The Effects of the Euro on Financial Flows Using Gravity Equation Estimations

Abstract

The launch of the Euro in 1999 has undoubtedly affected the financial integration in the Eurozone, affecting bilateral financial flows through decreased transaction costs and improved liquidity. We analyze the extent and evolution of the effect of the Euro on bilateral trade, FDI, debt, and equity flows using gravity equation estimations, both for the panel data and for individual years. First, we show that the gravity model is well suited to model financial flows. Next, we find evidence of Euro-bias in these financial flows, in particular for debt and equity flows. The results show that the Euro has led to increased levels of financial flows between the currency member countries, relative to other country pairs in the data. In the year by year results, we find that the fundamental effects of the Euro, in its effect on reduced transaction costs, have not significantly changed its impact on bilateral financial flows, even through the crisis years since 2008. Further robustness checks using a “gravity toolkit approach” show that the Euro’s positive impact on enhancing Euro area bilateral debt and equity flow is stronger and more significant that its impact for bilateral trade and FDI flows.