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Financial Liberalization and Consumption Volatility in Developing Countries Andrei A. Levchenko Full Text of this Article (PDF 380K) Abstract: One of the chief
benefits of financial liberalization proposed by theoretical literature
is that it should allow countries to better smooth consumption through
international risk sharing. Recent empirical evidence does not support
this prediction. In developing countries, financial liberalization seems
to be associated with an increase in consumption volatility. This paper
seeks to rationalize the evidence by linking it to two important features
of developing countries. First, domestic financial markets are underdeveloped.
We model this by adopting the Kocherlakota (1996) framework of risk sharing
subject to limited commitment. Second, access to international markets
is not available to all members of society. We show that when risks are
idiosyncratic, that is, insurable within the domestic economy, opening
up to international markets reduces the amount of risk sharing attained
at home and raises the volatility of consumption. When risk is aggregate
to the economy, the underdeveloped financial system prevents the pooling
of aggregate risk across agents for the purposes of insurance in the international
markets. Thus, while the volatility of consumption coming from aggregate
risk decreases with financial liberalization, it does so by much less
than would be predicted by a representative agent model. |
