# Euro Currency Risk and the Geography of Debt Flows to Peripheral European Monetary Union Members

Eylem Ersal-Kiziler<sup>a,</sup><sup>_∗_</sup> , Ha Nguyen<sup>b</sup>

> _aUniversity of Wisconsin - Whitewater, Department of Economics, 809 W. Starin Road, Whitewater, WI 53190, USA_

> _bWorld Bank, Development Research Group, 1818 H Street NW, Washington D.C. 20433, USA_

## **1. Introduction**

Hale and Obstfeld (2016) and Hobza and Zeugner (2014) document an interesting and puzzling empirical fact: since the foundation of the EMU, the financing of peripheral EMU members’ trade deficits versus the rest of the world was mostly indirect and intermediated by the large countries of the core EMU.<sup>1</sup> Peripheral EMU’s debts were held mainly by Germany and France.<sup>2</sup> In turn, core EMU’s debts were largely held by outside investors.

It is puzzling why investors outside the euro area are more reluctant to hold periphery bonds, and the core EMU countries hold an overwhelming portion of periphery bonds. Why do outsiders not lend to peripheral EMU directly? Using a stylized model, Hale and Obstfeld (2016) argue that this is because the transaction costs of lending to the peripheral EMU are lower for the core EMU than for the rest of the world. Coeurdacier and Martin (2009) find that preferential financial liberalization lowers transaction costs inside the Eurozone (relative to outside the Eurozone) by about 17% for bonds and 10% for stocks. Kalemli-Ozcan et al. (2010) consider three potential candidates to explain financial integration within the EMU: elimination of currency risk, legal harmonization and trade. They find that the elimination of currency risk is the primary explanation for the increasing integration.

In this paper, we theoretically investigate the role of currency risk, and its impact on the geographic pattern of debt flows to the peripheral EMU. We argue that the core EMU has a clear advantage compared to the outside lenders when lending to the peripheral EMU. Core countries share the same currency with the periphery and are not concerned about the currency risk. Due to this advantage, core EMU lenders can push outside lenders out of the periphery bond market.

However, we do not underestimate the importance of other factors that might have caused this market segmentation. Hale and Obstfeld (2016) argue that four main factors contributed to the comparative advantage of the core EMU in lending to the periphery: the decline in (perceived) risks of investing in the peripheral EMU, the decline in transaction costs and the elimination of the currency risk, the European Central Bank‘s policy of applying an identical collateral haircut to all euro area sovereigns, regardless of their varied credit ratings, and uniform financial regulations within the euro

> _∗_ Corresponding author

> _Email addresses:_ `kizilere@uww.edu` (Eylem Ersal-Kiziler), `hanguyen@worldbank.org` (Ha Nguyen)

> 1Peripheral EMU refers to Portugal, Italy, Ireland, Greece, and Spain. Core EMU refers to mainly Germany and France.

> 2Previous empirical studies such as Lane and Milesi-Ferretti (2005), Lane (2006), Spiegel (2009), De Santis and Grard (2009) and Haselmann and Herwartz (2010) ... also highlight the euro bias as an explanation to the euro area countries’ increasing investments in other euro area countries after the formation of the EMU.