Euro currency risk and the geography of debt flows to peripheral EMU

• Until 2007, the debt flows to peripheral EMU were mostly indirect and routed through the core members.
• The role of currency risk is quantitatively examined in a DSGE model.
• Lack of currency risk allows core lenders to push outsiders out of the periphery bond market.

The pattern of debt flows to peripheral European Monetary Union members seems puzzling: they are mostly indirect and channeled through the large countries of the EMU. We examine to what extent the introduction of the euro and the elimination of the intra-area currency risk can explain this puzzle. We develop a three-country DSGE framework with endogenous portfolio choice and two currencies. In the equilibrium, the core members of the EMU emerge as the main group of lenders to the peripheral EMU. Outside lenders are pushed out of the periphery debt markets because of currency risk. The model generates a pattern of debt flows consistent with the data despite the absence of any exogenous frictions or market segmentations.