8 In such an ideal scenario, each economy would be perfectly positioned to withstand economic shocks. This portfolio theory provides a benchmark for assessing the degree of financial integration in a given country. Over the last decade many countries have indeed been reducing their risk positions in equity markets through this mechanism, and in several developed countries the tendency to invest in domestic equity assets has decreased. However, the latter are still far from having a theoretically optimal portfolio, i.e. one with a zero home bias. In 2003, equity home bias amounted to 70% in the euro area and the US, and almost 90% in Japan (see Chart 1). 9 The degree of home bias in the fixed income market is also high, and has only decreased over time in the euro area (see Chart 2). Chart 1. Home bias in the equity market for the Chart 2. Home bias in the debt instruments market euro area, the US and Japan (annual data) for the euro area, the US and Japan (annual data)  Sources: IMF, Thomson Financial DataStream, Sources: BIS, IMF, ECB calculations. ECB calculations. Note: The home bias of the euro area is Note: The home bias of the euro area is computed computed excluding intra-euro area asset trade excluding intra-euro area asset trade allocation. allocation. We can, therefore, say that the global tendency to invest in the home market has been declining, albeit possibly more slowly than one would have expected, and only in the equity market.
Foreign exchange reserves In the last decade, emerging countries have constantly sought to expand their foreign exchange reserves. The emerging markets’ average reserve ratio has more than quintupled from 4 percent to over 20 percent of GDP since 1990 (Obstfeld et al. 2009, Matteo y Lagos et al., 2009). One cannot assume, however, that equilibrium has been reached and that the demand for reserves will stabilize. On the contrary, there are strong indications that this trend will persist, or even be amplified, following the crisis. How much reserves are enough? Theoretical reasoning would balance the benefits of holding reserves against their cost, with some notion that there is an optimum. On the benefit side, reserves can be detained or accumulated for a variety of motives:   to smooth out the impact on consumption of shocks on the current account, which is the most basic and traditional motive, even in the absence of international capital flows    as a result or by-product of foreign market intervention to prevent exchange rate appreciation. This is usually defined as a “mercantilist” motive.   as precaution against possible abrupt capital outflows (the “sudden stop” syndrome)  The costs of holding reserves are also well identified:   there is a direct opportunity cost because foreign exchange reserves’ risk / return profile may be lower than for other, alternative, investments.   finally, as reserves accumulate, countries are getting increasingly exposed to exchange rate risk and face the possibility of significant valuation losses.