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Asymmetric International Risk Sharing in the Euro Area
Holger Zemanek*
University of Leipzig
Institute for Economic Policy
Grimmaische Straße 12
D-04109 Leipzig, Germany
[email protected]
Tel: +49-341-9733566
Fax: +49-341-973569
Previous version: 06.10.2010
Abstract
In this paper we argue that persistent intra-euro area capital flows to southern Europe
have created an asymmetric international risk sharing in the euro area. Theoretical
results suggest that asymmetric international risk sharing reduces overall consumption
smoothing as countries participate differently in international risk sharing. However,
net borrowing countries are in particular negatively affected. An empirical panel
analysis for the euro area confirms these propositions. Thus, beside rigid labour
markets and only marginal fiscal risk sharing in the euro area, economic adjustment
via the capital market is limited, too. This is an alarming result for the euro area.
JEL-Codes: E32, F32, F36
Keywords: capital flows, international risk sharing, euro area, asymmetries
* I thank Jan Fidrmuc, Bent Sørensen, Geoffrey Wood, and participants of the 3rd Economics and
Finance PhD conference at Brunel University for helpful comments as well as the Institute of
Economic Affairs, London, for support.
1
1. Introduction
Main internal economic adjustment mechanisms in a monetary union are flexible
labour markets, fiscal risk sharing or international risk sharing via capital markets. All
three mechanisms mitigate income effects of asymmetric shocks or adverse business
cycles. In the euro area, labour markets are quite rigid (EC 2008, Zemanek 2010) and
fiscal risk sharing almost does not exist as competence on fiscal policies has remained
at national level (EC 1993). Moreover, national fiscal policies are constrained by high
deficits and debt levels after the financial crisis. Thus, internal adjustment within the
euro area seems to rely basically on the functioning of the international risk sharing
mechanism (EC 2008).
However, persistent intra-euro area capital flows during the last decade from northern
European countries to southern European countries have spurred an accumulation of
foreign assets in the capital providing countries, in particular in Germany, while
Greece, Portugal and Spain accumulated foreign liabilities. This asymmetric foreign
capital asset distribution have created an asymmetric international risk sharing, which
limits international risk sharing in the euro area. This becomes a crucial issue in the
light of the necessary real adjustment in the euro area (EC 2010) and for the stability
of the euro area. The aim of this paper is to shed light on asymmetric international
risk sharing in theory and empirically for the euro area.
The international risk sharing approach as adjustment mechanism in a monetary union
was first proposed by Mundell (1973). Mundell argued that a monetary union would
accelerate capital market integration, thus increased cross-border capital asset
holdings. This portfolio diversification would provide a risk sharing mechanism
between countries as income and consumption effects of an asymmetric shock are
compensated by varying capital income and capital asset valuation. However, this
approach assumes implicitly a relatively symmetric distribution of cross-border
capital assets, which will be abandoned in our analysis.
Empirical literature on international risk sharing among countries is substantial, as the
question was deeply analysed prior to EMU and afterwards. For instance, Atkeson
2
and Bayoumi (1993) as well as Melitz and Zumer (1999) test risk sharing within the
US and among countries to draw implications for EMU. Later research scrutinizes
international risk sharing more in detail and looks for determinants, such as financial
globalisation, that may have influenced the risk sharing mechanism, (Sørensen et al.
2006, Kose et al. 2007, Stavrev 2007, Demyanyk et al. 2008).
The paper is structured as follows. In Section 2, we show first evidence for
asymmetric foreign capital distribution as a source of asymmetric international risk
sharing. Section 3 analyses asymmetric international risk sharing in a basic model.
We test our hypotheses on asymmetric international risk sharing in a panel
econometric framework in section 4. Section 5 concludes and gives implications.
2. Asymmetric foreign capital asset distribution in the euro area
While Germany has experienced rising trade surpluses against euro area countries
since EMU up to the recent crisis, other countries like Greece, Spain, Italy and
Portugal have perpetuated large current account deficits (EC 2010, Zemanek et al.
2010). These opposite current account balances within the euro area reflect private
intra-euro area capital flows from surplus countries to deficit countries.
Blanchard and Giavazzi (2002) called these intra-euro area capital flows the end of
the Horioka-Feldstein puzzle (Horioka and Feldstein 1980). Instead of domestic
savings being invested domestically as found by Horioka and Feldstein (1980),
savings are invested abroad in countries with the largest marginal return on capital.
Therefore, correlation of domestic saving and domestic investment is observed low
for the euro area (Blanchard and Giavazzi 2002).
Why did the Horioka-Feldstein puzzle disappear for the euro area? Although, the
literature gives many explanations, the main driver might be the European integration
process. Spain, Italy, Greece and Portugal especially have taken advantage of
improved access to international financial markets following the creation of EMU.
The expected rate of return increased in these countries and long as well as short term
3
interest rates have converged strongly towards low German rates since the mid 1990s
(Fagan and Gaspar 2007, Mendoza et al. 2007). Moreover, the abolition of exchange
rate risk for lenders and borrowers, improved macroeconomic conditions, and lower
borrowing constraints as a result of financial deepening accelerated capital flows
within the euro area (De Santis and Lührmann 2006).
After almost a decade of one-way capital flows from saving countries (mainly in the
north of Europe) to southern Europe, the results are not only the widely mentioned
large current account deficits (EC 2009) but also an asymmetric distribution of
foreign capital assets in the euro area. Capital exporting countries, have lent large
amounts to southern European economies, building up their foreign assets and lifting
their net international investment position. In contrast, Greece, Portugal, Spain, Italy,
Ireland, and France have substantial debt held by foreign lenders but relatively few
assets abroad. This becomes evident in Table 1 which shows the net international
investment positions (IIP) in percent of GDP and how they changed for EMU 12
countries. Germany, the Netherlands and Finland are those countries, which have seen
a substantial rise of their net IIP since 1998.
Table 1: Net international investment position in percent of GDP for EMU 12.
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
1998
-19.6
38.7
-76.9
9.0
0.4
-26.9
-1.6
-3.8
-25.0
-21.6
2002
-21.1
41.3
-40.6
3.0
5.6
-58.8
-20.0
-5.9
79.1
-27.0
-62.5
-46.8
2008
-14.4
31.4
-4.1
-18.1
25.3
-69.7
-54.1
-20.2
75.0
10.5
-91.9
-75.7
Δ 1998-2008*
5.2
-7.3
72.7
-27.1
24.9
-42.8
-34.1
-18.6
-4.1
14.3
-67.0
-54.1
Source: DataStream, 2010. * Percentage points, difference for Ireland and Luxembourg 2002-2008.
Although data on IIP also include investment in and from countries other than EMU
12 countries, they allow us a first sight into asymmetric foreign capital asset
4
distribution.1 Data on foreign bank claims provided by the Bank for International
Settlement2 partly confirm asymmetric capital asset allocation. Figure 1 shows net
outstanding claims of German banks in Spain in relation to Spanish GDP. Until 2004,
net claims remained relatively stable. However, since then, German banks have
accumulated massive claims in Spain, outrunning claims of Spanish Banks in
Germany. The outbreak of the financial crisis in 2007 stopped the development,
however, on a high level.
This evidence for asymmetric foreign capital asset distribution between euro area
countries raises the question of their impact on international risk sharing and, thus, on
the internal adjustment capability of the euro area.
Figure 1: Net outstanding claims of German banks in Spain.
20
18
Percent of Spanish GDP
16
14
12
10
8
6
4
2
0
Jun.1999 Dec.2000 Mar.2002 Jun.2003 Sep.2004 Dec.2005 Mar.2007 Jun.2008
Source: Bank for International Settlement, 2010. Note: Net figures are calculated by claims of German
banks in Spain minus claims of Spanish banks in Germany. GDP Figures: IMF World Economic
Outlook 2010.
1
Detailed figures on IIP against single countries are not available.
BIS Quarterly Review, Table 9B: Consolidated foreign claims of reporting banks - immediate
borrower basis, December 2009.
2
5
3. Asymmetric international risk sharing
Capital markets are a third internal adjustment channel within a monetary union. They
allow an international risk sharing between countries of a monetary union, to smooth
consumption in the case of asymmetric shocks and adverse business cycles. This
economic explanation was given by Mundell (1973) in his late research on optimum
currency areas. Mundell argued that cross-country capital asset holdings3, and thus
capital market integration, will increase as the devaluation risk of nominal exchanges
rates disappears in a monetary union (McKinnon 2000). If each country is holding
claims on output of all other members of a monetary union, asymmetric shocks or
adverse business cycles are shared by varying capital income and capital valuation,
which smoothes consumption over time in all countries of a monetary union.
In general, the risk sharing mechanism by Mundell (1973) has two channels through
which income is distributed. First, investment income is a direct channel. Dividends
or profits surge in a boom, while they are supposed to shrink in a recession. In a boom
(recession), a country has to pay more (less) dividends on its foreign liabilities, but
receives less (more) investment income from its investments in the recession (boom)
country. Second, capital valuations are an indirect income distribution channel. In a
boom (recession), equities and real estates may rise (fall) in their value. However, it is
unclear, to which extent these valuation gains or losses affect income. It depends on,
whether valuation gains or losses are realized or valuation losses affect income via
write-offs.
The textbook case of international risk sharing by Mundell (1973) implicitly assumes
a symmetric cross-country holding of capital assets. Each country holds capital assets
of all other member countries relatively to their economic size. However, as we have
shown in section 2.2, intra-euro area capital flows have led to a substantial asymmetry
in foreign capital asset distribution during the last decade. International risk sharing
becomes asymmetrical.
3
Capital assets are bonds, equities as well as direct credits by the banking system.
6
To compare the effects of symmetric vs. asymmetric international risk sharing, we set
up a basic model of consumption smoothing for a two-country monetary union and
assume fully adverse business cycles. Consumption in both countries (indicated by
superscript i and j) depends on income (GDP) and net investment income. During a
boom (denoted by h), GDP will increase by Yh − Y0 above the trend GDP (denoted by
0) and falls in a recession (denoted by l) by Y0 − Yl . However, the international risk
sharing mechanism distributes some of GDP between both countries. First, each
country has capital income from its foreign assets in the other country. That income
depends on yield r and the size of its assets, measured as share a of foreign GDP, thus
a i r Y j . Secondly, countries have to pay dividends on foreign liabilities, which would
be
a j rY i .
(
Therefore,
consumption
)
Chi = Yhi − Y0i + a i rYl j − a j rYhi
in
country
i
(
can
be
expressed
as
)
in a boom or Cli = Y0i − Yl i + a i rYhj − a j rYl i in a
recession. By assuming r equal over the business cycle, we only account for capital
valuation effects. That simplifies the model without changing the interpretation.
To analyse consumption smoothing effects, we calculate the consumption variation
over the business cycle, relative to trend consumption
ΔCh− l
. Inserting consumption
C0
equations yields for country i:
[
]
ΔChi − l
Yhi − Y0i ) + a i rYl j − a j rYhi ) − ((Y0i − Yl i ) + a i rYhj − a j rYl i )
(
(
=
C0i
Y0i + a i rY0 j − a j rY0i
(1)
If we assume for simplicity Yhi = Yhj , Yl i = Yl j , Y0i = Y0 j , Yhi − Yl i = 2 x and r equal in
both countries, then the equation (1) reduces to:
(
(
ΔChi −l 2 x − 2 xr a i + a j
= i
C0i
Y0 + Y0i r a i − a j
)
)
(2)
In equation (2) the first part of the nominator ( 2 x ) is simply the amount that GDP
varies during the business cycle. The second part − 2 xr (a i + a j ) shows the
redistribution of GDP between both countries. The difference of both, the full
7
nominator, is the amount of undistributed GDP, thus the absolute consumption
variation over the business cycle. Relative consumption variation, as stated in the full
equation (2) depends positively on GDP variation x, negatively on GDP variation
relative to GDP x/Y0, and negatively on the asset yield r. The shares of investment a i
and a j determine relative consumption variation negatively. Rising investment shares
increase the distributed GDP, thus increasing consumption smoothing. However, the
effects of a i and a j are different. Both derivations of
ΔChi − l
with respect to a i and
C0i
a j are negative, but with:
⎛ ΔChi −l
i
⎝ C0
δa i
δ ⎜⎜
⎞
⎛ ΔC i
⎟⎟ δ ⎜⎜ hi −l
⎠ < ⎝ C0
δa j
⎞
⎟⎟
⎠
(3)
This implies, that a variation of either a i or a j away from symmetric international
risk sharing, thus any case of asymmetric risk sharing, affects consumption smoothing
in both countries differently. If for example, either a i or a j falls below any
symmetric case, consumption variation in country i increases compared to symmetric
risk sharing, thus consumption smoothing is reduced. However, a reduction of a i , the
country i’s own share of foreign assets, will increase consumption variation relatively
more than if a j reduces. Moreover, any asymmetric international risk sharing makes
both countries participate differently in international risk sharing. Consumption
smoothing will be different in both counties. In the light of the net IIP figures of Table
1, a reduction of a i would be the southern European perspective and the reduction of
a j the perspective of Germany. Thus, Germany is expected to benefit more from
international risk sharing with more smoothed consumption than southern European
countries with highly negative net IIP figures.
That relationship is displayed in Figure 2, which shows the graphical solution of
equation (2) by using the same values as used for Table 2: Y=100, r=0.1 and x=2.
While, the dashed line shows relative consumptions variation for country i dependent
on a i given a j =2 (net IIP of country j is 200 percent), the solid line shows relative
8
consumption variation for country i dependent on a j , given a i =2 (net IIP of country
i is 200 percent). In the case of symmetric international risk sharing, as both countries
have an equal share of assets held abroad of 200 percent of foreign GDP.
Consumption varies by 2.4 percent in both countries over the business cycle, although
GDP varies by 4 percent (point A). Consumption is equally smoothed in both
countries.
However, if country j (say Spain) has a share of foreign assets of only 50 percent,
consumption in country i (say Germany) will slightly more fluctuate by 2.6 percent
(point B) over the business cycle. In contrast, from Spain’s perspective a i reduces to
0.5 (50 percent), increasing consumption fluctuation for Spain to 3.6 percent (point
C), which is close to GDP variation. Overall, asymmetric international risk sharing
reduces consumptions smoothing in all countries of a monetary union compared to a
symmetric case. This result is true for both types of countries, net foreign asset and
net foreign liability countries, but in particular for the latter.
Figure 2 – Graphical solution of asymmetric international risk sharing
Relative consumption
variation in country i
0.050
0.045
0.040
C
0.035
ai(aj=2)
0.030
B
0.025
0.020
0.0
A
j
i
a (a =2)
0.5
1.0
9
1.5
2.0
a i, a j
4. Empirical analysis
Taking our analysis in sections 2 and 3 as a starting point, we test the empirical
significance of asymmetric international risk sharing and its effect on consumption
smoothing in a panel econometric framework for the euro area. In this context, we test
the following two hypotheses:
1. Participation in international risk sharing differs significantly between euro area
countries, revealing an asymmetric risk sharing.
2. The asymmetric foreign capital asset distribution in the euro area is a source for
asymmetric international risk sharing, and reduces overall consumption smoothing
within the euro area.
Model and data
The empirical analysis follows closely Sørensen et al. (2006), Kose et al. (2007) and
Stavrev (2007). International risk sharing is measured by the correlation of GDP
growth and consumption growth relative to a country group, which is the euro area in
this analysis. The idea is to analyse how a deviation of a country’s GDP growth from
the average GDP growth of the euro area systematically affects the deviation of
consumption growth relative to the euro area. This can be shown in the following
baseline estimation relationship:
(ΔC
i ,t
) (
− ΔCtEMU = β ΔYi ,t − ΔYt EMU
)
(4)
ΔCi ,t is the consumption per capita growth rate, ΔYi ,t is GDP per capita growth rate
for a specific country i in time t.4 The subscript EMU indicates euro area consumption
per capita growth or euro area GDP per capita growth. Coefficient β is the
percentage of uninsured risk in the euro area. If β is zero then relative deviations of
per capita GDP growth in country i ( ΔYi ,t − ΔYt EMU ) will not systematically affect
relative per capita consumption growth ( ΔCi ,t − ΔCtEMU ). That is the case for perfect
risk sharing within the euro area. In reverse, β will be 1 for non risk sharing as no
4
( )
(
)
We calculate ΔCi , t = ln Ci , t − ln Ci , t −1 and ΔYi , t respectively.
10
consumption smoothing via the capital market occurs. Then relative deviations of
GDP growth are perfectly correlated with relative deviations in consumption growth.
Hence, β is expected to be in the range of 0 and 1.
We base our empirical analysis on a panel of quarterly data for twelve euro area
countries.5 Our data set covers the period from Q1/1996 to Q3/2009. As we use year
on year growth data, the seasonal pattern of quarterly data is not relevant. We leave
Cyprus, Malta, Slovakia and Slovenia out of the sample because they have been euro
area members for a too short period relative to other countries and relative to the full
sample period. As data are not available for the full sample length for all EMU 12
countries, the number of observations reaches at maximum 632. Appendix 1 shows
the data availability for each country. Data sources for consumption6 and GDP are the
Eurostat Database on Quarterly National Accounts and for population figures the IMF
World Economic Database. The latter are only available in an annual frequency and
are assumed to be stable during the year.
To evaluate hypothesis one, that participation in international risk sharing differs
between euro area countries, we refer to the following standard panel estimation
equation, with country-specific effects ρ i , a constant α and μ i,t indicating the white
noise error term:
(ΔC
i ,t
− ΔCtEMU ) = α + β EMU (ΔYi ,t − ΔYt EMU ) + ρi + μi ,t
(5)
However, to discriminate between country differences in consumption smoothing, we
will include a threshold dummy variable. The estimation equation changes according
to Sørensen et al. (2006). Starting from equation (5), we split uninsured risk β EMU
into a country specific effect and a remaining uninsured effect:
β EMU = β1 + β T ,i Di
(6)
5
The respective countries are Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Netherlands, Portugal and Spain.
6
We use final consumption, which includes public consumption. Therefore, we implicitly account for
varying public budgets policy.
11
By doing so, the overall euro area uninsured risk β EMU consists of a country specific
uninsured risk βT ,i with T indicating our threshold dummy approach. Di is a country
specific dummy for each country i, which is 1 for the specific country i and 0 for all
other 11 countries.7 β1 is the remaining uninsured risk. Inserting equation (6) into (5)
yields:
(ΔC
i ,t
)
(
)
(
)
− ΔCtEMU = α + β1 ΔYi ,t − ΔYt EMU + β T ,i ΔYi ,t − ΔYt EMU Di + ρ i + μ i ,t
(7)
Equation (7) includes an interaction term. Therefore, the interpretation of the
coefficients changes (Hardy 1993: 81-82), which allows us to differentiate between
single countries while using the explanatory power of the full data set. With respect to
our estimation equation, the coefficients can be interpreted as follows:
-
β1 gives the value of uninsured risk if Di is zero, hence, yielding the average
uninsured risk for all countries but country i.
-
βT ,i gives the number of units that β 1 changes if Di becomes one.
-
The sum β 1 + β T ,i is the uninsured risk for country i.
Given that interpretation, we cannot reject our first hypothesis if there is a significant
coefficient βT ,i , and thus, a significant variation in consumption smoothing between
euro area countries.
In a similar way, we test the validity of hypothesis two that an asymmetric foreign
capital asset distribution has affected consumption smoothing in the euro area. For
this specification, we use the net international investment position (IIP) in percent of
GDP as a proxy for foreign capital asset distribution within the euro area (compiled
from DataStream). We assume that overall uninsured risk β EMU is determined by the
net IIP. Therefore, we again split β EMU in one part which is affected by the net IIP
β IIP and the remaining uninsured risk β 2 :
β EMU = β 2 + β IIP IIPi ,t
(8)
7
Di is basically equal to the dummy variables related to country specific effects ρi. However, we use
different notations, to separate different meanings. While ρi captures the country specific effect related
to the constant α, Di indicates the country specific effect on uninsured risk β.
12
Inserting equation (8) into (5), the estimation equation becomes:
(ΔC
i ,t
)
(
)
(
)
− ΔCtEMU = α + β 2 ΔYi ,t − ΔYt EMU + β IIP ΔYi ,t − ΔYt EMU IIPi ,t + ρ i + μ i ,t
(9)
In this specification, we interact relative GDP growth with the respective net IIP. The
interpretation of coefficients changes in a similar way as above (Jaccard and Turrisi
2003). In so doing, β 2 indicates the value of uninsured risk if the net IIP is zero. This
is the level of risk sharing for a hypothetic symmetric capital distribution. In contrast,
β IIP shows whether risk sharing will be affected by a net IIP unequal zero. According
to our analysis in section 3, we would expect a negative coefficient β IIP . Net foreign
liabilities increase the share of uninsured risk, thus, they reduce a country’s
consumption smoothing within the euro area. We also expect a lower uninsured risk
β 2 for a hypothetic symmetric risk sharing compared to β EMU where we do not check
for net IIP using equation (5). To check for changes over time and robustness we
estimate for equations (9) and (5) additional to the full sample (Q1/1996-Q3/2009)
several sub-samples. These are a “pre-EMU” sub-sample (Q1/1996-Q4/1999), an
EMU period sub-sample (Q1/1999-Q3/2009) and two “late-EMU” sub-samples
(Q1/2002-Q3/2009) and (Q1/2004-Q2/2009). Additionally, we recursively estimate
β 2 and β EMU over time and display their development.
For all specifications, we estimate a standard least square dummy variable (LSDV)
estimator with country fixed effects, as suggested by the Hausman-Test (Hausman
1978), and with robust standard errors. Panel unit-root tests based on Levin et al.
(2002), Maddala and Wu (1999) and Choi (2001) reject non-stationarity of our time
series:
13
Table 2: Panel Unit Root test results (Q1/1996-Q3/2009).
Consumption
(ΔC-C EMU )
Panel Unit Root Test
Levin/Lin/
ADF-Fisher PP-Fisher chiChu t*
chi-square
square
0.000
0.000
0.000
Output
(ΔY-Y EMU )
0.000
0.000
0.000
Interaction term
IPP*(ΔY-YEMU)
0.000
0.002
0.000
Note: Lag selection has been conducted using the modified Hannan-Quinn criterion, an individual
intercept is not allowed.8 Entries are p-values.
Estimation Results
Results concerning our hypothesis one are shown in Table 2. Eight of twelve country
specific threshold dummies β T ,i reach the common levels of significance. Spain,
France, Italy, the Netherlands and Austria have a positive coefficient. This suggests
that these countries share on average less risk via the capital market than the
respective remaining eleven EMU countries. In particular, Spain and Italy perform
badly in our test on consumption smoothing. On the other hand, Luxembourg, Finland
and Greece have a negative coefficient indicating a relatively better risk sharing
within the euro area for these countries. The performance of Greece is surprising, but
has to be interpreted carefully as only 35 observations are available for Greece.
Overall, we cannot reject our hypothesis two. Results suggest significant differences
in international risk sharing participation among euro area countries, which might be
evidence of asymmetric international risk sharing.
8
A variation of the lag selection criteria as well as estimating the regression equation without intercept
and trend or without trend does not change the results significantly.
14
Table 2: LSDV estimation results, discriminating for country specific risk sharing
Sample
#
Country
β1
β T,i
Constant
R-square
Observations
Q1/1996-Q3/2009
1
2
Belgium
Germany
3
Ireland
4
Greece
5
Spain
6
France
0.526***
(0.130)
0.206
(0.131)
0.003**
(0.001)
0.527***
(0.131)
0.202
(0.131)
0.003**
(0.001)
0.487**
(0.178)
0.131
(0.178)
0.003**
(0.001)
0.544***
(0.131)
-0.533***
(0.131)
0.004***
(0.000)
0.518***
(0.130)
0.424***
(0.130)
0.002**
(0.000)
0.530***
(0.128)
0.273*
(0.128)
0.003**
(0.001)
0.41
632
0.42
632
0.42
632
0.42
632
0.42
632
0.41
632
10
Austria
11
Portugal
12
Finland
Sample
#
Country
β1
β T,i
Constant
R-square
Observations
7
Italy
8
9
Luxembourg Netherlands
0.469***
(0.126)
0.477***
(0.126)
0.003***
(0.001)
0.663***
(0.073)
-0.562***
(0.073)
0.002***
(0.000)
0.524***
(0.130)
0.313**
(0.130)
0.003**
(0.001)
0.524***
(0.131)
0.235*
(0.131)
0.003**
(0.001)
0.522***
(0.133)
0.204
(0.133)
0.002**
(0.001)
0.554***
(0.138)
-0.283*
(0.138)
0.003**
(0.001)
0.45
632
0.50
632
0.42
632
0.42
632
0.42
632
0.42
632
Robust standard errors are reported in parentheses. *, ** and *** indicate significance at 10%, 5% and 1% level.
Related to hypothesis two, the impact of net IIP on consumption smoothing in the
euro area is shown in Table 3. The respective coefficient β IIP becomes significant in
almost all samples, at least at the 10 percent level. The net IIP has a positive impact
prior to EMU. Nevertheless, the coefficients are negative in the EMU samples and
rise in their absolute values since 1999 indicating a rising importance of the net IIP
for international risk sharing within the euro area. In the sample Q1/2004-Q3/2009,
international risk sharing increases (decreases) on average by 0.005 units per each
percentage of net IIP assets (liabilities) per GDP. That figure seems to be small.
However, net IIP positions have reached quite high levels (negative as well as
positive) for single countries (see Table 1).
Moreover, the levels of uninsured risk assuming a symmetric international risk
sharing β 2 are significantly lower than β EMU in Table 4 where we do not check for
15
net IIP, referring to equation (5). Based on a t-test with H0: βEMU= β2, the t-statistic
for sample Q1/1999-Q3/2009 is 2.68, for sample Q1/2002-Q3/2009 3.34 and for
sample Q1/2004-Q3/2009 3.37. The critical value for 5 percent significance is 1.98.
Thus, we have to reject the H0; β2 is in all three samples significantly lower than
βEMU.
Table 3: LSDV estimation results for β 2 , controlling for net IIP
Sample
#
β2
β IIP
Constant
R-square
Observations
Q1/1996Q4/1999
13
Q1/1996Q3/2009
14
Q1/1999Q3/2009
15
Q1/2002Q3/2009
16
Q1/2004Q3/2009
17
0.851***
(0.051)
0.007***
(0.002)
0.000**
(0.000)
0.510***
(0.140)
-0.003
(0.003)
0.002***
(0.001)
0.270***
(0.067)
-0.003*
(0.002)
0.005***
(0.001)
0.221***
(0.046)
-0.004***
(0.001)
0.006***
(0.000)
0.212***
(0.051)
-0.005***
(0.000)
0.007***
(0.000)
0.83
105
0.43
551
0.23
446
0.23
333
0.38
240
Robust standard errors are reported in parentheses. *, ** and *** indicate significance at 10%, 5% and 1% level.
Table 4: LSDV estimation results of β EMU
Sample
#
β emu
Constant
R-square
Observations
Q1/1996Q4/1999
18
Q1/1996Q3/2009
19
Q1/1999Q3/2009
20
Q1/2002Q3/2009
21
Q1/2004Q3/209
22
0.669***
(0.103)
-0.000
(0.000)
0.532***
(0.127)
0.003***
(0.001)
0.450**
(0.164)
0.004**
(0.001)
0.375*
(0.175)
0.004***
(0.001)
0.384**
(0.174)
0.004***
(0.001)
0.68
124
0.41
632
0.30
508
0.19
372
0.20
267
Robust standard errors are reported in parentheses. *, ** and *** indicate significance at 10%, 5% and 1% level.
That result is confirmed by recursive estimations. We estimate equations (5) and (9)
forty-two times. We start with the full sample and reduce the sample size in every step
by starting one quarter ahead until Q4/2006. The sample end remains always
Q3/2009. Therefore, we constantly increase the weight of more resent data. Figure 5
shows the development of β EMU and β 2 over time and the corresponding p-values
below. It clearly shows, that we measure more uninsured risk in the case of
16
asymmetric international risk sharing (indicated by β EMU ) rather than assuming a
hypothetic symmetric international risk sharing (indicated by β 2 ).
Figure 3: Development of β EMU and β 2 over time based on recursive LSDV
estimations (variable start quarter – end quarter Q3/2009).
Coefficient
0.600
0.500
βEMU
0.400
0.300
β2
0.200
0.100
1996Q01
1997Q03
1999Q01
0.20
2000Q03 2002Q01
start quarter
2003Q03
2005Q01
2006Q03
2005Q01
2006Q03
p-value
0.15
βEMU
0.10
0.05
β2
0.00
1996Q01
1997Q03
1999Q01
2000Q03
2002Q01
2003Q03
start quarter
Therefore, we cannot reject our second hypothesis. Persistent capital flows, leading to
asymmetric capital asset distribution among euro area countries, seem to have
affected the international risk sharing mechanism and thus consumption smoothing in
the euro area. Results suggest that, overall consumption smoothing within the euro
area seems to have been limited by asymmetric risk sharing. Furthermore, countries
with net foreign assets are supposed to share risks much better than countries with net
foreign liabilities, which is in line with our theoretical findings.
We can summarize our empirical analysis for the euro area that (i) the participation in
risk sharing differs significantly between countries. The divergence in net IIP seem to
be one important determinant, for (ii) different country specific consumption
17
smoothing and (iii) for limiting overall consumption smoothing throughout the euro
area. That leaves countries with high foreign liability less insured against adverse
economic developments within the euro area and with more volatile consumption.
5. Conclusion
In this paper we have analysed how an asymmetric foreign capital asset distribution
changes international risk sharing and effects consumption smoothing in the euro
area. That analysis has become necessary after almost a decade of one-way capital
flows in particular from Germany to southern European euro area countries. That
resulted in a divergence of current account balances as well as net international
investment positions within the euro area.
Substantial asymmetric foreign capital asset distribution creates an asymmetric
international risk sharing mechanism, which reduces, in comparison to a symmetric
case, consumption smoothing in the monetary union as a whole and in both types of
countries – countries with net foreign assets countries as well as with net foreign
liabilities. However, countries with high net foreign liabilities are in particular
exposed to consumption volatility. These theoretical propositions are confirmed by
our empirical analysis for the first 12 euro area countries.
Hence, the international risk sharing mechanism does not work as properly and as
equally in the euro area as assumed by the theoretical symmetric international risk
sharing approach by Mundell (1973) and as argued by the European Commission (EC
2008). Without sufficient labour market flexibility, very limited room for fiscal policy
and also poorly working international risk sharing, the adjustment capability of the
euro area seems to be very limited. That is an alarming result for the euro area in
general and in particular for currently suffering euro area countries facing real
adjustment needs.
18
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20
Appendix
1. Data availability and data sources
Data:
Nominal GDP, quarterly
Source:
Eurostat
Availability:*
Q1/1995 – Q3/2009
Ireland: Q1/1997-Q/2009
Greece: Q1/2000-Q/2009
Consumption, quarterly
Eurostat
Q1/1995 – Q3/2009
Ireland: Q1/1997-Q/2009
Greece: Q1/2000-Q/2009
Population, annually
IMF World Economic
Outlook
1995-2009
International Investment
Position (IPP), annually,
Assets-Liabilities
IMF International Financial
Statistics, via DataStream
1995-2008 (quarterly data
were created by linear
interpolation)
Ireland: 2001-2008
Greece: 1998-2008
Luxembourg: 2002-2008
Portugal: 1996-2008
* y-o-y growth figures used in the empirical analysis start four quarters later.
21