The geography of trade in goods and asset holdings

Gravity models have been widely used to describe bilateral trade in goods. Portes and Rey [Portes, R., Rey, H., 2005. The Determinants of Cross-Border Equity Flows. Journal of International Economics, 65(2), 269–296.] applied this framework to cross-border equity flows and found that distance, which proxies information asymmetries, is a surprisingly very large barrier to cross-border asset trade. We adopt a different point of view and explore the complementarity between bilateral trade in goods and bilateral asset holdings in a simultaneous gravity equations framework. Providing different instruments for both endogenous variables, we show that a 10% increase in bilateral trade raises bilateral asset holdings by 6% to 7%. The reverse causality is also significant, albeit smaller. Controlling for trade, the impact of distance on asset holdings is drastically reduced. Keywords: Gravity models; International finance; International trade; Simultaneous equations