Current Account Imbalances in the euro area:

Catching up or competitiveness?

Ansgar Belke, University of Duisburg-Essen, DIW Berlin and IZA Bonn

Christian Dreger, University of Frankfurt/Oder and DIW Berlin

(2011)

Introduction and stylized factsIn the debate over the global imbalances the euro area has not been investigated properly, differently from the case of the U.S.

• The U.S. accumulated large external deficits until the Great Recession of 2008-09 while Asian countries realized big current account surpluses

• The euro area kept a current account balance at the aggregate level; however there are huge disparities across member states

Introduction and stylized factsCountries like Spain, Greece and Portugal accumulated current account deficits;On the contrary, Germany and Netherlands experienced huge surpluses

With the financial crisis, the imbalances have been reduced, but as the economic conditions normalize they are expected to pick up again

Public finances have also deteriorated, particularly in high deficit countries

Introduction and stylized factsCurrent account dynamics can be decomposed in catching up and competitiveness factors:

Catching up: imbalances can reflect a convergence process among countries with different gdp per capita.

Full balance not optimal in the short run: countries with lower gdp per capita will seek to attract foreign capital due to future growth perspectives. Viceversa for high income countries.

Moreover, with a greater financial integration, the elimination of exchange rate risk and the lower interest rates might have boosted investment/saving.

Competitiveness: real exchange rate appreciations will redirect demand from domestic to foreign goods. Deficit countries may have become less competitive because domestic prices increased more than foreign prices.

Balassa-Samuelson hypothesis: increases in overall price level and real exchange rate expected for deficit countries.

Excessive nominal wage growth: excessive deficits because of overheating problems due to overly optimistic expectations and/or asset prices booms.

Governments can be forced to depreciate real exchange rate via deflation policies, with adverse effects on the catching up process.

Introduction and stylized facts

This paper explores to which extent the euro area imbalances can be traced back to catching up and competitiveness factors.

Panel integration and cointegration techniques are used, given the presence of stochastic trends in the data.

After a review of the determinants of current account positions according to the previous literature, it will be shown the econometric methods used in the analysis and the empirical evidence drawn from the data.

Introduction and stylized facts

The determinants of the current account position are selected from the variables that have an impact on investment and saving decisions.

Typical regressions can include (Lee, Milesi-Feretti, Ostry, Prati and Ricci, 2008):• income per capita and income perspectives• fiscal balance• population growth• old-age dependency ratios• stock of net foreign assets• real interest rate• variables about institutional framework

Determinants of current account positions

Real exchange rate captures the competitiveness channel. It influences the foreign trade balance via the effects on import/export as well as the return of domestic and foreign assets.

Population growth and old-age dependency ratios are expected to lower current account because of their adverse impact on saving.

A restrictive fiscal policy will raise national savings and current account balance, if not offset by a fall in private saving.

Higher net foreign assets will raise current account balance, as they increase net investment income balances.

Determinants of current account positions

Higher growth opportunities (a lower relative per capita income) and a real exchange rate appreciation should lower current account.

Higher social spending and welfare protection will reduce saving rate and deteriorate current account balance.

Determinants of current account positions

Current account imbalances in a global setting: Chinn and Prasad (2003), Gruber and Kamin (2007), Bracke, Bussière, Fidora and Straub (2008) and Lee, Milesi-Feretti, Ostry, Prati and Ricci (2008)

Current account imbalances in the euro area: Blanchard and Giavazzi (2002) pointed out how with more integrated markets national investment and saving appear to be increasingly uncorrelated.

Holinski, Kool and Muysken (2010) have argued that the imbalances are actually caused by the behaviour of the private sector.

Arghyrou and Chortareas (2008) the real exchange rate affects the current account position in most euro area member states.

Empirical literature

Overall, a “great ratio” of the three most important variables to focus on seems to be

Current account balances

A catching up variable

A measure for competitiveness

Other potential variables are not included in this setting because of some caveats to their use within a cointegration framework and because they are absorbed by the catching up and/or competitiveness variables, at least in part.

All variables are characterized by stochastic trends, therefore it appropriate to use cointegration analysis. Since time series are enriched by the cross section, inference relies on a bigger information set.

Cointegration tests and panel unit root are based on the assumption of independent panel members: this is rejected in the data.

Panel integration and cointegration tests that control for these dependencies via a common factor structure will be used.

Panel econometric methods

CADF test (Cross-sectionally Augmented Dickey Fuller test) by Pesaran (2007): the traditional ADF equation is extended with cross-section averages of lagged levels and first differences of the individual series.

Regression is run for each panel member separately. To test for the presence of a unit root, is it analyzed the t-ratio of the first order autoregressive parameter.

To built a panel statistic, the t-values are pooled across individuals. A standardized version of the test is asymptotically distributed as a standard normal under the joint null hypothesis of non stationarity for all individuals.

If the null is rejected, the series is stationary for at least one panel member.

Panel econometric methods

To examine cointegration, panel and group mean statistics suggested by Westerlund (2007) are applied.

The principle is to evaluate the null hypothesis of no cointegration by inferring whether the feedback parameter in a conditional panel error-correction model is equal to zero.

If null is rejected, cointegration holds for all units in case of the panel statistics and at least for one individual in the group statistics.

The tests behave asymptotically as standard normal. However, because cross-section are not independent, critical values are obtained by bootstrap methods.

Panel econometric methods

The data are taken from the AMECO database.

• 11 euro member states (Austria, Belgium + Luxembourg, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal and Spain)• 1982-2008 period• ca (current account to nominal GDP ratio) as a measure of imbalances• cat (real GDP per capita) as a measure of the catching up component• com (the effective real exchange rate) as a proxy of competitiveness effects. It is based on unit labour costs of the respective country compared to the rest of the EU economies (export-weighted).

Data and empirical results

Two main events are crucial in the overall evolution:

• The introduction of the common currency in 1999 that has fostered financial market integration and the ability to run huge and persistent imbalances.

• The second factor is the Eastern enlargement of the EU in 2004. For example, Germany has tighter relationships to Eastern Europe than other euro area members.

Data and empirical results

All series appear to be I(1), as they are nonstationary in their levels and stationary in the first differences.

Tests for unit roots

Tests for cointegration

Tests for cointegrationWhere Gτ and Gα are the group mean statistics and αi is the estimated error correction parameter (Westerlund, 2008):

And Pτ and Pα are the panel statistics with the common error correction parameter α and its standard error.

Tests for cointegration

The imbalances are cointegrated with their potential determinants.

Both determinants are required to ensure cointegration.

Thus, it exists an equilibrium relationship between the current account positions, catching up and competitiveness factors.

As expected, the current account of a euro area member countryimproves if the per capita income increases relative to the euro area. • If the relative real exchange rate appreciates, the current account will

worsen. • Competitiveness appears to be more important in driving the external

imbalances than the catching up component.

(rgdp)

(rer)

InterpretationThe significance of the catching up effect diminishes for the whole panel, while the role of competitiveness is confirmed. Therefore, the imbalances are increasingly related to changes in the real exchange rate. The decline of the relevance of relative per capita incomes is be cause of its insignificance for the deficit countries.

For the surplus countries and the states with relatively low imbalances, the income effect is still more important than the effective real exchange rate.

In contrast, competitiveness is of primary relevance for the deficit states.

A rationale for this finding is that countries with huge surpluses like Germany have particularly benefitted from the integration of markets into the world economy.

Conclusions

In this paper, the imbalances are traced to catching up and competitiveness factors using paneleconometric techniques.

In line with the inter-temporal approach to the current account, low income countries tend to run deficits, while rich countries realize surpluses.

However, the effect decreases, if early years are dropped from the sample.

The competitiveness channel is more robust and shows the expected sign: a real appreciation leads to external deficits.

Conclusions

To restore competitiveness, a reduction of unit labour costs is on the agenda.

Since a deterioration of competitiveness is not a feasible strategy for the surplus countries, an asymmetric response across countries is required in order to reduce the imbalances.

Fiscal consolidation remains on the agenda for all member states.