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Trade integration and risk sharing in Sub-Saharan Africa Do Institutions and Financial Depth Matter? By John Bosco Nnyanzi Supervisors: Prof. Dr. Michael Landesmann Prof. Dr. Joseph Francois 23/05/2017 1 Introduction – Research Question Investments in markets of other countries help reduce exposure to idiosyncratic risks arising from country-specific shocks. Via diversification of portfolios This is called risk sharing (RS) Studies show low RS in developing countries (Kose, et al., 2009) But precise avenues via which risk is shared are not unambiguous 23/05/2017 2 Four Issues 1. 2. 3. 4. Extent to which trade integration contributes to consumption risk sharing; The role of institutional quality to consumption Risk Sharing; The extent to which financial depth affects consumption risk sharing ; and, The extent to which the role of trade integration to risk sharing depends on institutional quality and/or financial depth. 23/05/2017 3 Role of Integration? Focus: EAC, ECOWAS, SADC, and AU, - 1986-2007. Why these groups? Established in Africa during the 1990s with an aim to expand trade via trade integration, increase capital and financial flows, impact on risk sharing is still an empirical question. By trade integration we mean trade openness (TOP) Why? economic agents forge economic ties, flow of capital, joint production and development, transaction costs Foreign bank participation 23/05/2017 4 Trade cont’d Monetary union: removal of trade restrictions as pre-condition. Why? Trade integration helps in greater synchronization of economic cycles (United Nations Economic Commission for Africa, 2008). In absence of access to international capital markets, countries, via trade openness, could enjoy the risk sharing benefits from international integration. The expected benefits of risk sharing accruing from TOP have however proven hard to substantiate, and its impact on risk sharing is still an empirical question. TOP contribution could depend on domestic financial markets and institutional environment (Broner and Ventura, 2006). Does extent to which TOP contributes to risk sharing depend on institutional quality and financial depth? 23/05/2017 5 Why Financial depth? Financial depth (proxied by credit to GDP) Access to capital for investment projects that investors might forego; facilitate trade. Determine volume of trade across borders. NOTE: Financial deepening is much less developed in SSA than in most of the emerging market countries. Domestic credit to private sector as percentage of GDP in SSA decreased from 69.3% to 58.5% in the year 2007 and 2008 respectively. Implication of trend to risk sharing still an empirical question. Does the potentiality of TOP to influence CRS depend on how it acts as proxy for a country’s creditworthiness? 23/05/2017 6 Why institutions? Matter for investment decisions Incentive to trade e.g. the protection of property rights (Olson, 1996) Encourage contract enforcement and trust (Dixit, 2009; Volosovych, 2005) higher rates of return via lowering transaction costs. Corruption and bureaucracy increase transaction costs and discourage investment (Papaioannou, 2009; Wei and Wu, 2002) Outward flow impact: E.g, capital flight. How?? increasing the riskiness of the economy or depressing the domestic investment climate (Cerra, et al., 2008; Ali, 2010). 23/05/2017 7 Literature Broner and Ventura (2006): Effects of TOP depend on domestic financial markets. If deep, trade TOP allows for better risk-sharing; if thin, trade integration destroys risk sharing. Giovanni et al., (2006): more open to trade countries tend to be more volatile, contradicts TOP as shock absorber (Martin et al., 2006). Kose et al., (2007): No substantial evidence in in emerging economies. role of financial integration in risk sharing depends on TOP. Ventura (2008) and Corcoran (2007): role of trade openness appears possible. So, role of trade integration for risk sharing is imprecise. 23/05/2017 8 Literature Cont’d Kose et al.,(2007), do not find institutions and credit depth helpful in risk sharing but call for more careful investigation. Fratzscher et al., (2009): low institutional quality but high degree of risk sharing if financially open. closed economies experience virtually no risk sharing. high levels of investor protection leads to less share of consumption risk (Scharler, 2004) potential risk sharing gains are smaller in countries with better perceived institutional quality (Imbs and Mauro, 2007) 23/05/2017 9 Model Practically we adopt a model similar to that of ASY (1996) that takes the form: log Cit log Ct i ( log GDPit log GDPt ) it is the year-on-year growth rate of real consumption per capita for country i in year t; log C is the growth rate for “world” real consumption per capita; log GDP is the year-on-year growth rate of real GDP per country i in year t; log GDP is the growth rate of the “world” real GDP; log C it t 23/05/2017 it 10 Model cont’d measures the average co-movement of the countries’ idiosyncratic consumption growth with their idiosyncratic GDP growth during the entire time period. Its slope measures the average deviation from perfect risk sharing in consumption. 100(1 )% A measures the degree of international risk sharing in percentage terms. 23/05/2017 11 Interaction-based Model We follow Sørensen, Wu, Yosha, and Zhu (2007) by in addition allowing to change over time so that 0 1 (t t ) 2 ( X it X t ) Xit is proxy for trade openness and/or, domestic institutional factors or financial depth. X t is the average of Xit across countries. t t is a time trend that captures the trend decline/increase in risk sharing not directly caused by the potential variables. 23/05/2017 12 Model cont’d Therefore we estimate the following parametized regression model log Cit log Ct i 0 (t t ) 1 ( X it X t ) 2 3[t t ] 4 [ X it X t ] log GDPit log GDPt it 23/05/2017 13 Data Study covers Africa with data for period 1986-2007 Data on real per capita consumption and real per capita GDP measured in real constant terms are from PWT 7.0 (2011). Data on TOP (proxied by the sum of exports and imports over GDP) is from PWT 7.0. Data on financial depth (proxied by the ratio of total credits to GDP) is from World Development Indicators (WDI). Data on institutional quality is from PRS Control for financial integration (measured as sum of a country’s foreign assets and liabilities to GDP) Data is from External Wealth of Nations Mark II by Milesi-Ferreti (2008) and WDI. Control for changes in real exchange rate. Data on this variable is from PWT version 7.0. Calculate the world aggregates as GDP weighted averages. 23/05/2017 14 Table 1 Descriptive Statistics 23/05/2017 15 Table 1 Cont’d 23/05/2017 16 Table 2 Correlation Matrix 23/05/2017 17 23/05/2017 18 23/05/2017 19 23/05/2017 20 23/05/2017 21 23/05/2017 22 23/05/2017 23 Summary of Results SSA experiences about 34% CRS – Table 3a TOP has a positive impact on CRS – Table 3a Indications that Financial depth helps in risk sharing but weak evidence – Table 4a Weak evidence that aggregate institutions matter for CRS – Table 5a Individual Institutions matter: Tables 5a & 5b Corruption in SSA & ECOWAS & AU Government Stability in EAC & SADC Bureaucracy, Rule of law, in SADC & AU Institutions could be deleterious e.g. Bureaucracy in SADC & AU TOP contribution could depend on Institutional quality and financial depth – Tables 6 &7 FOP and CRE in interaction facilitate TOP role in CRS – Table 8 23/05/2017 24 End Thanks for listening 23/05/2017 25