Unveiling the drivers of portfolio equity and bond investment in the European Union: The interplay of tax havens and gravity factors

This paper examines the determinants of portfolio equity and bond investment in the European Union. We estimate the impact of different drivers typical of the gravity model developed by Okawa and van Wincoop (2012). A notable aspect of our study is that it accounts for the effects of tax havens through the recent database of Coppola et al. (2021). Another distinctive trait of our paper is that we model bilateral and multilateral resistance measured as financial restrictions between the country pair (bilateral) and relative to the rest of the world (multilateral). Our findings suggest that gravity variables (distance, economic size, and resistance), as well as historical links and global risk, explain portfolio holdings allocation. Our extended gravity model also captures the positive effect of government quality and financial development on portfolio equity and bonds. Given the differences in nature and risk between assets, we also compare the results for portfolio equity and bonds; we find that while portfolio equity is more mobile, portfolio debt tends to be invested in neighboring countries; more specifically, EU debt tends to remain in the EU. Our results also suggest that portfolio equity is more affected by global risk and multilateral financial restrictions. Finally, our comparative analysis using the IMF CPIS database (constructed under the residence principle) shows that not accounting for tax havens underestimates the gravity and fundamental factors explaining portfolio equity and bonds holdings investment.