarky, firms in emerging economies invest in risky capital while facing a borrowing constraint that creates a need for precautionary savings. Financial integration provides firms with access to foreign risk-free assets and results in two effects: a substitution effect, whereby firms divert some investments to foreign assets and cause capital outflows; and a wealth effect, whereby they grow richer in equilibrium and thus demand more domestic capital. Savings gluts and asset price booms occur when the wealth effect dominates. The increases in savings and asset prices are inefficiently high relative to the socially optimal level and can be amplified by heterogeneity in productivity among domestic firms.