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In this paper, we aim to better understand how social and financial fragmentation impact capital flows now that businesses are encouraged to achieve sustainable growth objectives. We introduce financial and social fragmentation in gravity models of European capital flows. We use data from 19 Eurozone countries from 2000 to 2021 and show how fragmentation impact capital flows, namely foreign direct investment, cross-border loans as well as equity and bond flows. Since capital is, in principle, free to flow in the Eurozone, our analysis directly identifies the roles of potential sources of fragmentation: social inequalities, market openness, and domestic regulations such as macroprudential controls. Our results show that financial fragmentation and domestic inequalities matter for capital flows in Europe, although the impact varies across capital flow types, which emphasizes the importance of disaggregating the data. Domestic inequalities have a strong positive impact on financial assets flows used to finance local projects such as cross-border loans. On the contrary, FDIs are negatively affected by inequalities which, in the context of the Eurozone, cannot be associated with traditional determinants such as political or foreign exchange risk. Finally, inequality spreads across countries deter capital flows.
