Equity Home Bias When Firms are Indebted

We reassess one of the major puzzles in international macroeconomics, namely the equity home bias puzzle, to shed some light on how it is affected by financial leverage. As corporate debt is generally key to employment, the analysis can provide interesting insights to the mooted argument according to which equity home bias stems from agents’ attempt to insure against changes in their labor income. In a panel of advanced economies spanning the period 1980 through 2018, we find that the non-financial corporate credit-to-GDP ratio is negatively correlated with a standard equity home bias index. The former has increased over time while the latter has decreased, so we attempt to rationalize the data with a two-country, two-good model where firms face borrowing constraints and these constraints reduce agents’ appetite for domestic equities. We show that this happens because the borrowing constraints hinder employment after positive technology shocks, especially those hitting investment. After examining this result with a tractable framework, we find that it can also be true in an extended model, adding financial shocks, trade in bonds and non-unitary elasticity of substitution between goods.