Financial Integration and Risk Sharing in the East African Community

Abstract

This study explores the link between financial integration and risk sharing in the East African Community [EAC]. It empirically tests the standard risk sharing hypothesis that consumption growth rates of individual countries should be perfectly correlated with the average consumption growth rate and not the individual country income in the financially integrated area. It then links the level of risk sharing to the level of financial integration to determine how the two interact. Finally, risk sharing and financial integration are jointly considered after taking into account the stochastic properties of income growth, particularly the permanent and transitory components of income and their shocks and how these interact with financial integration to improve risk sharing. The results indicate less than efficient risk sharing in the EAC. Standard tests reject the risk sharing hypothesis but show strong correlation between individual country consumption growth rates and aggregate consumption growth in the EAC. However, when financial integration is accounted for, this effect disappears and consumption growth only responds to income growth. This result is considered as indicating the equivalence of financial integration to expected consumption growth. When the different components of the income process and their shocks are taken into account, results suggest that financial integration helps EAC countries achieve insurance against shocks to the transitory component of income. The overall results indicate that as financial integration in the EAC improves, there should be increased risk sharing and hence smoother consumption growth over time.