The Euro's Effect on Cross-Border Portfolio Investments in the Eurozone

Abstract: The introduction of the euro as a common currency represented a major step in the ongoing European integration process, with major implications for financial markets. This paper examines to what extent the euro has increased cross-border portfolio investments within the Eurozone, using newly released CPIS data. We show that cross-border portfolio investments have roughly doubled between two countries both using the euro, all else equal and controlling for a host of other factors. The results are significant and robust, and although they might seem large, they are in line with theory and are more conservative than previous findings. The euro thus appears to have reduced some of the obstacles to the international diversification predicted by the ICAPM. We also discover large differences in the euro?s effect across the individual Eurozone members, even though it is not confined to any sub-set of our sample. The effect on debt holdings is much greater for the countries with the least developed financial markets, whereas the relationship seems to be the reversed for equity holdings. The data also indicates that the effect has increased gradually over time. This paper contributes to the existing literature in several ways; it is the first study to use the complete CPIS panel dataset and estimate the euro?s effect over time; we apply an improved specification of the well-known gravity model and solve the “distance-puzzle”; and ours is the first study to isolate the euro?s effect on asset holdings by country. However, there is still plenty of scope for further research in this vast field.