Shock spillovers and international financial (dis)integration

Global shocks – ranging from climate-related disasters and geopolitical conflicts to pandemics – transmit rapidly across borders and shape financial market co-movements. This paper develops a two-country general equilibrium model to study how cross-border shock spillovers affect optimal international portfolio holdings and the degree of financial (dis)integration. The analysis highlights that both the magnitude and heterogeneity of spillovers across income sources (capital versus labour income) play a central role in determining international risk-sharing opportunities. When spillovers mainly affect capital income, countries reduce their foreign asset positions and markets become more segmented. By contrast, when labour-income spillovers dominate, financial integration strengthens. The model generates empirical implications regarding the relation between global shocks, international portfolio rebalancing, and time-varying degrees of financial integration, providing a structural framework that can help interpret recent episodes of global financial fragmentation.