Does Financial and social fragmentation matter for European gravity models?

This paper studies the main determinants of bilateral financial flows in the euro area to achieve sustainable and fair financing opportunities. We revisit the modern theory of the optimal currency area considering the impact of heterogeneity in inequality measures, within and across countries, on crossborder financial flows. To do so, we introduce financial and social fragmentation in gravity models of European capital flows. We use data from 19 Eurozone countries from 2000 to 2021 and show how fragmentation impacts capital flows, namely foreign direct investment, cross-border loans as well as portfolios, equity and bond flows. Since capital is, in principle, free to flow in the Eurozone, our analysis directly identifies the roles of potential sources of fragmentation: social inequalities, lack of market openness, and domestic regulations such as macroprudential controls. Overall, our results show that financial integration in Europe entails more capital flows of any type while social fragmentation across European countries is detrimental to capital flows, no matter which type. This is strong evidence of the importance of financial and social fragmentation in the Eurozone on the distribution of capital.