The determinants of cross-border equity flows

Very little was established about what determines international trade in securities, partly for want of data. This paper assembles a panel of annual bilateral gross cross-border portfolio equity transactions – purchases plus sales – among 14 countries from 1989 to 1996, 1456 observations in all, whose distinguishing feature is that it records country pairs that exclude the United States, so the US’s special status as the largest economy, a leading financial centre and the issuer of the main international currency can be controlled for rather than assumed away. Deriving the estimating equation from a micro-founded model of asset trade with imperfectly substitutable assets, transaction and information costs, and endogenous asset supply, the authors regress log transactions on the two countries’ equity market capitalisations, an index of financial-market sophistication, and distance. The elasticities on market capitalisation are close to and never statistically distinguishable from the theoretical value of one; adding distance gives a coefficient of -0.881 with a standard error of 0.031 and raises the R-squared from 0.555 to 0.693, so that “with five independent variables, this straightforward, simple ‘gravity’ regression captures almost 70% of the variance,” and 84 percent in a between-estimator cross-section. That distance matters so much is the puzzle the paper is built around, since “unlike goods, assets are ‘weightless’, and distance cannot proxy transportation costs,” and a diversification motive would give distance a positive sign because business-cycle correlations fall with distance. The authors’ answer is that distance inversely proxies information, which they test with variables that represent information more directly: bilateral telephone call traffic (normalised by country size, and exogenous to financial activity by construction), the number of branches in the destination country of banks headquartered in the source country, trading-hours overlap, and a survey index of insider trading in the destination market. Telephone traffic and bank branches are consistently significant with the expected positive signs and reduce but do not eliminate the distance coefficient; insider trading is the least stable, insignificant in the full panel but correctly signed and significant (-0.398, standard error 0.117) within Europe, where perceived insider trading varies far more. Six explanatory variables capture 45 percent of the variance of bilateral flows and 65 percent of the cross-sectional variance. The results survive a long list of robustness checks – full source- and destination-country dummy sets, adjacency and common-language dummies, regional and currency-bloc dummies, financial-centre dummies, dropping the US and then the UK (distance elasticities of -0.721 and -0.856), restricting to intra-European flows (-0.727) or excluding them (-0.632), year-by-year and country-by-country estimation, instrumenting market capitalisation, and controlling for bilateral goods trade (distance falls to -0.529 but stays strongly significant). On diversification the paper is deliberately cautious: the return-covariance term enters positively (0.346, standard error 0.136) when the information variables are omitted, takes its theoretically predicted negative sign only once distance and the information variables are included, and the authors conclude there is “weak evidence for a diversification motive for asset trade in our annual data, but only when we control for the informational friction,” explicitly less robust than the information results. Two extensions widen the claim. Running the same information variables through a matched panel of manufactures trade cuts the goods-trade distance elasticity from -0.547 to -0.279, suggesting distance proxies information in the goods gravity equation too. And on a separate US-centred dataset built from the 1994 and 1997 Treasury benchmark surveys, the elasticity of US transactions with respect to US holdings is 1.05 (standard error 0.053, R-squared 0.87) and a holdings regression reproduces a distance elasticity of -0.71 – results the authors call “illustrative” given only 80 observations. The paper’s summary verdict is that “[i]nternational capital markets are not frictionless: they are segmented by informational asymmetries or familiarity effects,” a claim about segmentation rather than about the welfare cost of it.

Richard Portes | Macro Paper Warehouse

The determinants of cross-border equity flows