Asset home bias in debtor and creditor countries

Abstract

Why do debtor countries have on average a less diversified international portfolio than creditor countries? With two symmetric countries, the existing literature has showed why portfolios are home-biased to the same degree across countries. We show that, in a model with debtor and creditor countries, a new hedging motive of net external positions implies a short (long) position of both home and foreign assets in the debtor (creditor) country. Marginally, the debtor (creditor) country loses (gains) the net foreign asset (NFA) as a diversified portfolio on top of the above symmetrically biased portfolio, which intensifies (dilutes) the home bias there. An extended model with both equity and bond assets also yields global two-way capital flows that are in consistent with the data. The theory helps understand the financial capital flows between the debtor developing and creditor developed countries during the financial globalization from 1990s, and receives empirical support.