Risk Sharing and Industrial Specialization: Regional and International Evidence by Sebnem Kalemli-Ozcan, Bent E. Sørensen and Oved Yosha. Published in volume 93, issue 3, pages 903-918 of American Economic Review, June 2003

We analyze the impact of financial globalization on business cycle synchronization using a proprietary database on banks’ international exposure for industrialized countries during 1978 to 2006. Theory makes ambiguous predictions and identification has been elusive due to lack of bilateral time‐varying financial linkages data. In contrast to conventional wisdom and previous empirical studies, we identify a strong negative effect of banking integration on output synchronization, conditional on global shocks and country‐pair heterogeneity. Similarly, we show divergent economic activity due to higher integration using an exogenous de‐jure measure of integration based on financial regulations that harmonized EU markets.

We examine the empirical role of different explanations for the lack of capital flows from rich to poor countries—the “Lucas Paradox.” The theoretical explanations include cross-country differences in fundamentals affecting productivity, and capital market imperfections. We show that during 1970–2000, low institutional quality is the leading explanation. Improving Peru's institutional quality to Australia's level implies a quadrupling of foreign investment. Recent studies emphasize the role of institutions for achieving higher levels of income but remain silent on the specific mechanisms. Our results indicate that foreign investment might be a channel through which institutions affect long-run development.