Corporate Debt, Capital Flows, and International Business Cycles

The G7 countries traditionally display home bias in assets (equities and bonds), but over the last 25 years this bias has progressively decreased, especially for equity portfolios. At the same time, the indebtedness of non-financial corporations has tended to increase and comove across countries. Motivated by this evidence, we develop a two-country two-good framework with portfolio choice and with credit market imperfections that lead firms to issue both equities and debt securities. This model can shed some light on how corporate debt affects investors’ financial decisions that are characterized by home bias. We show that the financial frictions and the shocks to these frictions can lower the hedging provided by a country’s equities against changes in labor income as well as the relative holdings of a country’s bonds which are useful to deal with changes in the terms of trade. The financial frictions and shocks can be calibrated to match the reduced equity home bias observed in the data, while improving the ability of the model to explain the business cycles of the G7 countries since the Great Moderation.