International Portfolios and Current Account Dynamics: The Role of Capital Accumulation

Abstract

Despite the liberalization of capital flows among OECD countries, equity home bias remains sizable, but is now less severe than in earlier decades; as a result, fluctuations in returns on foreign assets have a substantial effect on countries' wealth. As documented in this paper, changes in net foreign asset positions (NFA) are highly volatile, serially uncorrelated and countercyclical. We show that a two-country RBC model with productive investment and unrestricted international trade in stocks and bonds can explain these facts. Capital accumulation and shocks to the efficiency of investment are key ingredients for the success of the model. In contrast to related models that abstract from capital, equity home bias is not sensitive to preference parameters. In the model, NFA changes are largely driven by capital gains/losses due to movements in equity prices. The model thus matches the high volatility and low serial correlation of NFA changes. We compare settings with complete and incomplete financial markets. Imperfect hedging is required to generate a realistic conventional current account measure that solely reflects aggregate net flows of assets between countries.