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

Abstract

This paper examines the drivers of cross-border portfolio allocation within the EU and between EU countries and the rest of the world from 2007 to 2017, using a structural asset trade gravity framework. Relying on a dataset that corrects for distortions caused by tax havens through a remapping of portfolio positions based on the nationality principle, we estimate a model in which financial frictions are captured through bilateral and multilateral resistance terms. Our results show that gravity variables perform as expected: distance reduces holdings, while economic size and historical ties promote cross-border investment. A significant EU effect emerges only for bonds, suggesting the presence of a home bias. In contrast, equity holdings appear more globally diversified and sensitive to financial frictions. Comparisons with residence-based data confirm that failing to account for tax haven intermediation weakens model fit and biases key estimates. The results are robust across estimation methods and outperform traditional gravity models for goods trade. These findings highlight the importance of adjusting for offshore financial centers when analyzing international asset flows.