International Financial Flows, Real Exchange Rates and Cross-Border Insurance

Abstract

Whether cross-border financial market integration has raised global insurance, is still a controversial issue in the literature. If this is so, what should we observe in the data? The insurance literature emphasizes that efficient risk-sharing requires financial markets to channel resources to countries that have been made temporarily poorer by some negative conjuncture, net of physical capital accumulation. This standard condition, which provides the basis for virtually every test of international insurance, is however derived focusing on only one of the two channels of cross-border insurance, the financial flows channel, implicitly assuming no interaction between this and the other channel, international relative price fluctuations. This paper shows that testable conditions can only be derived theoretically placing the interaction between prices and financial flows centerstage in the analysis. Using a two-country general equilibrium model with endogenous portfolio diversification, I show that financial flows and relative prices can be either complements or substitutes in providing insurance. In the case of complementarity, financial inflows raise the international price of a country's output. This implies the standard condition. In the case of substitutability prices and flows transfer purchasing power in opposite directions. This implies a different condition: efficient financial markets are required to channel resources upstream, from relatively poorer to relatively richer countries. The conditions for substitutability appear to be quantitatively and empirically plausible.