Abstract
Panel analysis of 21 industrial countries shows evidence for pro-cyclicality of capital gains on domestic stock markets over a medium term horizon. Thus, with cross-border ownership of portfolio equity investments, potential for hedging against domestic output fluctuations by means of the capital gains channel of foreign liabilities is found. Individual country analysis reveals substantial heterogeneity of cyclicality patterns. Evidence suggests that this cross-country variation can be explained by the level of economic development and the size of financial markets.
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Notes
See Lane and Milesi-Ferretti (2007) for a documentation of the rapid growth in cross-border financial holdings.
See Table 3 in the Web Appendix for a country analysis of rates of capital gains on foreign liabilities using international investment positions data. For portfolio investments, these are usually very similar to market rates, but often less accurate and poorer in terms of data availability—see Lane and Milesi-Ferretti (2008a).
The realisation of capital gains and losses involves liquidation costs however, which increase with the extent of illiquidity. This applies to FDI in particular, but less to portfolio investments.
Capital gains on foreign assets, on the other hand, are influenced by a broad range of global factors such that a satisfying analysis is beyond the scope of this paper.
This two-step approach is adapted from Lane’s (2003) cyclicality analysis on fiscal policy.
If firms choose not to pay out dividends, but instead to keep retained earnings, the mechanism works as well, since this should be reflected in higher stock prices and thus capital gains.
See their paper for a model of international trade in risky financial assets under incomplete markets.
Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United States.
Data availability differs by country. See Appendix for an overview.
If β is < 0, thus counter-cyclical, risk sharing would be in theory possible if foreign investors take short positions in the domestic markets. However, this possibility is not very feasible on a large scale on current financial markets.
We use average values by country for the explanatory variables over the period from 1975 to 2006 (until 2004 for GDP per capita), including only those years where actual rates of capital gains were available.
We weight by the (in the previous step) obtained t-statistics.
In the main tables of the country-by-country analysis we focus on reporting the estimated β-coefficients and associated standard errors in order to present the key results as clear and concise as possible. More diagnostic statistics are provided in Table 1 and Table 2 of the Web Appendix.
Using quarterly total returns data from 1970 to 1991.
For 22 countries from 1970 to 1995.
The significant negative βs obtained by estimation 4 for Belgium, Denmark, United Kingdom and the United States could theoretically imply the potential to share idiosyncratic macroeconomic risk by short positions of foreign investors.
We drop Switzerland from the heterogeneity analysis of stock markets, as it represents an outlier in terms of its average stock market capitalisation.
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I am grateful to Philip Lane for his encouragement and very helpful comments. I am also thankful for comments and discussions to two anonymous referees, Thierry Bracke, Christiane Hellmanzik, Nils Holinski and Sébastien Wälti. Seminar participants at the International Macro Group and the Graduate Seminars at Trinity College Dublin and at the Jean-Monnet Workshop “Financial Market Integration, Structural Change, Foreign Direct Investment and Economic Growth in the EU-25” in Brussels, April 2008, provided insightful feedback. The author gratefully acknowledges the financial support of the Irish Research Council for the Humanities and Social Sciences (IRCHSS) and the IIIS.
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Schmitz, M. Financial Markets and International Risk Sharing. Open Econ Rev 21, 413–431 (2010). https://doi.org/10.1007/s11079-008-9100-x
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DOI: https://doi.org/10.1007/s11079-008-9100-x