Financial reforms and low‐income households' impact on international consumption risk sharing

• Published date: 01 December 2022
• Author: Malin Gardberg
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/infi.12418

Received: 23 August 2021

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Accepted: 28 June 2022

DOI: 10.1111/infi.12418

ORIGINAL ARTICLE

Financial reforms and low‐income

households' impact on international

consumption risk sharing

Malin Gardberg

Research Institute of Industrial

Economics (IFN), Stockholm, Sweden

Correspondence

Malin Gardberg, Research Institute of

Industrial Economics (IFN), Grevgatan

34, 2nd floor, Box 55665, SE —102 15,

Stockholm, Sweden.

Email: malin.gardberg@ifn.se

Funding information

Jan Wallanders och Tom Hedelius

Stiftelse samt Tore Browaldhs Stiftelse,

Grant/Award Number: W19‐0030;

Marcus och Amalia Wallenbergs

minnesfond; Svenska Litteratursällskapet

i Finland, Grant/Award Number:

Bröderna Lars och Ernst Krogius

forskningsfond

Abstract

Complete financial markets allow countries to share

their consumption risks internationally, thereby creat-

ing welfare gains through lower volatility of aggregate

consumption. Using a panel of 116 countries between

1970 and 2019, I show that a higher share of low‐

income households reduces consumption risk sharing,

especially so in less‐developed countries. Moreover,

I find that a broad range of financial market reforms

and financial integration have a positive impact on

international consumption risk sharing in poorer

developing countries, while in emerging market

countries, financial market development, financial

reforms, and capital account openness has an impact.

In advanced economies, financial (stock and bond)

market development as well as financial integration

improves international risk sharing. A lack of financial

reforms, a lower degree of financial integration and a

high share of low‐income households thus contribute

to the degree of risk sharing being lower in developing

countries than in advanced economies.

KEYWORDS

financial integration, financial liberalization, international

consumption risk sharing, low‐income households

JEL CLASSIFICATION

C23, E02, E21, E44, F38, F62, G15

International Finance. 2022;25:375–395. wileyonlinelibrary.com/journal/infi © 2022 John Wiley & Sons Ltd.

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1|INTRODUCTION

If markets are complete, countries can pool their resources and eliminate differences in

consumption growth between themselves, according to conventional macroeconomic theory.

International consumption risk sharing thus enables consumption smoothing, which creates

welfare gains through lower aggregate consumption volatility. In reality, aggregate consump-

tion is highly sensitive to domestic income shocks. The empirical evidence shows fairly limited

international consumption risk sharing among countries, and especially in developing

countries, see, for example, Kose et al. (2009), Bai and Zhang (2012) and Flood et al. (2012).

Common explanations for this observation include financial market incompleteness, frictions,

and transaction costs. Kollmann (2012) and Cociuba and Ramanarayanan (2019) show

theoretically that the low levels of international risk sharing (IRS) can be explained by limited

asset market participation.

Although the literature on international consumption risk sharing in advanced economies

is abundant,

1

risk sharing in developing economies has received much less attention. The main

constraints on IRS in developing countries have not yet been identified, and there is

disagreement regarding the empirical relationship between IRS and financial market

development and integration. Corcoran (2007) points to the importance of financial integration

for improving IRS in developing countries, while Kose et al. (2009), Flood et al. (2012) and

Fuleky et al. (2018) conclude that emerging markets (EMs) and developing countries seem

unable to benefit from this.

This paper therefore aims to identify determinants of international consumption risk

sharing with a focus on developing countries. As consumption growth in developing countries

is generally volatile, and much more so than in advanced economies, there are large potential

welfare gains from increased consumption smoothing, especially in less‐developed countries

(LDCs). To this end, I study international consumption risk sharing in a panel of 116

developing and advanced economies during 1970–2019. Using panel estimators that account for

cross‐sectional dependence, I empirically look at the degree of international consumption risk

sharing, its evolution over time, and its relation to low incomes, financial reforms, and

integration.

I first show that countries share on average 34% of consumption risks internationally, which

is in line with or slightly higher than estimates by Kose et al. (2009), Bai and Zhang (2012) and

Fuleky et al. (2018). IRS is higher in the latter part of my sample. This can explain why my

estimates are higher than in the previous literature, as the previous studies considered a less

recent time period. The emerging and less‐developed economies share around 23%–32% of their

consumption risks internationally, whereas advanced economies share on average between 50%

and 70%.

High poverty rates in developing economies may exclude a large share of the population

from international financial market participation and thereby lower IRS. Antonakakis and

Scharler (2012) show that poor credit availability lowers IRS for advanced economies.

Unfortunately, historical time series on financial market access or credit availability does not

exist for developing countries. I will therefore use the poverty headcount ratio to proxy for the

lower bound of the share of individuals excluded from the international asset markets due to

poverty. My second addition to the risk‐sharing literature is showing empirically that a larger

share of low‐income households reduces international consumption risk sharing in emerging

and less‐developed economies.

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GARDBERG