1 Introduction
Following a capital market approach, we analyse the potential smoothing of domestic out-
put and wealth fluctuations by means of cross-country ownership of foreign portfolio assets
and liabilities. In times of increasing international financial integration, both investment
income flows and capital gains are channels that can potentially provide international risk
sharing.1
Lane (2001) analysed the former channel using data on international investment posi-
tions, whereas the main innovation in this paper is to introduce the latter. This channel
is of particular relevance to countries with large equity shares in their portfolios which
make most of their returns in the form of capital gains (thus not affecting investment
income flows). We focus in our analysis on capital gains on domestic financial markets
(as a proxy for the foreign liability side).2
If domestic capital markets are partly owned by foreign investors, a pro-cyclical co-
movement of capital gains on domestic capital markets with GDP growth brings about
economic or wealth stabilisation.3 Faria et al. (2006) indeed find higher equity shares
in the composition of foreign liabilities in the last decade. We analyse if this provides
improved potential for international risk sharing, namely if pro-cyclicality of equity and
bond markets is observable.4
Obstfeld (2004) provides a comparison between an idealised world of fully-enforceable
state-contingent contracts and the world of asset trade in non-contingent contracts (i.e.
bonds and loans). In the ideal world with complete Arrow-Debreu securities a country is
fully insured against domestic output shocks. Securities that could in theory deliver the
desired improved international risk sharing are bilateral GDP income swaps as proposed
by Merton (1990) or GDP linked securities (Shiller, 1993).
Due to the lack of these instruments we use the following application: When domestic
GDP grows faster, the domestic stock market performance should improve accordingly;
that is delivering higher capital gains for domestic and foreign investors. The benefit for
foreign investors from this economic up-swing is in the form of capital gains and dividend
1 See Lane and Milesi-Ferretti (2006) for a documentation of the rapid growth in cross-border financial
holdings.
2 An extended version of this paper also includes the analysis of rates of capital gains on foreign assets
and liabilities using international investment position data. These are usually very similar to market
rates, but often less accurate and poorer in terms of data availability.
3 The realisation of capital gains and losses involves liquidation costs however, which increase with the
extent of illiquidity. This applies to FDI in particular.
4 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.