Financial Market Access and International Risk Sharing

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