Financial liberalization and consumption volatility: explaining heterogeneity across countries

Abstract

Most previous studies mainly focus on the direct impact of financial liberalization on consumption growth volatility with less emphasis on explaining heterogeneity across countries. This paper, therefore, contributes to the existing body of literature by analysing factors which explain such differences. The initial level of inequality and domestic financial development play a prominent role in explaining why the benefit of financial integration differs across countries. Overall, our results, using data from 26 countries, indicate that financial liberalization reduces consumption volatility, ranging between 1.57 and 2.11 (61% to 82%). An increase in the initial level of income inequality by one standard deviation increases consumption volatility, ranging between 0.36 and 0.48 (14% to 19%). Moreover, an increase in one standard deviation of financial development decreases consumption growth variability by 0.16 (6%). Policy measures that promote redistribution and improve domestic financial markets help to reap the potential benefit of financial integration.