Australia’s equity home bias and real exchange rate volatility

Abstract

The main purpose of this paper is to consider the effect of real exchange rate volatility on equity investment by Australian investors. Equity investment is of major importance to savers and investors in Australia. Also real exchange rate volatility is an important influence on Australia’s financial integration in the global economy. Analysis of the effect of real exchange rate volatility on Australia’s equity home bias is important since Australian dollar is a commodity currency. There is a close relationship between Australia’s terms of trade and real exchange rate volatility. Home bias is measured on the basis of free float-adjusted market capitalization in recognition of the fact that closely held shares are not available to ordinary investors. Real exchange rate volatility is measured by deviations from purchasing power parity on a bilateral basis between Australia and 35 countries. The cross-border equity investment data over the period 2001–2007 are from International Monetary Fund’s Coordinated Portfolio Investment Survey. Australian investors are found to invest significantly less in a country if the real exchange rate volatility of that country is relatively high (results that are robust to standard control measures and generalized method of moments).

Appendix: Tax

The model takes the perspective of an Australian investor who can freely invest in host countries, and in both mature and emerging markets. There are no international barriers other than domestic and foreign taxation of returns on international equity investments. The Australian investor’s foreign equity returns are first taxed abroad. Host country j taxes the Australian investor’s dividends at a rate $t_{j}^{d}$, while capital gains are taxed at a rate $t_{j}^{c}$. The Australian investor is also subject to Australia’s corporate income tax at a rate of t _aus .

The foreign country’s capital gains tax base represents real capital gains tax (TAXR _j ) and purely inflationary gains tax (TAXN _j ).

$$ TAXR_{j} = t_{j}^{c} \left( {{\frac{{\left( {{\frac{{FE_{t} }}{{FP_{t} }}} - {\frac{{FE_{t - 1} }}{{FP_{t - 1} }}}} \right)}}{{{\frac{{FE_{t - 1} }}{{FP_{t - 1} }}}}}}} \right)\left( {{\frac{{Ex_{t} }}{{Ex_{t - 1} }}}} \right) $$

(A.1)

where TAXR _j  = Real capital gains tax per Australian dollar invested in the equity market of country j; $t_{j}^{c}$ = Withholding tax on the Australian investor’s foreign capital gains in country j; FE _t  = The foreign currency equity market index at the end of period t; FE _t−1 = The foreign currency equity market index at the end of period t − 1;FP _t  = The foreign price index at the end of period t; FP _t−1 = The foreign price index at the end of period t − 1; Ex _t  = The exchange rate expressed in Australian $ per unit of foreign currency at the end of period t; Ex _t−1 = The exchange rate expressed in Australian $ per unit of foreign currency at the end of period t − 1.

$$ TAXN_{j} = t_{j}^{c} \left( {{\frac{{FP_{t} - FP_{t - 1} }}{{FP_{t - 1} }}}} \right)\left( {{\frac{{Ex_{t} }}{{Ex_{t - 1} }}}} \right) $$

(A.2)

where TAXN _j  = The nominal capital gains tax per Australian dollar invested in the equity market of country j; $t_{j}^{c}$ = Withholding tax on the Australian investor’s foreign capital gains in country j.

$$ TAXD_{j} = t_{j}^{d} \left( {{\frac{{D_{i} Ex_{t} }}{{FE_{t - 1} Ex_{t - 1} }}}} \right) $$

(A.3)

where TAXD _j  = The dividend tax per Australian dollar invested in country j; D _i  = The foreign currency dividend return per Australian dollar invested in country j; $t_{j}^{d}$ = Withholding tax on the Australian investor’s foreign dividend in country j.$\overline{\lambda }_{r}$ is the incidence of the foreign capital gains (real gains) tax applied to the Australian investor.

$$ \overline{\lambda }_{r} = {\frac{{\lambda_{r} }}{{1 - t_{aus} }}} $$

(A.4)

$$ \lambda_{r} = 1 - \omega_{r} \, $$

(A.5)

ω _r is the share of foreign capital gains (real gains) of the Australian investor. $\overline{\lambda }_{n}$ is the incidence of the foreign capital gains (inflationary gains) tax applied to the Australian investor.

$$ \overline{\lambda }_{n} = {\frac{{\lambda_{n} }}{{1 - t_{aus} }}} $$

(A.6)

$$ \lambda_{n} = 1 - \omega_{n} $$

(A.7)

ω _n is the share of foreign capital gains (inflationary gains) of the Australian investor.

$$ \overline{\lambda }_{d} = {\frac{{\lambda_{d} }}{{1 - t_{aus} }}} $$

(A.8)

The Australian imputation tax system was introduced in 1987, and allows companies to distribute franking credits to dividends paid. Franking credits are the tax already paid by a company; and therefore the eligible shareholders are taxed only once at their individual tax rate.

$$ \lambda_{d} = 1 - \omega_{d} $$

(A.9)

ω _d is the share of dividend taxes paid that are eligible for an Australian credit.

$$ TAX = \overline{\lambda }_{r} TAXR_{i} + \overline{\lambda }_{n} TAXN_{i} + \overline{{\lambda_{d} }} TAXD_{i} $$

(A.10)

The data on withholding capital gains tax, withholding dividend tax, dividend yield, foreign price index and foreign currency equity market index is from Standard and Poor’s Stock Market Factbook (2008). The data on exchange rates is from Data Stream.