How Does Financial Globalization Affect Risk Sharing? Patterns and Channels

How Does Financial Globalization Affect Risk Sharing?
Patterns and Channels


M. Ayhan Kose, Eswar S. Prasad and Marco E. Terrones*




June 2007


Abstract

In theory, one of the main benefits of financial globalization is that it should allow for more
efficient international risk sharing. In this paper, we provide a comprehensive empirical
evaluation of the patterns of risk sharing among different groups of countries and examine
how international financial integration has affected the evolution of risk sharing patterns.
Using a variety of empirical techniques, we conclude that there is at best a modest degree of
international risk sharing, and certainly nowhere near the levels predicted by theory. In
addition, only industrial countries have attained better risk sharing outcomes during the
recent period of globalization. Developing countries have, by and large, been shut out of this
benefit. The most interesting result is that even emerging market economies, which have
witnessed large increases in cross-border capital flows, have seen little change in their ability
to share risk. We find that the composition of flows may help explain why emerging markets
have not been able to realize this presumed benefit of financial globalization. In particular,
our results suggest that portfolio debt, which has dominated the external liability stocks of
most emerging markets until recently, is not conducive to risk sharing.

* Kose and Terrones are with the IMF’s Research Department. Prasad is the Tolani Senior Professor
of Trade Policy at Cornell University. Emails: akose@imf.org; eswar.prasad@cornell.edu;
mterrones@imf.org. Earlier versions of this paper were presented at the 2006 IMF Annual Research
Conference, the January 2007 AEA meetings, and the 2007 IMF-Cornell conference on Financial
Globalization. We are grateful to our discussants, Jonathan Heathcote and Bent Sorenson, for their
helpful suggestions. We also thank Karen Lewis, Enrique Mendoza, Fabrizio Perri and conference
participants for helpful comments. Dionysios Kaltis provided able research assistance. The views
expressed in this paper are those of the authors and do not necessarily reflect the views of the IMF or
IMF policy.

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I. Introduction

In theory, one of the main benefits of financial globalization is that it provides
increased opportunities for countries to smooth consumption growth in the face of country-
specific fluctuations in income growth. With well-developed domestic financial markets,
economic agents within a country can share risk amongst themselves. However, insuring
against country-wide shocks requires openness to financial flows that would allow agents in
different countries to pool their risks efficiently. Thus, financial globalization should
generate welfare gains by reducing the volatility of aggregate consumption and also by
delinking national consumption and income (see Kose, Prasad, Rogoff, and Wei, 2006).

There is a substantial literature examining patterns of risk sharing among advanced
industrial economies (some of the notable contributions include Obstfeld, 1994, 1995; Lewis,
1996, 1997; Sorenson and Yosha, 1998). The main conclusion of this literature is that the
degree of risk sharing is rather limited even among advanced industrial economies, leaving a
considerable amount of potential welfare gains unexploited. Recent work examining the
evolution of risk sharing among these economies presents conflicting results. While some
studies suggest that it has increased during the recent period of globalization (e.g., Sorensen,
Yosha, Wu and Shu, 2006; Artis and Hoffman, 2006a, 2006b; Giannone and Reichlin, 2006),
others have found little evidence of better risk sharing among industrial economies (see
Moser, Pointner, and Scharler, 2004; Bai and Zhang, 2005).

The literature on risk sharing patterns for non-industrial economies is relatively
sparse. Obstfeld (1994) and Lewis (1997) do include some of these countries in their
analysis, but their samples (which end in 1988 and 1992, respectively) do not cover much of
the recent wave of financial globalization that enveloped the emerging market economies
starting in the mid-1980s. Given the relatively higher volatility of consumption fluctuations
in these economies, and the higher potential welfare gains of stabilizing these fluctuations,
understanding these economies’ risk sharing patterns is clearly of considerable interest.1

The objective of this paper is to study the impact of financial globalization on the
degree of international consumption risk sharing for a large set of industrial and developing
countries. In particular, we make three contributions to the empirical literature on

1 Quantitative estimates suggest that the potential welfare gains for developing countries can be very
large (Prasad, Kose, Rogoff and Wei, 2003; and Imbs and Mauro, 2007).

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international risk sharing. First, we extend the analysis to a large group of emerging markets
and other developing economies, and investigate the extent of risk sharing in these
economies in a unified framework. Second, we examine changes over time in the degree of
risk sharing across different groups of countries and attempt to relate those changes to
increased financial flows and other factors, including country characteristics. Third, we
provide a careful evaluation of alternative measures of risk sharing, drawn from different
empirical approaches. In principle, many of these approaches are equivalent, but there are
subtle differences that affect the results. Thus, our comprehensive evaluation of risk sharing
patterns based on a range of measures provides a benchmark set of results that should be
useful for further theoretical and empirical work in this area.

Our main conclusion is that, notwithstanding the prediction of conventional
theoretical models that financial globalization should foster increased risk sharing across all
countries, there is no evidence that this is true for developing countries. Even for the group of
emerging market economies—which have become far more integrated into global markets
than other developing countries—financial globalization has not improved the degree of risk
sharing. For advanced industrial economies, there is indeed some evidence that risk sharing
has improved in the last decade and a half. Our formal econometric analysis confirms that
increased financial openness improves risk sharing among industrial economies, but this
effect is absent for the other two groups of countries.

Why are non-industrial countries unable to share risk more efficiently despite their
increasing integration into global financial markets? One possibility is that these countries
rely largely on less stable capital such as bank loans and other forms of debt that may not
allow for efficient risk sharing. Indeed, when we break up capital stocks into different
categories—FDI, portfolio equity, portfolio debt etc.—we find some evidence that the
composition of stocks influences the ability of developing countries to share risk. In
particular, external debt appears to hinder the ability of emerging market economies to share
their consumption risk.

Another possibility is that the combination of domestic financial liberalization and
international financial integration could generate phenomena such as consumption booms
that can end badly, especially when they are financed by debt accumulation. The inefficient
intermediation of foreign finance by underdeveloped financial systems that exist in many

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developing countries may be another reason. In our empirical work, we attempt to explore
the relationship between domestic financial development and financial integration in terms of
risk sharing outcomes. We also look at whether other factors such as trade openness and
institutional quality systematically affect risk sharing outcomes. None of these factors seems
to be a major determinant of differences in the degree of risk sharing outcomes across
different groups of countries (or of changes over time within specific groups of countries).

One interpretation of our results is that there is a threshold effect in terms of how
financial globalization improves risk sharing, in that only countries that are substantially
integrated into global markets (in de facto terms) appear to attain these benefits. Indeed,
Kose, Prasad, and Terrones (2003) document that the volatility of consumption growth
relative to that of income growth, a crude measure of risk sharing, tends to increase at
intermediate levels of financial integration, and then declines at higher levels of integration.

In section II, we present a survey of theoretical arguments linking increased financial
integration to improvements in the degree of consumption risk sharing. In section III, we
provide a summary of the rich empirical literature on the changes in the patterns of risk
sharing in response to rising international financial flows. Next, we discuss the main features
of our dataset. This is followed in section V by a set of basic stylized facts concerning the
evolution of correlations of output and consumption growth. In section VI, we examine how
the degree of risk sharing has changed over time using various regression models. In section
VII, we evaluate the direct impact of financial globalization on the degree of risk sharing. In
section VIII, we then examine if the composition of flows and certain country characteristics
could explain the inability of emerging markets to attain the risk sharing benefits of financial
globalization. We conclude with a brief summary of our findings in section IX.

II. International Consumption Risk Sharing in Theory
Conventional theoretical models in open economy macroeconomics and international
finance yield clear predictions about the impact of financial integration on risk sharing. We
first summarize the predictions of theory about the impact of financial integration on the
patterns of international consumption and output correlations. Since most of these predictions
turn out not to be supported by the data, we then discuss some extensions of the basic models
to account for the empirical facts. We also briefly survey theoretical predictions about the

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volatility of consumption since these involve different, but related, approaches to measuring
the impact of financial globalization on international risk sharing.

II.1. Theoretical Predictions Regarding Output and Consumption Correlations
Standard intertemporal open economy models yield predictions about the effects of
financial integration on risk sharing, as measured by cross-country correlations of
consumption. Dynamic stochastic general equilibrium (DSGE) models, in particular, have
been able to generate quantitative predictions along these lines. In the absence of trade in
goods and financial assets (the case of autarky), consumption should be perfectly or highly
correlated with domestic output, depending on the formulation of the utility function and
possibilities for intertemporal smoothing through investment (or storage technologies).
By contrast, with complete markets that enable perfect risk sharing, it should be
possible to decouple fluctuations in consumption from those of output, yielding lower
correlations between domestic consumption and national output. Predicted cross-country
correlations of consumption growth rates would be perfect or very high. Consumption
fluctuations would be more correlated across countries than output fluctuations. Moreover,
theoretical models with complete markets predict that correlation of consumption growth
with the growth of world output (or, equivalently, world consumption) would be higher than
that with domestic output.2 Contrary to these predictions, the data suggest that cross-country
consumption correlations are rather low and, in most cases, are lower than output
correlations. Backus, Kehoe, and Kydland (1995) refer to this as “the quantity anomaly”.




2 See Backus, Kehoe, and Kydland (1995) and Pakko (1998). If consumption was the only argument
in the utility function, the consumption-world output correlation would be unity. If the utility function
included other arguments such as leisure, the correlation would be less than one, but would still be
very high. Heathcote and Perri (2004) argue that, by introducing certain modifications such as
differences in consumption baskets across countries into an otherwise standard model, it is possible to
alter the theoretical predictions regarding consumption and output correlations, even with complete
markets and efficient international risk sharing. Pakko (2003) notes that the assumption of a
sufficiently low elasticity of substitution between domestic and foreign goods could get some
predictions of the model closer to the data.

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II.2. Explaining Imperfect Risk Sharing in Theory
As we discuss in the next section, a number of empirical papers test the risk sharing
implications of theory and show that they are mostly rejected by data. Some of the leading
theoretical explanations for the low degree of risk sharing are as follows.
● Non-tradable and durable goods. Models with non-traded goods, when augmented
with large preference shocks, generate low predicted cross-country consumption correlations
even with perfect risk sharing (see Stockman and Tesar, 1995). However, the empirical
evidence supporting the relevance of large preference shocks in generating business cycles is
weak. The lumpiness of durables purchases may also make consumption expenditures more
correlated with output even in an environment with risk sharing.
● Market incompleteness. International financial markets are incomplete as it is not
possible to buy insurance against all future contingencies. Moreover, one could argue that
since it is not yet possible to trade financial instruments linked to a broad measure of national
output, it is normal to expect less than perfect consumption correlations across countries.
Models with incomplete asset markets have been more successful in generating the rankings
of cross-country consumption and output correlations observed in the data, although even
these models require some strong assumptions to match certain features of the data (Baxter,
1995, and Heathcote and Perri, 2002).
● Transaction costs. Transaction costs associated with international trade of goods
and assets are large, and could reduce the incentives for international risk sharing. Recent
models with trade costs--such as transportation costs, tariffs and non-tariff barriers--are able
to generate relatively low cross-country output and consumption correlations (see Obstfeld
and Rogoff, 2001). Bai and Zhang (2005) argue, however, that trade transactions costs
cannot by themselves account for imperfect risk sharing since the risk sharing benefits of
financial integration could be realized only if international financial flows are much larger
than their current levels.3




3 Brandt, Cochrane and Santa-Clara (2006) show that, when the extent of risk sharing is computed
using asset market data, the extent of risk sharing is quite high between some pairs of G-7 countries.

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II.3. Theoretical Predictions Regarding Consumption Volatility
Theory suggests that financial integration should reduce the volatility of consumption
(relative to that of output or income). In particular, if output fluctuations are not perfectly
correlated across countries, it is possible to show that trade in financial assets can be used to
delink national consumption levels from the country-specific components of output
fluctuations in a DSGE model with complete markets, which should make consumption
growth less volatile relative to income growth. From a time series perspective, increasing
financial integration should lead to declining relative volatility of consumption growth.
Contrary to these predictions, Kose, Prasad and Terrones (2003) document that the
volatility of consumption growth relative to that of income growth increased for emerging
market economies in the 1990s, even as these countries were becoming more financially
integrated. Interestingly, increasing financial openness is associated with rising relative
volatility of consumption only up to a threshold. Beyond a certain level of financial
integration, an increase in integration reduces the relative volatility of consumption. In other
words, the benefits of financial integration in terms of improved risk sharing and
consumption smoothing possibilities appear to accrue only beyond a threshold level of
financial integration—the evidence suggests that it is almost entirely just industrial countries
that are beyond this threshold level of integration.
A number of recent theoretical papers have attempted to explain the positive
association between financial integration and the relative volatility of consumption growth.
For instance, Levchenko (2005) and Leblebicioglu (2006) construct dynamic general
equilibrium models where only some agents have access to international financial markets. In
both models, financial integration leads to an increase in the volatility of aggregate
consumption since agents with access to international financial markets stop participating in
risk sharing arrangements with those who do not have such access.

III. Empirical Studies on International Risk Sharing

There is a rich empirical literature studying various dimensions of international risk
sharing. We divide this literature into three categories. The first category includes studies
focusing on the patterns of international correlations of output and consumption to determine
the degree of risk sharing. The second comprises studies that test the hypothesis of perfect

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risk sharing using regression models. The third category includes studies that employ various
regression models to measure the extent of risk sharing and to examine the impact of
financial flows on the degree of risk sharing. Our paper is closely related to those in the last
category, although our empirical work encompasses the first two approaches as well.

III.1. Studies on the Patterns of Output and Consumption Correlations
Numerous studies have documented a variety of stylized facts associated with the
patterns of cross-country comovement of output and consumption in order to examine the
extent of risk sharing. These studies differ in terms of country coverage (developed versus
developing), the correlations that they focus on (cross-country consumption correlations
versus correlations of consumption with a global aggregate), and empirical techniques
(simple correlations versus more sophisticated measures of comovement).
Obstfeld (1994, 1995) documents the cross correlations of consumption and output
growth rates between individual countries and the rest of the world using PWT data for a
group of developed and developing countries over the period 1950-1988. He finds that
correlations of consumption growth rates are lower than those for output for the majority of
the countries. His results also indicate that there was an increase in these correlations after
1973 for most of the industrial countries in his sample, which he interprets as an indication of
increased international trade in financial assets after 1973.
Using two datasets-- PWT (1950-90) and OECD (1955-73)--Pakko (1998) finds that
cross-country output correlations are higher than consumption correlations, but notes that his
results are somewhat sensitive to the choice of dataset and detrending method. His results
also suggest that correlations between consumption and domestic output are generally higher
than those between consumption and world output, contrary to the predictions of theory.
Using quarterly data for OECD countries over the period 1960-2000, Ambler, Cardia, and
Zimmermann (2004) conclude that cross-country consumption correlations are quite low
even in the period 1973-2000. Using a similar dataset, Canova and Ravn (1997) find that
consumption correlations are significantly different from unity in almost all country pairs.
They also find that the correlations are sensitive to the method of detrending.
Kose, Prasad, and Terrones (2003) employ annual data over the period 1960-1999 for
a sample of 76 countries—21 industrial and 55 developing—to examine the correlations of

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output and consumption growth rates in each country with the growth rates of composite
measures of world output and consumption. They document that, on average, industrial
countries have stronger output and consumption correlations with world aggregates than do
developing economies. They find that consumption correlations are typically smaller than
output correlations. For industrial countries, these correlations on average increase sharply in
the 1970s and rise further in the 1990s. For developing countries, they decline in the 1990s.4
Kose, Otrok, and Whiteman (2003) provide further empirical evidence about the
extent of imperfect consumption risk sharing. They estimate a dynamic factor model using
data for 60 developed and developing countries over the period 1960-1990. They find that
the world and region-specific factors together account for a larger share of fluctuations in
output growth than in consumption growth. In most countries, country-specific factors play a
more important role than those two common factors in explaining consumption fluctuations.
Taken as a whole, the results of this vast literature indicate that the theoretical
predictions regarding perfect risk sharing do not have much empirical support. First, the
observed cross-country correlations of consumption fluctuations are relatively low. Second,
these correlations are lower than those of output. Third, correlations between consumption
and domestic output are generally higher than those between consumption and world output.

III.2. Studies on Tests of Perfect Risk Sharing
In addition to the basic stylized facts surveyed above, researchers have employed
more rigorous methods to test the risk sharing implications of models with financial
integration. These tests generally use some versions of reduced form solutions (or the first
order conditions) of the models and focus on the links between various measures of domestic
consumption and world consumption.5

Obstfeld (1995) examines the empirical links between domestic consumption growth
and world consumption growth for the G7 economies. Based on the reduced form solutions
of a simple endowment economy, he develops a test of the hypothesis of perfect consumption

4 Recent studies looking at the time profile of cross-country correlations of output and consumption
do not reach a clear conclusion, even for industrial countries (see Kose, Prasad, and Terrones, 2003
and Kose, Otrok, Whiteman, 2005 for summaries of recent studies).
5 Cochrane (1991) and Mace (1991) provide early examples of these types of tests using consumer
level data and analyzing the extent of risk sharing between individual and aggregate consumption.

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risk sharing. In particular, he runs a regression of the growth rate of domestic consumption
on world consumption growth and national output growth. The model implies that the
coefficient on world consumption should be one and that on national output should be equal
to zero under perfect risk sharing. His results suggest that that the hypothesis of perfect risk
sharing is rejected in most cases during the periods 1951-1972 and 1973-1988.
Lewis (1996, 1997) examines the roles played by nonseparabilities between tradables
and nontradable leisure (or goods) and the restrictions on financial flows in explaining the
lack of international risk sharing. She finds that, while formal tests reject risk sharing even
among countries with relatively loose capital controls, correlations between domestic
consumption and output appear to be higher for countries with more restrictions. She
concludes that neither nonseparabilities between consumption and leisure, nor the inclusion
of nontradables and/or durable goods, is sufficient to explain imperfect risk sharing.

III.3. Studies on the Channels and Extent of Risk Sharing
The empirical tests of the risk sharing hypothesis that we have discussed cannot shed
light on the channels through which risk sharing takes place or about the extent of risk
sharing. Asdrubali, Sørenson and Yosha (1996) develop a methodology to measure the extent
of risk sharing achieved through different channels. They quantify the amount of risk sharing
across U.S. states by decomposing the cross-sectional variance of gross state product data
into various components representing different channels of risk sharing.6 They find that
roughly 40 percent of shocks to gross state product are insured by capital markets, 13 percent
by the federal government, and 23 percent by credit markets. Sørenson and Yosha (1998) use
the same methodology to analyze the patterns of international risk sharing among European
Community and OECD countries. They document that approximately 40 percent of shocks to
GDP are insured in both groups.7

6 Their paper is related to a voluminous literature on intranational risk sharing (using data from
regions within a country), which concludes that that risk sharing is imperfect on that dimension as
well but exceeds the degree of international risk sharing (see Hess and van Wincoop, 2002).
7 Kalemli-Ozcan, Sørenson and Yosha (2006) study the evolution of risk sharing in the European
Union using the same methodology. Kalemli-Ozcan, Sørenson and Yosha (2001a, 2001b) consider
the empirical links between risk sharing and industrial specialization.

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