European Central Bank

We develop a standard model to show how transaction costs in international investment a¤ect conven-tional tests of consumption risk sharing, both in a multilateral and a bilateral setting. We implement the tests in a novel international dataset on bilateral holdings of equity, bonds, foreign direct investment and bank loans. International consumption risk sharing increases with foreign capital holdings; this is especially true of investment in equity or bonds, but not of foreign direct investment or bank loans. In our model, this implies transaction costs are higher for FDI and international loans. The discrepancy may reect technological di¤erences across asset classes, but also the prospect of expropriation, perhaps most stringent for FDI or loans. We argue that expropriation risk is endogenous to both the borrowers institutions and its openness to international markets. The detrimental impact of poor institutions is muted in open economies, where the possibility of subsequent exclusion from world markets deters ex-propriation of foreign capital. We show the implied non-linear e¤ects of institutions prevail in both th