The Decline of EMU Core Countries' Portfolio Equity Investments in the Euro Area: The Role of Stock Return Correlations

Abstract

While the enlargement of the Euro area to new countries has reduced the average return correlation among member countries, the financial crisis and the sovereign debt crisis have led to an increase in stock return correlation among old members. We find that EMU core countries portfolio allocation has been significantly driven by diversification motives: they have reduced their portfolio equity investment in assets issued by member countries featuring a stronger returns' correlation with domestic assets. This evidence sheds light on the determinants of the sharp decline in bilateral equity investments in the Euro area after 2007, and points to the importance of diversification benefits.