International Financial Integration*

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(e.g. learning costs), this may provide another reason why international cross-holdings
might rise with income levels. The Martin-Rey framework also naturally delivers such a
positive relation.

The size of the domestic financial sector plausibly facilitates international asset trade in
several ways.⁷ Domestic financial intermediaries that also distribute international assets
offer a local channel by which investors can gain foreign exposure. Exposure to domestic
financial markets may also increase the desire for international diversification. On the
liability side, an extensive financial infrastructure is attractive to foreign investors.

However, a substitution effect may also operate: by necessity, domestic agents will have to
invest on foreign markets if the domestic financial sector is underdeveloped. The quality
of domestic financial regulation may also be important: foreign investors will stay away
from markets that do not protect their interests.

Tax policy may also influence the level of international cross-holdings. Firm assets may
be shifted to countries with low corporate income tax rates. Moreover, such a regime will
also attract international financial intermediaries engaged in offshore financial
transactions. In addition, at a household level, high tax rates on investment income will
stimulate the growth of offshore savings vehicles, if overseas investments can be more
easily hidden from domestic tax authorities.⁸

These factors may not have uniform effects on the different components of the
international balance sheet. For instance, if the greatest barriers to trade have been with

⁷ At this point, we are not attempting to establish lines of causality: some other studies in
fact have tried to make a link running from external liberalization to domestic financial
development. See, for example, Klein and Olivei (2000).

⁸ See also Grilli (1990). This can directly create two-way financial trade if foreign loans
can be raised on the back of these offshore assets. For instance, such round-tripping was
popular in Ireland during the 1980s.

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