Taking gravity online: The role of virtual proximity in international finance

Christiane Hellmanzik, Martin Schmitz 01 April 2016

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The internet is unquestionably irreplaceable today in accessing and transmitting information globally, and has undoubtedly enhanced economic activity in various ways. Yet, there are only limited cross-country data available on internet information flows, making empirical research on the internet’s impact on international economic transactions difficult.  

However, there are a few notable exceptions. For international trade, Freund and Weinhold (2004) find a significant effect of the internet (measured by growth in web hosts in a country) on export growth of goods, which is consistent with a theoretical model in which the internet reduces market-specific fixed trade costs. Moreover, Freund and Weinhold (2002) show that the US’s services trade increased with partner countries where internet development occurred. Blum and Goldfarb (2006) point out that gravity models also hold digitally in the absence of actual trade costs, as physical distance has a negative impact on the online consumption of taste-dependent digital products such as music and games.

With respect to the financial sector, Barber and Odean (2001) stress that the internet allows investors to access more information and to trade without intermediaries. Research on the effect of the internet on international investment patterns is, however, relatively sparse, with the exception of Mondria et al. (2010), who use data on internet search queries to measure the attention allocated to a country. They find that investors endogenously increase their cross-border investments to a given country in response to an exogenous increase in the information obtained about that country.

Virtual proximity as a novel indicator for countries’ closeness

The international finance literature has shown – both empirically and theoretically – that distance and proxies for informational asymmetries between countries, such as common language, colonial ties, and currency unions, are crucial in explaining bilateral asset holdings and flows (see, for example, Lane and Milesi-Ferretti 2008, Okawa and van Wincoop 2012). Thus, trade in financial assets can be estimated by gravity models, which implies a proximity bias in international investments due to information asymmetries that are increasing in distance.

In new research (Hellmanzik and Schmitz 2016), we explore the role of virtual proximity between countries for bilateral holdings of portfolio investments. Our virtual proximity indicator is based on data collected by Chung (2011) measuring the volume of bilateral, inter-domain hyperlinks that internationally connect webpages in country A to webpages in country B. The idea is to reflect, for instance, how often British or French internet users set links to websites hosted in the US. In case this indicator is, ceteris paribus, higher for the UK than for France. This indicates that British citizens are virtually closer to the US than the French. The underlying assumption is that virtual proximity between two countries increases with the interest shown in each other’s web content.

The internet as a bridge for information asymmetries

Our virtual proximity measure captures global interconnectedness and information flows. As such, virtual proximity is a good measure for the potential information set of international investors. Virtual connectedness should reduce uncertainty about the expected pay-offs of international investment decisions, and thus foster international financial integration.

In addition, in light of the pivotal role of the internet, web-based measures of revealed proximity can be expected to matter more for cultural closeness than, for example, a common religion. To test for the role of virtual proximity, we employ a gravity model framework including a host of traditionally used proxies for information asymmetries and cultural proximity.  

Bilateral portfolio investments are significantly affected by virtual proximity

Our findings show that bilateral portfolio investments are significantly affected by virtual proximity, indicating that countries which are more closely connected in terms of web content are also more integrated financially. Given that ‘virtual proximity’ not only captures cultural proximity but also actual information flows between countries, it is not surprising that virtual proximity is rather powerful in terms of its impact on international investments, even when controlling for traditional measures of cultural proximity. In fact, including virtual proximity in our econometric estimations reduces the importance of traditionally used proxies for information asymmetries and cultural proximity.

The internet matters more for equity trade

The impact of virtual proximity is stronger for portfolio equity than for portfolio debt investment, highlighting the greater information-sensitivity of equity investments that might derive from the more heterogeneous nature of equities relative to fixed income securities.

Moreover, we find the largest positive effects of virtual proximity for investments among advanced countries. This is indicative of the fact that advanced countries are more open in the virtual sphere and are thus better able to take advantage of the latest information technologies.

Overall, our results – which are robust to a host of tests – indicate the important role of virtual interconnectedness and information technologies for international financial integration and thus highlight the internet’s growing relevance for economic transactions and international integration.

Authors’ note: The views expressed in this column are those of the authors and do not necessarily reflect those of the European Central Bank.

References

Barber, B. and T. Odean (2001), “The internet and the investor”, Journal of Economic Perspectives 15(1): 41-54.

Blum, B. S. and A. Goldfarb (2006), “Does the internet defy the law of gravity?”, Journal of International Economics 70(2): 384-405.

Chung, J. (2011), “The Geography of Global Internet Hyperlink Networks and Cultural Content Analysis”, Dissertation, University at Buffalo.

Freund, C. and D Weinhold (2002), “The Internet and International Trade in Services”, The American Economic Review 92(2): 236-240.

Freund, C. and D. Weinhold (2004), “The effect of the Internet on international trade”, Journal of International Economics 62(1): 171-189.

Hellmanzik, C. and M. Schmitz (2016), “Taking gravity online: the role of virtual proximity in international finance”, ECB Working Paper No. 1879.

Lane, P. R., and G. M. Milesi-Ferretti (2008), “International Investment Patterns”, The Review of Economics and Statistics 90(3): 538-549.

Mondria, J., T. Wu and Y. Zhang (2010), “The determinants of international investment and attention allocation: Using internet search query data”, Journal of International Economics 82(1): 85-95.

Okawa, Y and E. van Wincoop (2012), “Gravity in International Finance”, Journal of International Economics, 87, pp. 205-215.

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Topics:  International trade

Tags:  digital trade, cross-border information flows, information flow regulations

Assistant Professor, Department of Economics, University of Hamburg

Economist, European Central Bank

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