International Financial Integration*

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at the beginning of this section is the increasing importance of portfolio equity and FDI
stocks in international portfolios. The increase in world stock market values during the
1990s has implied substantial capital gains and rates of return on these assets, thus
potentially explaining the high measured rates of return on external assets and liabilities.
Differences in countries’ external holdings of equity-type instruments can also account for
cross-country heterogeneity in rates of return.

Finally, differences between yields on external assets and external liabilities can be due to
the different weight in the two categories of equity-type instruments. Most of the return on
equity and FDI instruments comes through capital gains, and yields are relatively small.
However, investment income flows (that enter in the current account) include only yields,
but do not include capital gains. As a result, ceteris paribus yields on external assets will
tend to be higher in countries with more debt-type instruments in their portfolio.²⁷ A
corollary of this observation is that the current account is becoming less and less indicative
of changes in countries’ external position, since it ignores such valuation changes.

C. Empirical Specification

In order to understand the time-series behavior of rates of return on foreign assets and
liabilities, we consider the specification

r^BOP =αi+γ*rij^Mt +εijt                              (9)

ijt                                          ^{j               j}

where α_i is a country fixed effect, r_ij^B_t^OP is the rate of return on a given category of the
international investment position, as calculated from the balance of payments data and r_ij^M_t

²⁷ For example, Italy is a creditor country where investment income payments are higher
than receipts. This is accounted for by the fact that Italy’s external assets have a larger
share of equity-type instruments than Italy’s external liabilities.

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