International risk sharing and capital mobility: another look

Does opening up capital markets facilitate risk diversification across borders? Are all countries gradually better off in the process of international financial integration? This paper explores welfare implications for various countries in a center-periphery framework with endogenous portfolio choice. Financial integration is divided into four stages: financial autarky, two-country integration, center-periphery integration and global integration. Two effects from financial integration emerge: diversification effects and financial terms of trade effects. Results show that financial integration between the center and a new periphery in center-periphery integration generates welfare losses for the peripheral country already integrated and welfare gains for the central country. Allowing for financial integration between peripheries in global integration leads the welfare in the center to deteriorate. From two-country integration directly to global integration, the large country gains, while the small one loses.

We study the impact of mainland Chinese listings in Hong Kong on the quality and development of the Hong Kong equity market. At the macro-level, we find that the increasing presence of mainland Chinese stocks in Hong Kong increases the size, trading volume, and its link with the China and world markets but reduces the overall volatility of the Hong Kong stock market. At the firm level, the increase affects the market quality, resulting in lower turnover rate, higher Amihud illiquidity ratio, and higher spread for non-mainland Chinese firms. Furthermore, such an increase in presence causes Hong Kong stocks to move in a more synchronized way and reduces these firms investment sensitivity to stock price movement, implying deterioration in the information environment. As a whole, the increasing presence of Chinese companies in Hong Kong brings benefits to the Hong Kong market, yet not without cost.

Exchange rates depreciate by the difference between domestic and foreign marginal utility growth or discount factors. Exchange rates vary a lot, as much as 15% per year. However, equity premia imply that marginal utility growth varies much more, by at least 50% per year. Therefore, marginal utility growth must be highly correlated across countries: international risk sharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do: exchange rates are too smooth. We calculate an index of international risk sharing that formalizes this intuition. We treat carefully the realistic case of incomplete capital markets. We contrast our estimates with the poor risk sharing suggested by consumption data and home-bias portfolio calculations.

We examine the effects of both equity market liberalization and capital account openness on real consumption growth variability. We show that financial liberalization is mostly associated with lower consumption growth volatility. Our results are robust, surviving controls for business-cycle effects, economic and financial development, the quality of institutions, and other variables. Countries that have more open capital accounts experience a greater reduction in consumption growth volatility after equity market openings. We also find that financial liberalizations are associated with declines in the ratio of consumption growth volatility to GDP growth volatility, suggesting improved risk sharing. Our results are weaker for liberalizing emerging markets but we never observe a significant increase in real volatility. Moreover, we demonstrate significant differences in the volatility response depending on the size of the banking and government sectors and certain institutional factors.

This paper applies portfolio principles to explore potential diversification benefits of the European Union (EU). We apply the portfolio approach to judge whether a particular membership configuration of the EU dominates alternative possibilities based on growth rates and growth rate volatilities. Our conclusions are that, for the original six members of the EU (the EU6), no subset of countries would have dominated in growth/volatility terms, and that few portfolio benefits have been realized by expansion of the EU beyond the original six members. We also conclude that adding Turkey or Norway, whose economies are different from other EU members, would improve the growth and stability of the EU's portfolio of countries. Lastly, we find that the original EU6 was not far from an efficient portfolio.

Cross-country evidence on consumption, income, saving, and investment indicates that there remain opportunities for international risksharing. One explanation for the lack of global risksharing is that the gains are not sufficient to offset even small frictions. This paper evaluates the utility gains from risksharing under different assumptions about market structure, country size, technology, and preferences. I find that the gains from risksharing range from zero to two percent of lifetime consumption. When countries are able to “self-insure” by adjusting labor supply and investment, the gains from risksharing are insignificantly different from zero.