This paper develops a two-country model featuring financial frictions on capital investment and nontrivial portfolio choices by agents under incomplete markets. This framework allows us to analyze the concept of international financial multiplier working through the balance sheets of cross-border levered investors, as postulated in the literature on international transmission through financial channels (e.g. Calvo (2000) and Krugman (2008) ), and study its effects for shocks propagation, as empirically documented e.g. by Kaminsky and Reinhart (2000) in the context of fundamentals-based “contagion” of financial shocks and crises.

These authors argue that the need to rebalance the overall risk of an investor’s cross-border asset portfolio and to deleverage following the losses after the initial shock can lead to a marked reversal in investment and asset prices across markets where the investor has substantial exposure. For instance, the latter paper finds that in the case of banks this helps explain cross-border spillovers of shocks, since if a bank is confronted with a marked rise in nonperforming loans in one country it is likely to be called upon to reduce the overall risk of its assets by pulling out of other high risk projects elsewhere. Furthermore, it will lend less (if at all), as it is forced to recapitalize and adjust to its lower level of wealth.