International Financial Integration*

-8-
ratio of portfolio equity holdings by foreigners to stock market capitalization has increased
over the past 10 years. Note that this ratio underestimates the increase in foreign equity
holdings because it excludes the “controlling shares” of companies that are classified as
FDI.

In a similar vein, we next investigate the degree to which the value of international
portfolios is related to the boom in equity valuations during the 1990s, rather than an
increase in capital flows. Table 1 reports the change in external assets and liabilities
between end-1995 and end-2000 (as a ratio of GDP in 2000), cumulative capital outflows
and inflows during the same period, and, as residual, the part of the change in the external
position not explained by capital flows. The table shows clearly the remarkable increase in
the size of country external portfolios, and the magnitude of the underlying gross capital
flows. The increase in external diversification is particularly high in financial centers such
as Switzerland and the United Kingdom, and small open economies such as the
Netherlands and Scandinavian countries, and is much faster than in previous years. Indeed,
compared with the previous 5-year period (1990-95), gross capital flows more than
doubled, both in absolute terms and as ratios of GDP.

A second notable fact is the importance of capital gains and losses in explaining the
dynamics of the external position. These are primarily due to exchange rate fluctuations
and changes in stock market values, which were substantial during this period. In our
sample, a remarkable case is Finland, where the increase in the market value of its equity
liabilities (in particular Nokia, a stock widely held by non-residents) implied an increase in
external liabilities unexplained by new inflows of over 100 percent of its GDP. The impact
of capital gains and losses on the net external position, which can be derived by
subtracting column (6) from (3), is even more substantial (in relative terms) than the
impact on gross positions.

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