The Rise and Fall of Financial Flows in EU 15: New Evidence Using Dynamic Panels with Common Correlated Effects

Comput Econ. 2023 Mar 16:1-40. doi: 10.1007/s10614-023-10366-7. Online ahead of print.

Abstract

This paper assesses capital mobility for a panel of 15 European countries for the period 1970-2019 using dynamic common correlated effects modeling as proposed in Chudik and Pesaran (J Econ 188(2):393-420, 2015). In particular, we account for the existence of cross section dependence, slope heterogeneity, nonstationarity and endogeneity in a multifactor error correction model (ECM) that includes one homogeneous break. The analysis also identifies the heterogeneous structural breaks affecting the relationship for each of the individual countries. The ECM setting allows for a complete assessment of the domestic saving-investment relationship in the long-run as well as two other elements usually neglected: short-run capital mobility and the speed of adjustment. When we account for a single homogeneous break, this is found at the euro inception. We obtain that long-run capital mobility is high but not perfect yet. We also provide empirical evidence for the Ford and Horioka (Appl Econ Lett, 24(2), 95-97, 2017)'s hypothesis, who argue that goods market integration is a necessary condition to obtain zero correlation between domestic saving-investment. Our results stress the role played by the euro as a booster for both financial and real integration. However, a complete degree of economic integration has not been fully achieved. Short-run capital was highly mobile for the whole period, with some exceptions, coinciding with turmoil episodes. Additionally, from the application of the CS-DL threshold analysis proposed by Chudik et al. (Adv Econ, 36, 85-135, 2016), we find that economic risk and openness play a key role in capital mobility.

Keywords: Capital mobility; Cointegration, unit roots; Cross-sectional dependence; Feldstein–Horioka puzzle; Structural breaks.