Do capital gains on international portfolios have risk sharing benefits? Evidence from Europe

Sebnem Kalemli-Ozcan, Bent Sørensen

23 May 2012



A common currency and harmonised financial regulation has led to increased financial integration in Europe which, according to standard theory, should lead to increased risk sharing, i.e. income and consumption smoothing in the face of country-specific shocks. Shocks that hit all countries at the same time cannot be smoothed through integrated financial markets but the impact of country-specific shocks will be diluted if ownership of production units is spread over many countries.

The standard GDP-based approach, however, misses one potentially important channel of income insurance; namely, wealth transfers between countries from revaluation of assets. Obstfeld (2004), Lane and Milesi-Ferretti (2001), Gourinchas and Rey (2007), and others point out that such valuation effects can play a significant role in the process of adjustment to international imbalances.

However, such positive or negative wealth changes are not recorded in the national accounts, which is why their contribution to risk sharing typically is not made explicit. By now, gross holdings of foreign assets are often larger than output (GDP), in which case a 10% capital gain on foreign assets implies a substantial increase in wealth of more than 10% of output.

The evidence on this channel has been mixed. Asdrubali et al. (1996) devise a way of quantifying risk sharing from cross-state and cross-border ownership of assets and find that this mechanism insures 50% of shocks to state-level output in the US. However, Sørensen and Yosha (1998) find no such insurance from cross-ownership in Europe before 1990. But things changed with the introduction of the euro.

In work with Oved Yosha, we find that about 12% of (idiosyncratic) output shocks have been shared among EU countries since the beginning of the 2000s (Kalemli-Ozcan et al. 2003). Kalemli-Ozcan et al. (2010) further show that a country that increases the holdings of external bank assets by 100% achieves 17% additional consumption smoothing.1

Recent research

In recent work with Faruk Balli (Balli et al. 2012), we set out to quantify how much capital gains help insure output shocks in Europe in addition to the 12% achieved in the last decade through measured factor income flows.

As Devereux and Southerland (2010) have previously pointed out, capital gains typically are large and unpredictable, as shown in Figures 1-3. That is, a capital gain for, say, the UK, in a given year is just as likely to be followed by a capital loss the following year. On the contrary, a gain in output tends to persist indefinitely. We argue that a non-persistent capital gain of 10% of output is not equivalent to a persistent increase in output of 10%, but rather the annuity value of the capital gains (the interest rate times the capital gain) is equivalent to a 0.5% increase in permanent wealth (assuming an interest rate of 5%). Using this convention, we find that capital gains on average insure 6% of output shocks since the turn of the century. In comparison, measured net factor income flows (the difference be Gross National Income and Gross Domestic Product) insure 6%-14% of shocks in the Eurozone (dependent on the exact sample of countries) and about 6% among all European Union countries.

Figure 1. Capital gain to GDP ratio



Figure 2. Capital gain to GDP ratio for OECD and EU samples.


Figure 3. Annual capital gain to GDP, United States.

We further examine what determines capital gains. Not surprisingly, exchange rate movements explain a large fraction of capital gains, particularly in countries with large international gross assets and liabilities; while movements in the value of domestic and foreign assets also explain a fair amount of capital gains. A case in point Finland where valuation changes of the communications company NOKIA led to dramatic variation in Finland's foreign liabilities during the last decade, as shown in Figure 4.

Figure 4. Finland

The surprising and important conclusion of Asdrubali et al. (1996) is that private markets, not the US federal government, play the major role in insuring output shocks to US states. However, there is more than a century of capital market integration behind such insurance in the US and while markets for liquid assets are almost fully integrated in Europe, there is still a long way to go before, say, more German firms are owned by non-Germans than by Germans, which is needed for risk to be fully shared. For the stability of the Eurozone, it is crucial that market-based risk sharing between countries becomes as extensive as it is in the US, but until then it is hard to envision a successful Eurozone without a fiscal union. It is therefore important to closely monitor if the Eurozone is moving in the right direction along this dimension and our quantifications highlight that capital gains are a part of the equation that should not be ignored – even if the National Accounts currently do so.


Asdrubali, Pierfederico, Bent E Sørensen, and Oved Yosha (1996), “Channels of interstate risk sharing: US 1963—90”, Quarterly Journal of Economics, 111:1081-1110.

Balli, Faruk, Sebnem Kalemli-Ozcan, and Bent E Sørensen (2012), “Risk Sharing Through Capital Gains”, Scandinavian Journal of Economics.

Devereux, Michael B, and Alan Southerland (2010), “Valuation effects and the dynamics of net external assets”, Journal of International Economics, 80:129-143.

Gourinchas, Pierre-Oliver, and Helene Rey (2007), “International financial adjustment”, Journal of Political Economy, 15:665-703.

Kalemli-Ozcan, Sebnem and Bent E Sørensen (2007), “How integrated are European financial markets? And what’s trust got to do with it?”,, 28 November.

Kalemli-Ozcan, Sebnem, Bent E Sørensen, and Oved Yosha (2003), “Risk sharing and industrial specialization: Regional and International Evidence”, American Economic Review, 55:107-137

Kalemli-Ozcan, Sebnem, Simone Manganelli, Elias Papaioannou, and Jose Luis Peydro (2010), “Financial integration and risk sharing: The role of monetary union”, in The euro at Ten: 5th European Central Banking Conference Proceedings.

Lane, Philip and Gian Maria Milesi-Ferretti (2001), “The external wealth of nations: Measures of foreign assets and liabilities for industrial and developing nations”, Journal of International Economics, 55:263-294.

Obstfeld, Maurice (2004), “External adjustment”, Review of World Economics, 140(4):541-568.

Sorensen, Bent E and Oved Yosha (1998), “International risk sharing and European monetary unification”, Journal of International Economics, 45:211-238.

1External bank liabilities seem to have a dis-smoothing effect. Europe slowly is becoming more integrated financially although there is still a long way to go before the level of the intra-US income insurance is reached. (See, for instance Kalemli-Ozcan and Sørenson 2007)



Topics:  Europe's nations and regions Financial markets International finance

Tags:  financial integration, Risk sharing, Eurozone crisis, international portfolios

Neil Moskowitz Endowed Professor of Economics, University of Maryland; Research Fellow, CEPR

Lay Professor of International Economics, University of Houston and CEPR Research Fellow