International Financial Integration*



-2-

With regard to the third point, we have documented in previous work the existence of
substantial differences in rates of return on external assets and liabilities across countries
(Lane and Milesi-Ferretti, 2002a and 2002b). For example, rates of return on assets have
systematically exceeded those on liabilities for the US, so that the US investment income
position stayed positive for a number of years even when the net foreign asset position had
turned negative.

Rates of return matter since they are the channel through which international investment
positions provide risk sharing. The associated international transfers also are important in
determining the trade balance and the real exchange rate. Moreover, the dynamics of asset
and liability stocks depend on capital gains and losses in addition to new capital flows.

This is especially important for countries holding large portfolio equity and FDI portfolios
that may take most of their returns in the form of capital gains, which do not affect
investment income flows, rather than yields (which do). In this paper, we study the
dynamic behavior of rates of return, the links between rates of return on the international
investment position and various financial market returns, and the inter-relations between
domestic and foreign real rates of return and real exchange rate fluctuations.

This work has clear relevance for policymakers. Stocks of foreign assets and liabilities
represent an important global linkage—shocks in country A have an impact on country B
via revaluation and other wealth effects. This will be stabilizing to the extent that the
international balance sheet hedges domestic risks, but potentially raises volatility if
external investments leverage domestic positions. In addition, identifying the sources of
the growth in world asset trade can contribute to an understanding of its sustainability and
likely future trends. In this regard, growth that is related to the once-off elimination of
barriers to asset trade will not persist but rather represents the transition to a higher level



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