Cross-Border Equity Investment and the Business Cycle

Abstract:     
I present new evidence that gross foreign assets and liabilities in equity investments, measured at market value, are positively correlated over the business cycle in each of the Group of Seven industrialized countries (G7). The close comovement of assets and liabilities, in turn, reflects strong cross-country correlation between equity prices and moderate co-movement of gross outflows and inflows. I analyze an international real business cycle (IRBC) model to evaluate possible causes of these correlations: diminishing marginal product of capital, imperfect substitutability of goods, incomplete markets, and investment project duration. A complete markets model with diminishing returns to capital predicts positive cross-country correlation between equity prices. I show that imperfect substitutability between goods strengthens this correlation, and I show that cross-border financial costs lead to negative correlation between gross capital outflows and inflows. Finally, I develop a model that distinguishes foreign direct investment (FDI) in new projects from portfolio equity. The model suggests that assets and liabilities should be more closely correlated in portfolio equity than in FDI.

Number of Pages in PDF File: 37

Keywords: Foreign direct investment, portfolio equity, business cycle, international investment position, greenfield investment, open economy macroeconomics, DSGE models

JEL Classification: E32, F23, F32, F41

working papers series