The chapter examines the relationship between international trade and cross-border investment in financial assets which both have become increasingly important determinants of business cycles in recent decades. The major finding is that with rising trade, cross-border financial portfolios are tilted away from relatively risky equity holdings towards relatively safe debt holdings. In particular, cross-border holdings of debt securities strongly increase when trade linkages are strengthened. The uncovered empirical pattern is rationalised by a theoretical model of international portfolios in which households insure against risk arising from terms-of-trade movements.
The study is informative for debates concerning the implications of globalization for macroeconomic stability. For example, when it comes to find origins of the 2008/09 financial crisis, many observers and scholars argue that foreign debt inflows contributed to large credit growth, high banking leverage and rising house prices. The recent paper finds that a rising amount of cross-border debt holdings is a side-effect of deepening trade integration, a relationship that should be taken into account when seeking for right policy measures.
