Skip to main content

Within and across countries heterogeneity in international finance

Final Report Summary - INFINHET (Within and across countries heterogeneity in international finance)

Financial globalization has led to a surge in cross-border capital flows, a large increase in countries gross foreign asset and liability positions, together with increasing global imbalances. In this context, understanding the forces shaping the international allocation of capital has become a critical macro policy issue. INFINHET aims at providing new insights on the patterns of capital flows across the globe and the structure of international portfolio holdings. To do so, it develops multi-country dynamic models of the world economy and evaluates their ability to match the patterns of international trade in assets observed in the data over the last decades.

Why do countries borrow or lend in international financial markets? A common answer to this classical question is that countries use international markets to smooth consumption and finance investment in response to changes in productivity. However, empirically, cross-country differential productivity growth does not seem to explain a significant fraction of cross-country capital flows in the recent period, at least at medium-term horizon. Some fast growing emerging countries have not borrowed much in international markets, of at least to a much lesser extent than what theory would predict. Beyond differences in productivity changes, INFINHET investigates alternative sources of heterogeneity across countries as important drivers of international capital flows. It is shown that differences in the development of household credit markets and social security, as well as differences in the level of aggregate risk countries are facing can be powerful drivers of capital flows. It is also argued that worldwide demographic changes (e.g. aging), potentially interacted with these more structural differences across countries, crucially matter for the accumulation of wealth across countries and for our understanding of the worldwide allocation of capital. In doing so, INFINHET sheds light on how some very drastic demographic changes in large emerging markets (such as China) have had potentially large effects on wealth accumulation, global saving and capital flows. As a by-product, INFINHET investigates quantitatively how these evolutions might have affected the price of assets globally.

INFINHET shows that the workhorse dynamic multi-country models of the global economy perform significantly better than previously thought once these additional sources of heterogeneity across countries are properly taken into account. As in the data, the theory developed in INFINHET can generate a very rich pattern of capital flows, going downhill or uphill, depending on observable countries’ characteristics. Beyond the theoretical aspects, the research conducted in INFINHET provides an empirical investigation of its main predictions using variations across asymmetric countries and/or across agents within countries. This requires the development of novel cross-country panel data to properly measure cross-country asymmetries, as well as the use of household level data. Quantitative applications to large economies, developed and emerging, are provided, with a particular focus on China and the U.S. two countries at the opposite of the spectrum in terms of saving behavior and direction of capital flows over the last decades. From a more normative perspective, the results of INFINHET can be used for policy evaluation as it provides a novel multi-country quantitative framework in which policy counterfactuals can be performed. More specifically, the project revisits the growth and welfare implications of financial integration across developed and emerging countries.