International financial integration and risk sharing among countries: A production-based approach

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Highlights

  • Develop a production approach for asset trade in pooling risks among countries.

  • Provide new evidence for the correlation puzzle and risk sharing among countries.

  • The puzzle reflects a failure to allow for countries’ production risk sharing.

  • The estimated degree of international risk sharing is quite substantial.

  • Countries are found to pool more production risks than consumption risks.

Abstract

This paper develops a production-based model for analyzing a role of asset trade in pooling risks among countries and provides new evidence for the international consumption-output puzzle and risk sharing among countries. Efficient risk sharing rules among countries are the same as the conditions for full financial integration. Input prices and interest rates as well as technology shocks are found to be the driving variables for cross-country output co-movements. The international correlation puzzle reflects an inability to account for production risk sharing among countries in previous studies. The degree of international risk sharing is substantial relative to earlier estimates, which is largely realized from pooling production risks rather than consumption risks among countries.

Introduction

Many studies in international macroeconomics have found that measured cross-country correlations of consumption growth are surprisingly low – far from perfect as predicted by the model – and, more importantly, tend to be even lower than the corresponding output correlations (Backus et al., 1992, Baxter and Crucini, 1993, Obstfeld, 1994a, Obstfeld, 1994b, Tesar, 1995). This is contrary to the implication that integrated world financial markets should help individuals to smooth consumption in response to idiosyncratic fluctuations in income. This phenomenon has become known as the “international or cross-country consumption-output correlation anomaly or puzzle” (Backus et al., 1992). These studies typically rest on a consumption (or endowment)-based framework in which consumers maximize expected utility of consumption over time under the condition of uncertainty. Many attempts have been made to resolve the puzzle, but results are, by and large, not satisfactory (see Tesar, 1995, Lewis, 1996, Lewis, 1999, Baxter, 2011).

In an effort to shed some light on the well-known but unsettled cross-country correlation riddle, this paper develops an altogether different approach suitable for explaining financial market integration and risk sharing among countries or regions from the vantage point of the production side, rather than the consumption side, of the economy. The thesis of the proposed model is that production shocks are the driving force for output co-movements across countries and that international risk sharing, which is captured through asset trade in world financial markets, is possibly realized from diversifying production risks rather than consumption risks among countries. In many respects, the production-based model, though it has not received due regard, is more relevant than traditional consumption-based models to characterize international financial market integration and risk sharing among countries. Production variables such as output or investment are more characteristic of economic fluctuations than consumption, and stock returns are found to be significantly related to production activity (see Cochrane, 1991, Cochrane, 1996, Kim, 2013). While international financial markets may not be an adequate mechanism for consumers to share the risk of consumption, they do provide opportunities for firms to diversify the risk of international production. Multinational firms tend to shift production to take advantage of lower costs of production and hence to mitigate risk occurring in one country by shifting resources from other countries. The proposed production-based approach provides us an alternative measure for evaluating welfare gains from international risk sharing in contrast to the traditional consumption-based measure with a utility function (Tesar, 1995).

We analyze a multi-country, multi-factor production model with a focus on a hypothesized role for asset trade in pooling risks among countries. We view each country as a producer of goods and services, instead of as a consumer as in traditional consumption-based models, in a small open economy under conditions of production uncertainty or risk.1 The model is characterized as a state-contingent intertemporal production problem using the cost function that is a function of output, input prices, and a technology shock. The producer’s intertemporal marginal rate of substitution of output supply is described by the ratio of marginal costs of output in two successive periods, and the production Euler equation, which shows that asset returns are determined by the producer’s production decisions across time and states of nature, is derived. If countries are fully integrated financially, the growth rates of marginal cost of output must be the same for their producers across states of nature, which is equal to the (negative of) world interest rate. The international production risk sharing problem is modeled as the problem facing a social (world) planner who minimizes the sum of expected costs of an individual country over time for an efficient intertemporal allocation of output under production risk. The first-order conditions yield a set of rules for efficient output sharing among producers in different countries under uncertainty. In particular, efficiency in production requires that producers in different countries equalize their marginal cost of output at every state and time. This condition implies that the growth rate of marginal cost is constant across countries and does not depend on idiosyncratic shocks but rather on common shocks affecting all countries. If all shocks are common shocks, opportunities for risk sharing among countries are limited. Moreover, if international financial markets are complete or fully integrated, there is perfect risk sharing among countries. For a Cobb-Douglas cost function, efficient risk sharing implies that when countries experience common technology shocks (in addition to common input prices and interest rates), output growth rates should be perfectly correlated across them.

The country’s cost minimization problem that forms the basis of analysis is dual to the production problem in international real business cycle models. However, unlike earlier studies, this paper provides some new and critical results. International real business cycle models (see Backus et al., 1992), based on a production function, consider technology or productivity shocks as the sole determinant of cross-country dynamics. The proposed production-based model, on the other hand, employs the cost function for a small open economy and suggests a role for input prices and interest rates (or intertemporal substitution in production) as well as technology shocks to be driving variables for cross-country output co-movements. The model has a structure similar to consumption-based models for financial integration and risk sharing. However, the production-based approach can be more useful than consumption-based models because it identifies social institutions that are likely to act as social planners and because the assumptions/conclusions of the model are more closely approximated by stylized facts including the cross-country consumption-output correlation puzzle. In particular, there is a high correlation of output growth rates among countries, giving clear evidence of risk sharing in production among countries. Further, high cross-country output correlations relative to consumption correlations suggest that while countries face more consumption risks than production risks, they diversify production risks much better than consumption risks. The international consumption-output correlation puzzle reflects a failure to allow for risk sharing in production among countries in previous analyses, while accounting only for risk sharing in consumption. The extent of financial integration or diversification captures the degree of international risk sharing. The estimated degree of international risk sharing is quite substantial and much better than the consumption data show, and is, in large measure, realized from pooling production risks rather than consumption risks among countries.

Section snippets

The country’s state-contingent intertemporal production problem and the condition for international financial market integration

Each country produces a homogenous output and is inhabited by a single representative producer of goods and services who makes intertemporal production decisions under uncertainty. Uncertainty is described by a finite number of states of nature, indexed by s = 1, …, S, for each time period, t = 1, …, T. There are complete global financial markets that countries can use to hedge against exogenous country risks, and perfect competition is assumed for the markets for outputs and productive inputs,

The social planner problem for countries’ output allocation and efficient risk sharing rules

In the preceding section, each country was concerned with the optimal production decision over time under uncertainty by participating in world financial markets. We now examine the optimal decision taken by countries as a whole under uncertainty when there is a social (world) planner who coordinates the production activities of different countries over time and across states of nature. Inputs are perfectly mobile across countries. We postulate a small open economy in which each country faces

A reexamination of the cross-country consumption-output correlation puzzle and new evidence on international risk sharing

The state-contingent intertemporal production model and the social planner’s problem of output allocation under production risk are particularly relevant for analyzing international financial integration and international risk sharing by viewing countries as producers of goods and services. If countries have access to complete global financial markets, rates of return on assets are the same for all countries. Moreover, if there is perfect risk sharing among countries, correlations of output

Summary and conclusion

This paper has proposed a multi-country, multi-factor production-based model capable of explaining financial integration and risk sharing among countries. The model is based on producers’ cost minimization problems with the familiar Cobb-Douglas cost function, which is easily amenable to empirical analysis following the consumption-based methodology (see Obstfeld, 1994a, Lewis, 1996). The model has allowed us to find a possible resolution for the international consumption-output correlation

Acknowledgment

The author would like to thank the referee and Bob Pulsinelli for many helpful comments and suggestions to improve the paper.

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