This paper examines the optimal financial markets liberalization policy for a large country in a two-country general equilibrium production economy. In our model, household's portfolio choice is modeled separately from firm's investment decision and financial markets play an important role in the allocation of capital between production technologies. We find that the type of production technology, specifically whether it exhibits decreasing returns to scale in capital, is an important factor in evaluating the welfare gains from financial markets liberalization, and hence the optimal financial structure for a country. As financial markets become liberalized, there is gain from efficient capital allocation as a result of improved sharing risk sharing. On the other hand, a less wealthy country will not be able to gain by borrowing at a lower risk-free rate and reinvesting in a more productive risky technology when financial markets are completely liberalized. When production technologies exhibit decreasing returns to scale, the gain from efficient capital allocation as a result of financial markets liberalization dominates the opportunity cost of higher borrowing rate for the less wealthy country. Consequently, complete financial markets liberalization is more likely to be optimal when production technologies exhibit decreasing returns to capital.
