DP6496 | Risk Sharing, Finance and Institutions in International Portfolios

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We show that international consumption risk sharing is significantly improved by capital flows, especially portfolio investment. Concomitantly, we show that poor institutions hamper risk sharing, but to an extent that decreases with openness. In particular, risk sharing is prevalent even among economies with poor institutions, provided they are open to international markets. This is consistent with the view that the prospect of retaliation may deter expropriation of foreign capital, even in institutional environments where it is possible. This deterrent is anticipated by investors, who act to diversify risk. By contrast, capital flows headed for closed economies with poor institutions are designed and constrained so as to limit the cost incurred in case of expropriation, and thus achieve little risk sharing. We show this non-linearity continues to be present in the determinants of international capital flows themselves. Institutions are crucial in attracting capital for closed economies, but are barely relevant in open ones, with corresponding consequences on the extent of international risk insurance.