International Financial Integration*

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by the shares of equity instruments (both portfolio and FDI) in foreign assets and liabilities
(GEQSHARE).

The first variable we include in the list of regressors is a capital account liberalization
index EXTLIB. It is the period-average value of an index of capital account restrictions,
ranging from 0-4, with a score of 4 indicating complete liberalization. It is based on data
constructed by Grilli and Milesi-Ferretti (1995) and updated by Mody and Murshid
(2002).¹¹ To allow for gradual adjustment in stocks to the lifting of controls, we lag this
variable in the regressions: the average value in 1978-81 is used for the time period 1982-
85 and so on.

Our second regressor is trade openness, defined as the sum of exports plus imports relative
to GDP (TRADE).¹² Our third regressor, the (log) level of GDP per capita, is included to
allow for a systematic relation between cross-border financial activity and the level of
development. We also consider three indicators of domestic financial development,
potentially an important factor in driving international asset trade: the ratio of liquid
liabilities to GDP (FINDEPTH); the ratio of stock market capitalization to GDP
(STKCAP); and the ratio of cumulative privatization revenues to GDP (CUMPRIVAT).¹³
The latter is included to address whether the sale of state-owned assets has been an

¹¹ Edison and Warnock (2002) construct a capital controls measure based on restrictions of
access to equity holdings, but this is designed for emerging market economies rather than
the industrial economies in our sample.

¹² The theory discussed in the previous section indicates that there should be a direct
relation between trade and financial integration. At a bilateral level, it is interesting also to
consider the extent to which ‘gravity’ equations explain financial trade as compared to
goods trade. See Portes and Rey (2002) and Devereux and Lane (2003) on the
determinants of bilateral financial flows.

¹³ FINDEPTH is drawn from Beck et al (1999); STKCAP was kindly provided by Hali
Edison; CUMPRIVAT is based on OECD data.

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