The geography of trade in goods and asset holdings

Gravity equations have been a very useful and powerful tool to model international trade in goods and asset portfolios. However, the negative impact of distance (justified by trans-portation costs for trade in goods and by transaction costs for trade in assets) is surprisingly high. This paper shows that bilateral asset holdings and trade in goods are strongly correlated. The causality can run in both ways: it could be that asset holdings enhances trade in goods and/or that trade in goods enhances asset holdings. This relationship raises the question about the robustness of the results obtained by the gravity literature when considering only one of these variables. To address this problem, we jointly study trade in goods and asset portfolios which lead us to build adequate instruments for trade in goods (mainly geographical determinants and transportation costs) and bilateral financial claims (legal and fiscal environ-ments). Taking endogeneity into account, we find that the causality between bilateral asset holdings and trade in goods runs significantly in both ways and that these effects are strong. Furthermore, we find that distance very weakly affects asset holdings once trade in goods is included. In turn, the impact of distance on trade in goods remains significant but is reduced.