Determinants of International Consumption Risk Sharing in Emerging Markets and Developing Countries

The first objective of the paper is to identify determinants of international consumption risk sharing with a focus on developing countries. International consumption risk sharing is generally lower in developing countries, but the main constraints on international risk sharing in these countries have so far not been identified. As consumption growth in developing countries is generally volatile, and much more so than in advanced economies, there are high potential welfare gains from increased consumption smoothing especially in less developed countries. The second aim of my paper is to exploit the cross-sectional dependence when estimating the degree of international consumption risk sharing between individual countries and country groups. I use a standard risk sharing equation originally developed by Mace (1991), which later on has been modified by among others Hoffman and Nitschka (2009) and Kose et. al (2009) for studying international consumption risk sharing. The study is done using an unbalanced panel of 123 advanced and developing countries from 1970 to 2011. The analysis is also conducted separately for subgroups of advanced, emerging markets and less developed countries to allow for a differential impact of the determinants in the different country groups. In order to correct for potential cross-sectional dependence, I use Pesaran’s CCE estimator which exploits the cross-sectional dependence when estimating the degree of international consumption smoothing. I show that financial integration, measured either as an index of financial reform, capital account openness or as total external liabilities to GDP, has a significantly positive impact on international consumption risk sharing in developing countries. This result applies especially to poorer developing countries. Emerging market countries however seem to have gained less from financial integration in terms of consumption risk sharing. Remittance flows from migrant workers' positively affect risk sharing in developing countries, whereas foreign aid does not have a significant impact. Moreover, there is some evidence that high income inequality and also a high share of low income individuals reduces consumption smoothing in less developed countries. A lower degree of financial integration and higher inequality can thus partly explain why the degree of risk sharing is lower in developing countries than in advanced economies.