International Risk-Sharing: Macroeconomic and Financial Aspects

Abstract

International risk-sharing is one of the most important benefits from the process of international financial integration, which gained in speed, scope, and geographical coverage during the past decades. As long as different national economies are not perfectly correlated, there are possibilities for risk-sharing through cross-border trade in assets and goods. By pooling risk in a larger, global (capital) market, the residents in these economies can diversify the idiosyncratic, country-specific portion of the risk they face, thereby obtaining additional welfare gains that are not available within their national borders. However, alternative approaches suggest different conclusions with respect to the degree of cross-country risk-sharing that actually takes place. While macroeconomic methods, based on consumption and output series, suggest rather limited risk-sharing, asset pricing models, based on asset-markets excess returns, imply very high degrees of actual international risk-sharing. The aim of this thesis is to investigate the extent to which risk-sharing takes place across countries using macroeconomic and financial approaches, and present the evidence in a compact/synthetic framework. The introductory chapter is followed by an empirical investigation of the role of workers’ remittances as an alternative channel of international (consumption) risk-sharing. It shows that developing countries with above-average levels of workers’ remittances per capita also experience relatively smaller deviations from perfect risk-sharing, though this effect is statistically significant only for the group of transition economies. Focusing on one of the core indicators of the financial integration process, chapter 3 suggests that the rejection of the uncovered interest parity (UIP) condition might be limited to the conventional tests and related to a specific type of estimation bias. Though the empirical analysis provides evidence about the importance of this bias, it does not completely resolve the UIP puzzle. Chapters 4 and 5 present some limitations of the stochastic discount factor (SDF) approach to international risk-sharing. First, the measures for marginal utility growth crucially depend on the country with the highest stock market excess returns (highest Sharpe ratios). Second, the SDF approach “automatically” leads to perfect risk-sharing in episodes of fixed or very rigid nominal exchange rates. In contrast to the asset-markets-based SDF approach, chapter 6 builds upon an international real-business-cycle macroeconomic model. Using data for the Eurozone countries, it demonstrates that the nominal exchange rate is the main reason for one of the central puzzles in international macroeconomics – the Backus-Smith puzzle. In an attempt to sublimate the evidence from macroeconomic and financial (asset pricing) models, chapter 7 documents a broad “disconnect” and a “dichotomy” between the macroeconomic and the asset component of the real exchange rate. Irrespective of the numerous differences, all approaches reach at least one common conclusion – the (real) exchange rate plays a pivotal role in all measures for international risk-sharing. In fact, it seems to “drive” the risk-sharing results, largely overshadowing the importance of the co-movement among the underlying consumption and asset markets fundamentals. In turn, this thesis concludes that a common ground between the different approaches might be sought in a clear separation along the dichotomy lines. Finally, this thesis suggests that different measures for international risk-sharing might be used in evaluating the benefits and formulating policy steps for countries that desire (further) integration into the global capital market: policy recommendations might rely more on macroeconomic evidence in fixed/rigid nominal exchange rate regimes and probably more on asset markets measures in freely floating nominal exchange rate regimes