International Portfolio Allocation and Income Smoothing: Evidence from Recent Changes in Euro Region

In this paper, we make two contributions to the literature. First, we construct a new measurement to capture income smoothing effectively. Second, we present new empirical evidence on the linkages between international asset trading and income smoothing. We use factor income inflows instead of the commonly used net factor income and arrive at results, among others, similar to previous studies in the literature: (a) risk sharing and equity portfolio home bias are strongly correlated for EU members; and (b) Specialization in output plays a significant role in income smoothing. Our findings also confirm that the increased level of economic integration witnessed in the Euro area as a result of the monetary union fosters output specialization across EU members and leads to asymmetric output fluctuations. Cross-border financial assets’ trading within the Euro Area, though smaller in comparison to the overall OECD block, serves as a shock absorber as factor income flows to smooth domestic consumption and income. However, although we have observed a decrease in home bias for OECD members, we could not find any evidence of higher income smoothing as a result.