Repatriation of Debt in the Euro Crisis: Evidence for the Secondary Market Theory

Abstract

The Euro Crisis has marked a sharp inversion in the process of the European financial integration and, more specifically, a repatriation of countries' debt from foreign to domestic investors. Yet the drivers of the financial fragmentation remain unclear. This paper investigates the empirical patterns in light of competing theories of cross-border portfolio allocation. Three main empirical regularities stand out: i) the repatriation of debt occurred primarily in crisis countries; ii) the repatriation affected mainly public debt; iii) the public debt of crisis countries was reallocated to politically influential countries within the Euro Area. Standard theories of portfolio allocation and home bias can explain the first pattern at best. We argue that the second and, to some extent, the third pattern constitute evidence in favor of the secondary market theory of sovereign debt. The emerging picture suggests that the process of financial fragmentation may reverse as soon as risks of sovereign defaults abate.