Nominal Revaluation of Cross-Border Assets, Terms-of-Trade Changes, International Portfolio Diversification, and International Risk Sharing

1. Introduction All nominal assets are subject to nominal risks. The real value of nominal debt decreases under inflation. In open economies, nominal cross-border assets are subject to nominal risks, such as inflation risks and exchange rate risks. That is, when the price level and exchange rates fluctuate unexpectedly, the real value and real interest income of nominal cross-border assets change, and wealth is redistributed internationally. This is called the "nominal revaluation of cross-border assets."1 This international wealth redistribution or international wealth transfer is enormous when substantial nominal cross-border assets are held. In major industrial countries, foreign assets and liabilities have reached their GDP levels. Holdings of foreign assets by the United States were 73% of its GDP, and its foreign liabilities were 95%, in 2000. The ratios for the United Kingdom were even larger, 260% and 276%, respectively, in 1999.(2) In these circumstances, substantial wealth is transferred internationally through the "nominal revaluation of cross-border assets." In the United Kingdom, the annual average of this wealth redistribution was more than 5% of its annual GDP during the period 1987-2000.(3) This "nominal revaluation of cross-border assets" can work as international risk sharing under some restrictive conditions. When income and the price level move inversely, the real value and real return on nominal assets are proportional to income. Thus, by cross-owning or trading nominal assets internationally, countries can share some country-specific risks. In his simple twoperiod model where the only sources of uncertainty are endowment shocks, Svensson (1989) showed that even a perfect pooling equilibrium can result by trading only nominally risk-free bonds under a monetary policy that generates negative correlation between endowment and the price level. However, he did not emphasize the role of the mechanism in overall international risk sharing, and possibly for this reason, the result is not well known. In this paper, I apply the idea to the aggregate level of international risk sharing by considering all types of nominal cross-border assets as opposed to limiting the study to only nominal bonds themselves. The mechanism can be thought of as a nominal analogy to Cole and Obstfeld (1991). In Cole and Obstfeld's (1991) model, changes in the terms of trade can automatically transfer wealth to insure country-specific risks. In the nominal revaluation, the relative "nominal" price (nominal exchange rate) changes between countries, instead of relative "real" price (terms of trade) changes, make international risk sharing possible.4 Cole and Obstfeld (1991) further suggested that the welfare gains from international portfolio diversification may be small, and the "home bias" in international portfolio investments may be justified since changes in the terms of trade can insure some country-specific risks.5 Similarly, if the nominal revaluation works as international risk sharing, it may serve as another justification for home bias in equities since equities are only parts of total cross-border nominal assets, and the nominal revaluation of other cross-border assets (such as bonds, direct investments, currencies, loans, and so on) can provide risk sharing.6 On the other hand, the nominal revaluation has some interesting implications on the comparison between the flexible and the fixed exchange rate regimes. If it works as (or against) international risk sharing, it provides another merit (or drawback) of the flexible exchange rate regime since the changes in the nominal exchange rate can provide international risk sharing (or increase the country-specific risks). This paper empirically examines three international risk-sharing channels: the nominal revaluation of cross-border assets, the terms-of-trade channel suggested by Cole and Obstfeld (1991), and cross-border security ownership (or international portfolio diversification) that is thought of as a natural way of sharing country-specific risks. …