Do capital gains on international portfolios have risk sharing benefits? Evidence from Europe

by Sebnem Kalemli-Ozcan and Bent E. Sørensen

Vox
May 23, 2012

News reports today are full of negative stories on the Eurozone. This column presents evidence of a much-overlooked benefit. The common currency has led to increased financial integration and in turn increased risk sharing, which helps to significantly reduce output shocks. Those arguing for a break up of the Eurozone should take note.

A common currency and harmonised financial regulation has led to increased financial integration in Europe which, according to standard theory, should lead to increased risk sharing, i.e. income and consumption smoothing in the face of country-specific shocks. Shocks that hit all countries at the same time cannot be smoothed through integrated financial markets but the impact of country-specific shocks will be diluted if ownership of production units is spread over many countries.

The standard GDP-based approach, however, misses one potentially important channel of income insurance; namely, wealth transfers between countries from revaluation of assets. Obstfeld (2004), Lane and Milesi-Ferretti (2001), Gourinchas and Rey (2007), and others point out that such valuation effects can play a significant role in the process of adjustment to international imbalances.

However, such positive or negative wealth changes are not recorded in the national accounts, which is why their contribution to risk sharing typically is not made explicit. By now, gross holdings of foreign assets are often larger than output (GDP), in which case a 10% capital gain on foreign assets implies a substantial increase in wealth of more than 10% of output.

The evidence on this channel has been mixed. Asdrubali et al. (1996) devise a way of quantifying risk sharing from cross-state and cross-border ownership of assets and find that this mechanism insures 50% of shocks to state-level output in the US. However, Sørensen and Yosha (1998) find no such insurance from cross-ownership in Europe before 1990. But things changed with the introduction of the euro.

In work with Oved Yosha, we find that about 12% of (idiosyncratic) output shocks have been shared among EU countries since the beginning of the 2000s (Kalemli-Ozcan et al. 2003). Kalemli-Ozcan et al. (2010) further show that a country that increases the holdings of external bank assets by 100% achieves 17% additional consumption smoothing.

More