Financial Market Access and International Risk Sharing

Abstract

In the past three decades the stock of assets and liabilities of developing countries measured as a ratio of GDP has tripled. It is commonly believed that an increase in opportunities for diversifying risk allows more consumption smoothing. However, the data show that volatility of consumption in developing countries has persisted at high levels, showing only an average 11 percent decrease from the 60's to the 90's. This paper aims to explain this phenomenon by investigating to what extent domestic financial frictions related to heterogeneous home financial market access can help resolve the quantitative discrepancy between the change in volatility of consumption in the data and that predicted by a model economy that allows for higher degrees of financial integration. We show that in an endowment economy, if only 40 percent of the population has access to financial markets, full access to insuring country risk in international markets would reduce consumption volatility by 24 percent. In a world in which all agents have equal access to financial markets, the predicted impact of integration with world markets would be a much higher drop of 49 percent. The absence of a forward international market for the nontradable good and the inability of some agents to access a forward market for the tradable good opens a new role for the spot market of tradable and nontradable goods: individuals excluded from financial markets use the goods market to attenuate tradable risk, which is reflected in higher consumption volatility for these agents following international financial integration. In an extended version of the model allowing for production, opening the economy brings even less change in consumption volatility. Later, we investigate whether limited domestic financial market participation can break the theoretical result found by Backus and Smith (1993) that consumption ratios and the real exchange rate are perfectly correlated for pairs of countries. We consider a two-country world inhabited by individuals with heterogeneous access to financial markets in one country and full access in the other. Both countries are endowed with tradable and nontradable goods. We find that consumption ratios for individuals with access to financial markets are perfectly correlated with the real exchange rate across countries but the aggregate consumption ratio and the real exchange rate might not be perfectly correlated across countries.