Intertemporal risk sharing in the EMU: Disentangling the role of international credit markets and of the governments

Abstract

This paper provides a comprehensive examination of the role of intertemporal risk sharing – or consumption smoothing – in absorbing the impact of asymmetric shocks in the euro area. We attempt to disentangle the role of international credit markets from domestic net savings and that of governments from the private sector. Overall, inter-temporal risk sharing accounts for above 30 percent, and is the main absorption channel in the EMU. Households’ savings provide a negligible amount of smoothing whereas the role of corporate savings is significant and steady. Government’s saving is the main source of smoothing, although this effect vanishes after the eruption of the sovereign crisis in 2010, in particular in the periphery. The bulk of consumption smoothing is achieved domestically while international credit markets do not provide risk sharing. This appears to be at odd with the common understanding that greater financial integration should lead to international risk sharing. To contribute to the understanding of this puzzle, we analyze the effect of the main financial instruments for intertemporal consumption smoothing. Our findings suggest that FDI and bank lending did contribute to intertemporal smoothing, while short-term portfolio investments had a negative and dominant role.