This paper develops a two-country model with a financial accelerator and endogenous portfolio choice to study how the international transmission of asymmetric shocks is affected when levered investors hold cross-border assets.Foreign exposure in interconnected balance sheets of levered investors can act as a powerful propagation mechanism across countries. However, in the model financial and real interdependence can be very strong even with minimal balance sheet exposure to foreign illiquid assets, if financial markets are integrated across the board, reflecting a strong pressure towards the cross-border equalization of external finance premia faced by levered investors. In turn, the resulting global "flight to quality" may bring about tight international linkages in (de-)leveraging and macroeconomic dynamics.

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In 2005 all ECB publications will feature a motif taken from the €50 banknote. WO R K I N G PA P E R S E R I E S N O. 4 8 7 / M AY 2 0 0 5

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