Income Smoothing and the Determinants of Income Smoothing Via Foreign Asset Revenues and Foreign Liability Payments

Abstract

This paper investigates whether the recent increase in foreign equity and debt holdings has been associated with more income smoothing. In a novel approach, we decompose factor income smoothing channel into factor income inflows and outflows. We document that factor income smoothing channel is mostly driven by factor income outflows (payments for foreign liabilities) instead of the factor income inflows (revenues of foreign assets). Smoothing via factor income inflows is not a strong and effective channel for income smoothing. We also seek for the determinants of smoothing via factor income inflows and outflows. Contrary to the previous literature,we find that the increase in foreign equity and debt holdings is not associated with more income smoothing via foreign asset revenues. Rather, we find that the increase in foreign equity and debt liabilities is strongly related with an increase in smoothing via factor income outflows. We also discover that diversification of foreign equity and bond holdings across various markets leads to an increase in the extent of smoothing via factor income inflows, whereas the tendency of European investors on allocating their assets within the Euro area, i.e. portfolio Euro bias, restraints risk sharing.