Explaining Foreign Holdings of Asia's Debt Securities: The Feldstein–Horioka Paradox Revisited*

• Published date: 01 March 2016
• Author: Akiko Terada‐Hagiwara,Takaaki Nomoto,Charles Yuji Horioka
• DOI: http://doi.org/10.1111/asej.12082
• Date: 01 March 2016

Explaining Foreign Holdings of Asia’s Debt

Securities: The Feldstein–Horioka Paradox

Revisited

*

Charles Yuji Horioka, Akiko Terada-Hagiwara and Takaaki Nomoto

Received 10 February 2015; Accepted 26 November 2015

In this paper, we find that home bias is still present in all economies and regions,

especially in the case of short-term debt securities, but that there are substantial variations

among economies and regions in the strength of home bias, with the eurozone

economies, the USA and developing Asia showing relatively weak home bias and

advanced Asia, especially Japan, showing relativelystr onghome bias. Wethen examine

trends over time in foreign holdings of debt securities and find that capital has been

flowing from the USA and the eurozone economies to both advanced Asia (especially

Japan) and developing Asia, and that foreign holdings of debt securities have been

increasing in advanced as well as developing Asia but for different reasons. The main

reason in the case of advanced Asia (especially Japan) appears to be hig her risk-adjusted

returns, whereas the main reason in the case of developing Asia appears to be the growth

of debt securities markets combined with relatively weak home bias and (in the case of

short-term securities) lower exchange rate volatility.Finally, we find that since the global

financial crisis, foreign holdings of debt securities have declined (i.e. that home bias has

strengthened) in all economies and regions except developing Asia, where they have

increased (except for a temporary decline in 2008) but where their share is still much

lower than the optimal share warranted by the capital asset pricingmarket model.

Keywords: Feldstein–Horioka paradox, Feldstein-Horioka puzzle, foreign debt

holdings, Global Financial Crisis, home bias, international capital flows, safe haven.

JEL classification codes: F21, F32, F34, F65, G01, G15, O53.

doi: 10.1111/asej.12082

*Horioka (corresponding author): Asian Growth Research Institute, 11-4, Ohtemachi, Kokurakita-ku,

Kitakyushu, Fukuoka 803-0814, Japan; National Bureau of Economic Research, 1050 Massachusetts

Avenue, Cambridge, MA 02138, USA; Institute of Social and Economic Research, Osaka University, 6-1,

Mihogaoka, Ibaraki 567-0047, Japan. Email: horioka@iser.osaka-u.ac.jp. Terada-Hagiwara: Economic

Research and Regional Cooperation Department, Asian Development Bank, 6 ADB Avenue,Madaluyong,

Metro Manila 1550, Philippines. Nomoto: Cabinet Secretariat, 1-6-1, Nagatacho, Chiyoda-ku, Tokyo

100-8968, Japan. The authors are indebted to Maria Socorro Bautista, Hal Hill, Masahiro Kawai, Thiam

Hee Ng, Changyong Rhee, T. N. Srinivasan and other participants of the Asian Development Review

Conference on Development Issues in Asia, held at the Asian Development Bank, as well as to Joseph

Lim, Peter Morgan, Yoko Niimi, Eric Ramstetter and two anonymous referees for their valuable comments.

Finally, Junray Bautista provided superb assistance. This work was supported by Japan Society for the

Promotion of Science KAKENHI Grant Number 15H01950, an Asian Growth Research Institute project

grant and a grant from the MEXT Joint Usage/Research Center for Behavioral Economics, Institute of Social

and Economic Research, Osaka University.

© 2016 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2016, Vol.30 No. 1, 3–24 3

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I. Introduction

In its simplest form, the international capital asset pricing model (CAPM) predicts

that if capital is perfectly mobile internationally, investorsin all countries will hold

the same portfolio, the world market portfolio, in which each country’s share

equals its share of worldwide market capitalization. However, as Feldstein and

Horioka (1980) and subsequent studies have demonstrated,

1

investors exhibit

a strong tendency toward ‘home bias’, preferring to invest their wealth in domestic

assets for a variety reasons, including a desire to avoid foreign exchange risk, an

asymmetry in the availability of information about domestic and foreign assets,

and legal and institutional barriers to international capital flows.

2

Nonetheless, investors do invest at least some of their assets abroad, and cross-

border portfolio investments (especially those in foreign debt securities) have

increased sharply in recent years in most Asian economies. Thus, the present

paper contributes to the literature by analyzing data on trends in foreign holdings

of debt securities since 2000, with emphasis on Japan and non-Japan Asia and by

conducting an econometric analysis of the determinants of foreign holdings of

debt securities with a focus on differences between the pre-global financial crisis

(GFC) and post-GFC periods and on the Asian economies.

To preview our main findings, we test for the existence and strength of home

bias and find that it is still present in all economies and regions, especially in

the case of short-term debt securities, which suggests that the Feldstein and

Horioka (1980) paradox is still very much alive and well. However, we also find

that there are substantial variations among economies and regions in the strength

of home bias, with the eurozone economies, the USA and developing Asia show-

ing relatively weak home bias and advanced Asia, especially Japan, showing

relatively strong home bias. We then examine trends over time in foreign holdings

of debt securities and find that capital has been flowing from the USA and the

eurozone economies to both advanced Asia (especially Japan) and developing

Asia and that foreign holdings of debt securities have been increasing in advanced

as well as developing Asia but for different reasons. The main reason in the case

of advanced Asia (especially Japan) appears to be higher risk-adjusted returns,

whereas the main reason in the case of developing Asia appears to be the growth

of debt securities markets combined with relatively weak home bias and (in the

case of short-term securities) lower exchange rate volatility. Looking finally at

the impact of the GFC, we find that, since the GFC foreign holdings of debt secu-

rities have declined (i.e. that home bias has strengthened) in all economies and re-

gions except developing Asia, where they have increased (except for a temporary

1 See Obstfeld and Rogoff (2001) and Apergis and Tsoumas (2009) for surveysof this literature and

Kim et al. (2007, 2014) for applications to East Asia.

2 As noted by Ford (2015), however, the Feldstein and Horioka (1980) findings could be due to

frictions in the transfer of goods and services among countries arising from such things as transport,

marketing and distribution costs, technical standards, certification procedures and trade barriers.

ASIAN ECONOMIC JOURNAL 4

© 2016 East Asian Economic Association and John Wiley & Sons Australia, Ltd