In this paper, potential of international risk sharing for emerging markets will be investigated, particularly in terms of financial integration and liberalization. The incentives of financial integration will be surveyed in terms of international risk sharing, indicate benefits for emerging market economies. In addition, it will be investigated if huge foreign capital inflows show positive effects of risk sharing for them.
Several government leaders all over the world recognize the potential of financial globalization for their country. A strong incentive for deeper financial linking can be observed. Three of the development countries in Africa already grew up to the so called emerging markets: Egypt, Morocco and South Africa. To keep up with the fast growing population and facilitating the economic growth, they want to stimulate employments for agriculture and infrastructure by investment partnerships with the G20, whereas Donald Trump, the President of the USA, would like to cut funding World Bank programs like credit guarantees or small business access to finance for these countries. Indeed, these development countries, also including emerging markets, need to implement more structural changes like liberalizing financial markets and financial transparency for these intentions.
Is international risk sharing able to smooth uncertainties in the emerging markets? Will they catch up the distance to industrial countries? In light of ongoing financial integration and economic development, the influence of international risk sharing in terms of financial globalization for emerging markets will be investigated. Just little evidence of risk sharing can be seen throughout the last decades, but still some persuasive inquiries are to be considered. Improvements in international risk sharing potentially lead to stabilizing effects, scarcer sudden stops and smaller risk premiums. Structural policy changes and better financial integration could surmount the threshold effect.
Table of Contents
1. Introduction
2. Fundamental theory and theoretical predictions
a. Relevance of risk sharing
b. Gains of diversification
c. Home Bias Puzzle
3. Empirical investigations of risk sharing in emerging markets
a. Consumption risk sharing
b. Impact of financial integration
c. Impact of default risk
d. Policy interventions and capital flows
e. Risk sharing and defaults in different subgroups
f. Relations between idiosyncratic output fluctuations and financial market developments
4. Lacks of international risk sharing
a. Why is there so little risk sharing in emerging markets?
b. Sensitivity of international risk sharing for financial integration under sovereign default risk
c. Country heterogeneity in cyclicality patterns
5. Conclusion
Research Objective and Core Topics
This paper investigates the potential of international risk sharing for emerging market economies within the context of financial globalization and liberalization. The core objective is to analyze why, despite increased financial integration, emerging markets show little evidence of significant risk sharing benefits compared to industrial countries, and to determine the impact of foreign capital inflows on risk smoothing.
- The efficacy of international risk sharing in emerging market economies.
- The impact of sovereign default risk and borrowing constraints on financial stability.
- The role of foreign direct investment (FDI) and portfolio equity in hedging idiosyncratic shocks.
- Threshold effects and heterogeneity in country-specific cyclicality patterns.
- Comparison of default versus non-default models in financial integration.
Excerpt from the Book
b. Gains of diversification
How can international risk sharing lead to smoothed income streams? To get a first intuition, we shortly look at a generalized example of (Feenstra & Taylor, 2014, S. 237 ff.). In this example, there are only two countries in this world with perfect negative correlated (ρ = –1) capital income streams. The volatility is caused by asymmetric country-specific idiosyncratic shocks. If both countries diversify their capital by investing 50% of their capital in the domestic portfolio and 50% in the foreign portfolio, each of them would generate a smoothed capital income stream, namely the average income stream. However, there might also be common shocks, which are symmetrical for both countries and result in a volatile world capital income stream, respectively average income stream. Under these assumptions of idiosyncratic and common shocks, the minimum volatility portfolio is located at a 50% fraction of foreign assets in our model, (Feenstra & Taylor, 2014, S. 240).
Is an equally weighted diversification of capital the best way to smooth the overall income streams? No, we need to implement the labor income, too. Diversifying labor in the same way as capital is not feasible, because that would be slavery. Nevertheless, we can substitute the share of labor with the share of capital in terms of diversification. Following this perception, the share of foreign assets needs to be adjusted. As an example, (Feenstra & Taylor, 2014, S. 238) calculate with 60% labor income and 40% capital income to compute the optimal portfolio allocation. Applying the assumptions, they calculate a minimum volatility portfolio of capital invested 100% in foreign assets. This seems very improbable in practice, so we will see what the empirical research reveals.
Chapter Summaries
1. Introduction: Outlines the motivation for studying international risk sharing and sets the context of financial globalization for emerging economies.
2. Fundamental theory and theoretical predictions: Explores the conceptual necessity for risk sharing, the benefits of diversification, and the prevalent Home Bias Puzzle.
3. Empirical investigations of risk sharing in emerging markets: Examines empirical data regarding consumption risk sharing, the impact of default risk, and policy interventions.
4. Lacks of international risk sharing: Investigates reasons for the observed lack of risk sharing, including sensitivity to default risk and country-specific cyclicality.
5. Conclusion: Summarizes the key findings, noting that while equity and FDI show potential for risk sharing, debt-heavy capital structures often impair stability in emerging markets.
Keywords
International Risk Sharing, Financial Globalization, Emerging Markets, Consumption Smoothing, Diversification, Home Bias, Sovereign Default Risk, Capital Flows, Financial Integration, Idiosyncratic Shocks, Pro-cyclicality, Portfolio Equity, Foreign Direct Investment, Economic Expansion, Hedging Potential
Frequently Asked Questions
What is the primary focus of this paper?
The paper evaluates the effectiveness of international risk sharing within the framework of financial globalization, specifically focusing on why emerging market economies have not realized the same benefits as industrial nations.
What is the main research question?
The research asks whether international risk sharing can successfully smooth economic uncertainties in emerging markets and if financial integration contributes positively to this goal.
Which scientific methods are employed?
The paper utilizes empirical regression analyses, including cross-section, time-series, and panel regressions based on global financial data, alongside the examination of theoretical default versus non-default economic models.
What are the central themes of the work?
Central themes include the impact of capital flows on consumption smoothing, the role of sovereign default risk in restricting borrowing, and the differences in cyclicality patterns across various national economies.
What does the main body of the paper cover?
The main body covers the fundamental theories of risk sharing, empirical evidence on consumption correlations, the role of financial integration and default risks, and a detailed analysis of country-specific cyclicality.
How would you characterize this paper with keywords?
Key terms include Financial Globalization, International Risk Sharing, Consumption Smoothing, Sovereign Default Risk, and Emerging Market Economies.
Why do emerging markets seem to benefit less from financial integration than industrial countries?
The research suggests that emerging markets often attract capital flows, such as debt, that can actually impair risk sharing, combined with threshold effects and incomplete financial contracts that limit the benefits of globalization.
What role does the "Home Bias Puzzle" play in this study?
It is cited as a factor explaining why investors continue to prefer domestic assets, which hinders the global diversification required for effective international risk sharing.
How does sovereign default risk affect risk sharing?
Sovereign default risk creates time-varying impediments, making borrowing more costly and difficult precisely when countries need liquidity the most to smooth consumption in bad economic times.
- Quote paper
- Julian Fischer (Author), 2017, International Risk Sharing and Gains from Financial Globalization, Munich, GRIN Verlag, https://www.grin.com/document/371885
