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It is well documented that since the mid-1980s there has been a surge in capital flows due to the increased integration of world financial markets. Such episodes naturally lead to question the macroeconomic and welfare implications of increased financial liberalization. Most of the theoretical literature so far has shown that increasing international financial linkages should help to improve consumption smoothing possibilities in face of country-specific shocks. This is the starting assumption motivating the works by Backus and Smith 1993, Mendoza 1994, Baxter and Crucini 1995 who study the business cycle implications of restricting international asset trading. This paper builds a small open economy model with borrowing limits to show that capital account liberalization coupled with limited enforcement in financial markets can increase consumption volatility and reduce welfare in presence of risk averse agents.

The model used in this paper is a small open economy model where risk averse agents consume durable and non-durable goods, supply labour services and finance consumption with foreign lending. The latter is constrained by a borrowing limit in which foreign lending is secured by collateral in the form of durable stock. The small open economy produces and trades non-durable consumption goods with the rest of the world as there is imperfect substitution between home and foreign consumption. As shown in Backus, Kehoe and Kydland 1992 imperfect substitution allows for a better characterization of the current account dynamic. Accumulable durables play the role of collateral and can be seized by foreign lenders in the event of default. The reason for introducing durable goods is twofold. First, they account for a large portion of measured consumption and for this reason the current account becomes more variable as agents tend to lump their purchases of durables. Second, given the size of the transactions agents borrow mostly to finance the purchase of durable rather than that of non-durable goods. In this paper we assume that durables play the role of collateralizable wealth but they also provide utility services (see Davis and Heatcote 2005, Miles 1992 and Iacoviello 2005). The latter assumption allows to account both for the welfare effects of fluctuations in durable goods and for the business cycle implications of imperfect substitutability between durable and non-durable goods. Finally, I assume that agents face adjustment costs on durable consumption, an assumption that allows to reproduce persistence in response to various shocks (see Topel and Rosen 1988, Erceg and Levin 2005). The borrowing limit allows to model the assumption of imperfect financial linkages while the degree of financial liberalization is captured by the parameter characterizing the sensitivity of foreign lending to the value of collateral as a higher value of this parameter relaxes the constraint on foreign lending. The type of borrowing constraint considered is an ad hoc limit on the line of Kiyotaki and Moore 1997, Kocherlacota 2000, Chari, Kehoe and McGrattan 2005 among others.