more correlated with the peripheral EMU business cycles than with business cycles of the countries outside the Eurozone. Hence, periphery bonds might not be a good hedge for the core EMU lenders, as they do not want to receive low returns on their investment precisely when their economy worsens. This puts the core EMU in an inferior position compared to the outside lenders as the diversification benefits from investing in the Eurozone economies are small.

The two effects - the currency channel and the business cycle channel - influence the portfolio choice of the lenders in opposite ways. In particular, the currency channel encourages euro-denominated lending of the core EMU lenders, while the business cycle channel discourages this. On the contrary, the currency channel discourages euro-denominated lending of the outside lenders, while the business cycle channel encourages this. If we observe the core EMU does most of the lending to the peripheral EMU, it implies that the currency channel is stronger.

A natural question is why outside lenders are not pushed out of the core EMU’s bond market too? This is a legitimate question because when it comes to holding core EMU bonds, the periphery investors also have the currency risk advantage compared to the outsider lenders. We argue that this effect is quantitatively small. First of all, the periphery is small and cannot saturate the core EMU’s debt market. Second, since the inception of the euro, liabilities of the peripheral EMU have been increasing faster than their assets, and the peripheral EMU has been running a net deficit. Hence, we conclude that the periphery has little incentive to hold core bonds. Consequently, outside investors face less competition in the core bond markets than in the periphery bond markets, and end up investing most of their savings in the core bonds.

We describe our mechanism in detail using the framework of a DSGE model with incomplete markets. The model features three agents (’Periphery’, ’Core’, and a foreign lender called ’Outsider’), two sectors (tradable and non-tradable goods), two assets (periphery bond and core bond) with endogenous debt portfolio choices. In the model, the market segmentation arises endogenously based on optimal portfolio choice and does not rely on any exogenous market friction, such as information asymmetry or bailout discrimination. We adopt the new solution method developed by Devereux and Sutherland (2010) and Tille and van Wincoop (2010) to solve for the long run (i.e. zero-order) portfolio choice of countries. The paper is organized as follows. Section 2 presents some empirical stylized facts on the geographic pattern of EMU debt flows. The model is described in section 3. Section 4 presents the solution method and the calibration of the model. Section 5 discusses the results from the analyses. Finally, section 6 concludes.

# **2. Stylized Facts**

This section presents the stylized facts that motivate our theoretical model. As in Hale and Obstfeld (2016), we focus on the period between 1999 – when the Eurozone was formed– until before the crisis. This is to avoid the complications that the crisis might have caused.<sup>5</sup> Figures 1 and 2 are taken directly from Chen et al. (2013). Figure 1 presents the decomposition of

> 5For example, Brutti and Saur (2014) find that there was a strong repatriation of debt from foreign to domestic investors. This repatriation is particularly strong in crisis countries and for public debt.

3