Ebook Risk Sharing, Finance and Institutions in International Portfolios
Where do individuals choose to hold capital? Using what class of assets? What does their strategy achieve? Typical answers almost unanimously show that the international allocation of capital depends on the institutional and regulatory context, and observed investment does not seem to achieve much by way of diversification. The extent of international risk sharing appears to remain limited, and, according to Lewis (1996), largely driven by de jure restrictions to international capital flows. We argue that these conclusions, while true, obscure empirical regularities implying conditional relations between the regulatory environment, institutions, the composition of international investment portfolio, and the extent of risk sharing.
Our purpose is to improve in two dimensions the conventional test of international consumption risk sharing introduced by Lewis (1996). First, do diversification gains depend on the magnitude and the composition of international investment across various asset classes? If differences exist, why do they arise? Second, can one use information on bilateral capital flows to investigate the extent of risk insurance between pairs of countries? This provides an attractive alternative to considering the multilateral problem faced by a small open economy, especially when data on bilateral financial linkages are becoming readily available.
We frame the paper around a simple model of international investment with incomplete markets, inspired from Lewis (1996). The model purports to motivate the consumption risk sharing conditions we test, both multilaterally and bilaterally. It also provides an illustration of the reason why risk diversification may differ across asset classes. We assume domestic purchases of foreign assets entail payment of a transaction cost, that potentially differs across asset classes. But this is the only source of heterogeneity. In particular, equity, bonds, foreign direct investment (FDI) or bank loans are all assumed to confer identical control on the invested project, or to encapsulate identical information on the lender.
Obviously this is a strong assumption. But our aim is not to develop a general equilibrium theory of dynamic portfolio choice. Rather, we need tractable theoretical guidance to introduce asset specific investment in conventional tests of international risk sharing. The model shows that foreign assets with high transaction costs deliver little consumption risk sharing. As a result, domestic consumption will not decouple from domestic resources, as it would under complete markets and perfect risk sharing. We show this to be true both in the conventional multilateral setup, and extend it to a bilateral framework.
We then turn to the empirics, and bring to bear a novel dataset with information on bilateral asset holdings between up to 42 source and 90 host countries. Total bilateral holdings break down into three main components: portfolio investment (i.e. equity and bonds), direct investment, and bank loans. We find that the overall magnitude of international investment does improve risk diversification. Interestingly, this is exclusively delivered by portfolio investment not by FDI nor bank loans. The result is true both multilaterally and bilaterally.
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