Financial globalization, domestic financial freedom and risk sharing across countries

In theory, integrated global financial markets facilitate the diversification of consumption risks by decoupling consumption volatility from country-specific income fluctuations. However, the degree of risk sharing across countries is rather limited despite the recent waves of financial globalization. In this paper, we investigate an alternative avenue through which agents smooth their consumption volatility. We have noticed that apart from financial openness, domestic financial freedom is also a critical factor that determines a country’s ability to insure against consumption risks. To motivate our analysis, we first develop a modified model of intranational and international risk sharing. We then examine the relative importance of domestic financial freedom and financial globalization in shaping the risk sharing outcomes using a large cross-country panel dataset. Our empirical findings suggest that for most countries in the world, domestic financial environment matters more in stabilizing consumption fluctuations than financial integration. We also show that agents are willing to give up a large amount of their consumption to achieve complete intranational or international risk sharing.