International Financial Integration*

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III. Analysis of International Investment Positions

This section discusses theoretical determinants of international financial integration, and
conducts a simple econometric analysis aiming at identifying the key factors driving
international asset trade.

A. Conceptual Issues

A natural benchmark in thinking about the level of international asset cross-holdings is the
allocation that would hold under complete global financial market integration with no
cross-border transactions costs. In such a world, each country would hold a very high level
of foreign assets and liabilities, in line with full diversification. As a crude approximation,
a country representing 1 percent of the world endowment would hold 99 percent of its
wealth overseas and, in turn, 99 percent of its domestic tradable assets would be held by
foreigners.⁵

Although the world is still far from this idealized state, it is logical to relate the cross-
country and time series variation in international portfolios to the corresponding dispersion
in the (implicit and explicit) barriers to full integration and in the gains to international
diversification. The level of international asset trade will also depend on the ‘tradability’
of domestic assets: factors that reduce domestic transaction costs also facilitate cross-
border asset trade.

Martin and Rey (2000, 2001) provide theoretical models that address some of these issues.
In their framework, investors are risk averse, the number of financial assets is endogenous,

⁵ See Obstfeld and Rogoff (1996, Chapter 5) for a textbook review of the theory of
international financial trade.

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