Leverage Constraints and the International Transmission of Shocks


  • Devereux thanks the Bank for International Settlements, Bank of Canada, SSHRC, and the Royal Bank of Canada for financial support. The views expressed here are those of the authors and do not necessarily reflect those of the Bank for International Settlements or of the Bank of Canada. We thank two anonymous referees for detailed and constructive comments on the paper. In addition we thank, without implication, Phil Wooldridge for advice on data and participants at the JMCB/Board of Governors Conference “Financial Markets and Monetary Policy,” June 4–5, and People's Bank of China–Bank for International Settlements Conference “The International Financial Crisis and Policy Challenges in Asia and the Pacific,” August 6–8, 2009, for comments including, in particular, the discussants Paolo Pesenti and Kyungsoo Kim. We also thank seminar participants at the 7th Hong Kong Institute for Monetary Policy Summer Workshop and the Bank of Thailand. This paper was written while the first author was visiting the Reserve Bank of Australia and the Bank for International Settlements. He is grateful for the warm hospitality and resources provided by both institutions.


Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage-constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro comovements. When leverage constraints bind, however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel that results in a positive comovement of production, independently of the size of international trade linkages. In addition, the paper shows that with binding leverage constraints, the type of financial integration is critical for international comovement. If international financial markets allow for trade only in noncontingent bonds, but not equities, then the international comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.