In Europe there is a lively debate about imbalances in the euro area and how to address them. This debate is currently culminating in proposals about economic governance, which in addition to a revamped Stability and Growth Pact is also meant to avoid the built up of such imbalances in the future. In this context, the EU Commission has been pushing for a peer review process on country competitiveness, notably on relative unit labour costs and on current account positions. The debate about the economic governance in the euro area is entering the finishing stretch after the publication of the Van Rompuy Report. The debate will likely intensify in the coming weeks ahead of the European Summit in mid-December. In our view, it is likely that different views will emerge between the European institutions on the one hand and the national governments on the other hand. In addition, there are likely to be deep-rooted differences between the different national governments. Notwithstanding this intense debate, we think that all proposals presented thus far are one-sided in that they only look at the current account balances and neglect the capital flows that match them.
...in the Light of the Intra Euro Area Capital Flows
It is via these transborder capital flows (and via the net foreign asset positions in which the historical capital flows crystallize) that the debate on the imbalances in the euro area is closely connected to the sovereign debt crisis. There are several connections.
First, looking at which countries have funded the current account deficits of the EMU periphery in the past indicates the exposure of the core countries to the periphery (see Euroland Economics: Contagion, Exposure and Policy Response, July 2, 2010). This exposure together with systemic considerations underscores how much the core is interested in the periphery being able to avoid a debt restructuring.
Second, it is clear that the sovereign debt crisis can become a catalyst for change and that the euro area is in the midst of massive rotation in terms of country growth performance. As the currency crisis of the early 1990s sped up, the start of monetary union, the current crisis could eventually deepen the European Union towards more cooperation on macro economic policies, notably fiscal policies. Effective governance is key to ensuring the long-term success of the euro. In our view, however, all the current proposals made by official institutions or academic economists neglect one important aspect: the transborder capital flows.
Policymakers Ignored Imbalances for Too Long...
For a long time, ECB insisted on the euro area not playing an active role in the global rebalancing debate because its current account was broadly balanced during the first ten years of the euro. With the benefit of hindsight, this view was probably overly complacent for two reasons. First, despite not having a big current account balance itself, the euro area is still significantly affected by the evolution of global imbalances, if only via potentially abrupt exchange rate movements (which has been repeatedly named by the ECB as a downside risk to the euro area growth outlook). Second, while the euro area as a whole has had a broadly balanced current account, individual countries within the euro area have consistently sported outsized current account surpluses and deficits. In the periphery, the current account deficits were much bigger than the US current account deficit relative to the size of the economies in question.
...and so Did Many Private Sector Investors
Clearly, there was a lack of focus on these intra-euro area imbalances in the absence of any currency risks. But investors in other asset classes seem to have ignored the risks associated with the build-up of these intra-euro area imbalances. Instead, it was widely assumed that the arrival of the euro just meant that FX risk could be forgotten about. All else equal, however, historical norms for the volatility in other asset prices (e.g., equities, bonds, real estate) are likely to go up now that the currency union has been established. This is because, with the exchange rate no longer available as an adjustment mechanism, other prices - asset prices, consumer prices, wages - will have to bear the brunt of any adjustment process in relative prices. In addition, within a single currency union there is still a risk of capital inflows suddenly drying up, which can lead to abrupt movements in asset prices.
Unwinding the Imbalances Will Reshape the Euro Area
Many observers, including the European Commission and the ECB, have discussed the build-up of imbalances for a while and highlighted the unwinding of these imbalances as a potential downside risk. Now the rebalancing topic is high on the agenda, both for the G20 and for the euro area. Some observers have singled out Germany, the largest European economy with a consistent current account surplus, and accused it of pursuing a ‘beggar-thy-neighbour' policy. The debate on the imbalances within the euro area extends to the longevity of the euro.
In this note, we attempt to debunk the myths around rebalancing and discuss the implications for the euro area. We find that diverging growth trajectories and current account balances do not constitute a problem as such. In fact, the observed patterns in Europe can largely be explained by a combination of intra-EMU portfolio diversification, of the poorer periphery catching up with the richer core, of interest rate convergence towards the benchmark level, of different demographic developments and of divergent cyclical trends. In our view, the higher current account balances are due to a desirable rise in capital mobility since the start of EMU. The rise in capital mobility in the first ten years of EMU might also have been a one-off adjustment. As a result, we could already have seen this initial phase of big current account balances and much smaller balances may lie ahead even without any policy intervention.
But, we also fear that distortions could have caused an inefficient allocation of capital. This could for instance be due to the risks of investing abroad possibly having been systematically underpriced due to an oversupply of bank capital, weak risk management notably in banks owned by the public sector, and below average funding costs in some current account surplus countries. Going forward, current account balances will be watched closely to monitor changes in competitiveness and to track the deleveraging process. Given the two aspects of the current account - the trade flows and the capital flows - the intra-euro area adjustment cannot be one-sided. The imbalances are as much a problem of countries allocating foreign capital inflows inefficiently as it is of other countries providing the funding for excessive spending or housing booms.
Where We Differ in the Rebalancing Debate Is...
We disagree with many of conventional arguments made in the current debate about imbalances and how to reduce them. For starters, we disagree with the definition of an imbalance as simply implying a persistent current account surplus or deficit. There are many strong arguments in favour of current account balances that are different from zero over a long time period. Free trade in goods and services and free international capital mobility is one. Another is that current account balances also reflect the discrepancy between domestic savings and investment - and as such can help to achieve a better pattern of spending over time. Examining more closely some of the arguments put forward to reduce current account balances, many come down to endorsing protectionism. For instance, postulating that current account balances should be closer to zero also means demanding that there should be no net capital flows across national borders. This is because a country that spends less than it produces - i.e., runs a current account surplus - by definition makes some of its domestic savings available abroad. So, a current account surplus country is always also a capital exporter.
...That We Believe That Capital Mobility Is Beneficial...
It is generally established in economics that international capital mobility is beneficial for both countries, the donor and the recipient, because it helps to bring about a more efficient allocation of resources across countries. International capital mobility allows poorer countries to catch up faster with their richer neighbours. By attracting foreign capital to fund domestic investment projects, these countries can build up their capital stock much more quickly. Vice versa, it allows richer countries, where the returns on investment tend to be driven down due to saturation effects, to earn higher returns. Especially in the face of diverging demographic trends and different income levels, international capital flows are key to allowing the fast growing populations in emerging economies to grow more quickly. Equally, for rich ageing societies in the industrial countries, accumulating net foreign assets through running a persistent current account surplus can be an effective way of ensuring adequate old-age standards of living. Note that contrary to the US China debate, which saw much discussion on the exchange rate regime, the euro is a free-floating currency at the outside and permanently fixed on the inside.
...and That We Don't Mistake an Accounting Identity...
Thanks to the logic of double-entry book-keeping, all current account balances have to add up to zero globally. Where they are not, the mismatch stems from errors and omissions in the data collection. An accounting identity, however, cannot be used to derive any meaningful policy prescriptions. To arrive at a meaningful policy prescription, one needs to have an idea of what an equilibrium situation (or an optimal path) would look like. In mathematical terms, the accounting identity that globally all current account balances have to sum up to zero (give or take some errors and omissions in the statistics) is merely a condition that the optimal path has to meet. As in any mathematical optimisation problem, the focus needs to be on the maximising of the objective function subject to various conditions. A policy prescription based on one of the conditions can be misleading, as there is no reason why current accounts should be balanced. Within the euro area, capital has been flowing in the direction predicted by the intertemporal models of balance of payments: i.e., from the richer core to the initially poorer periphery. By the same token, the periphery ran persistent current account deficits, the core current account surpluses. The rise in capital mobility in EMU meant that domestic investment was no longer limited by domestic savings.
...for a Framework to Derive Policy Conclusions from...
The starting point of any meaningful policy conclusion has to be what economists call the steady state. The steady state is the sustainable long-run growth path in which the economy is in equilibrium - i.e., not too hot and not too cold. This might sound theoretical. But it is essential. An observed deviation from the long-term equilibrium determines what the adjustment process should look like. Note that this equilibrium in many cases includes consistent current account balances that are different from zero. Of course, it is difficult to determine the steady state. Academic estimates of long-term equilibrium current account balances, which try to capture this notion, can vary widely. But we cannot shy away from at least trying to benchmark the current state against the steady state.
...That Could Cause the Euro Area to Be Even Less Balanced Than Before.
The fact that current account balances are gravitating towards zero isn't a sign of a greater balance. Policy advice to ‘meet in the middle' as surplus countries boost domestic demand and deficit countries bump up net exports does not get to the core of the issue. Whether a deficit country is living beyond its means depends on how it uses the foreign funding - i.e., whether it consumes it or invests it. When it comes to investing foreign capital, the profitability of these investments matters. In this context, we would highlight that housing investment hardly raises the future capabilities of the recipient country to produce.
A current account deficit country does not just borrow from its trading partners, it also borrows from its own future. In our view, this intertemporal dimension is much more important than the cross-country dimension, especially in the face of a debt crisis. It matters a great deal more for the long-term growth prospects of the euro area than the short-term snapshot provided by current account balances across the different euro area countries. For it is these long-term growth prospects that determine a country's ability to service its foreign liabilities. Based on these long-term considerations, the IMF estimates that for the Mediterranean, periphery current account deficits of between 4.5% and 5.75% of GDP are sustainable, while Ireland should probably run a surplus of 1% of GDP and core countries such as Germany, the Netherlands and Belgium surpluses in the range of 2-2.5%.
Because of the national accounting identity, trade flows will always have to match the capital flows ex-post. Hence, it is not possible to clearly distinguish whether ex ante it is trade flows driving the capital flows or vice versa. As a result, it is not clear whether the ‘imbalances' we observe today are mainly due to a divergent performance in the trade of goods and services or due to a different investment environment. In this context, a current account surplus could also be a sign of a lack of attractive domestic investment opportunities, which is why the capital flows abroad. Or, it could be a sign of a systematic underpricing of the risks of those foreign investments.
As we see it, there is an asymmetry in the policy debate: a country sporting a current account surplus (such as Germany) also exports capital (i.e., domestic savings). While the former could suggest strong competiveness in international goods markets, the latter could suggest less attractive investment conditions at home. If Germany indeed has become ueber-competitive by reducing its relative unit labour costs aggressively vis-à-vis other euro area countries, why aren't investors putting more money to work there? Or is persistent capital outflow from Germany due to the fact that the risks of investing abroad are not adequately reflected in the decisions taken by various financial intermediaries. Vice versa, why are those countries that are under such pressure in terms of their export performance and their competitiveness still attracting foreign capital to fund the current account deficit? For a complete analysis, policymakers and financial investors have to look at both sides of the same coin - the current account balances and the capital flows that match them.
Also, Secular Shifts Such as Globalisation Cannot Be Ignored in Assessing the Intra-Euro Area Current Accounts
We have seen big secular shifts in the global economy over the last decade. Starting with the collapse of communism in Central and Eastern Europe (CEE), the Western European labour markets were directly (through inward migration) or indirectly (through outward offshoring) competing with highly educated, lowly paid workforces. With the subsequent integration of China and other large emerging economies into the global economy, this process gained even more momentum. In essence, globalisation causes the size of the global workforce to surge. Initially, the global workforce was estimated to have roughly doubled; later these estimates were regarded as too cautious still (see OECD 2004). Independent of the true size of the impact on the global labour force, the upshot of these undercapitalised labour forces entering the global economy is that labour has become a more abundant factor of production and (physical) capital has become more scarce. This tectonic shift between the availability of workers and capital should also be reflected in their relative remuneration. As a result, wages should experience downward pressure, and profits (or return of investment) should benefit from an upward trend. This shift was visible in the second half of the 1990s and in the early part of this decade.
Especially in High Wage Countries Bordering on CEE
In our view, it is therefore not surprising that high-wage countries such as Germany, the Netherlands, Austria or Finland, which find themselves in geographic proximity to CEE, felt these pressures on the relative prices for labour and capital in particular. These pressures were clearly reinforced in Germany, where regrettably a large part of reunification was financed via higher social security contributions, creating more upward pressure on non-wage labour costs. Hence, the labour cost dynamics observed in these core countries, which today are sporting sizeable current account surpluses, are likely to largely reflect the challenges of globalisation and EU enlargement rather than a ‘beggar-thy-neighbour' policy vis-à-vis the periphery of the euro area. Crucially, these developments are largely the outcome of market dynamics, and not of interventionist policies. In this context, it is interesting to note that Germany, like many emerging economies, has become much more open to international trade over the last 20 years. Deeper integration in the international division of labour is beneficial to the resource allocation in the country because it forced it to focus on the activities where it has a comparative advantage. In our view, this deeper integration into the international division of labour is one reason for the marked spurt in productivity growth that followed a phase of in-depth corporate restructuring between 2003 and 2006. As countries such as Germany deepened their integration into the global economy, they experienced both strong export and strong import growth. In our view, the problem for the euro periphery is mainly that they have been losing market share to the new competitors from CEE and emerging economies in general. So, it is not Germany's competitiveness that they are struggling with. It is the competiveness of the emerging economies of Europe.
Smaller Countries Should Be Easier to Turn Around
Within the euro area, rebalancing could become an issue for the larger countries such as Germany, France, Italy and Spain. But this is not an excuse for small countries like Greece and Portugal. Ireland has already shown what this adjustment could look like (see Ireland: Mastering the Challenges Ahead, September 13, 2010). Only the large countries need to have meaningful offsets in each other's current account positions. For the small countries, however, even very big adjustments in their current account deficits won't make a big difference for the euro area or for large surplus countries such as Germany. On the contrary, it seems to be easier for small countries to manage a turnaround within the euro area. Fro example, the Netherlands and Finland seem to have found the adjustment process a lot faster than Germany because any improvement in competitiveness - be it via relative prices or relative unit labour costs - is leveraged over a much bigger share of GDP that is traded internationally. In a detailed study of the German export success in the G5 context, we concluded that the strong export performance wasn't attributable mainly to cost-cutting. Instead, much seemed to be explained by outward foreign direct investment. It was the outward FDI that caused German companies that build plants overseas to bring the machinery and equipment from home - thus giving a boost to the export performance (see Germany Economics: Excelling at Export, February 19, 2007).
Gaining Competitiveness Is Not the Same as Cost Cutting
Competitiveness has many different facets and non-price elements clearly also play an important role. So does the export structure in terms of its geographic destinations and product offering. There is also some robust evidence that for some countries, exports demand reacts much more sharply to a change in prices than for others. For instance, the European Commission shows that the price elasticity of German exports is significantly lower than for Italy or Spain. This likely reflects that Germany's exports are often heterogeneous, highly specialised products, notably in the capital goods sector, for which substitutes are difficult to find. Hence, Germany actually gained less from improving its price competitiveness than some of the peripheral countries would.
Getting Costs Down Does Not Mean Cutting Wages
There are two ways to reduce relative unit labour costs of a country within the euro area: below wage increases and above average productivity gains. While the former is typically likely to be due to a lack of labour demand, the latter will often be due to supply-side or structural reforms, such as the liberalisation of labour and product markets for which there is a lot of scope in the euro area periphery. An additional dial that then can be moved to boost cost-competiveness is longer work time without any extra pay. In addition, the government could cut non-wage labour costs by lowering social security contributions. If such a cut in social security contributions is funded by a higher VAT (which is imposed on imports but not on exports), the country's terms of trade improve. Ireland - a small open economy that is highly flexible - is already regaining price-competitiveness at an impressive speed (see Ireland: Mastering the Challenges Ahead, September 13, 2010). Plotting the country's core HICP developments relative to the euro area average, we find that the Irish bilateral exchange rate vis-à-vis the rest of the euro area has already depreciated by about 7% from its peak in 2008.
Beware Any Arbitrary Starting Point
But looking at the developments in relative prices or costs compared to an arbitrary point in time such as the start of EMU in January 1999 completely ignores any disequilibria that existed at the start of monetary union. Hence, we would caution against reading into such relative movements anything that amounts to an over- or undervaluation of the bilateral real exchange rates. Indexing all price indicators to 100 at that point also neglects important differences in the levels. Naturally, one would expect a high-cost country such as Germany to have lower wage growth than a low-cost country such as Portugal. These structural trends in prices, costs and wages growth, stemming from the starting levels themselves, would cause persistent inflation differentials. Despite regaining competitiveness, Germany remains a high-cost producer.
What Anchor for the Euro Zone?
Much discussion has centered on whether the euro area needs to become more like Germany or Germany more like the periphery to facilitate a rebalancing of the euro area. In our view, it will likely have to be a bit of both. But we think it is also clear that, if one goal of monetary union was to allow all euro area countries to enjoy the more favourable German yield curve, this can only be sustained if all countries also follow the frugality that used to characterise pre-EMU Germany. Despite looking somewhat more prudent than some of its euro area peers, we would stress though that Germany's fiscal position is far from being sustainable. As the monetary policy stance in the run-up to EMU converged to the Bundesbank's lower interest rate level rather than the average of the euro area aspirants, the same holds for the fiscal policy stance - another key determinant of bond yields. But, while cutting interest rates was easy, cutting budget deficits will be hard.
Our bottom line: When deciding what the adjustment should look like, what matters most is the deviation from the sustainable long-term growth trajectory. In our view, it does not make sense that countries which seem to be closer to their steady state path deviate further from this path in order to ease the adjustment elsewhere. In the face of a global debt turmoil, it is crucial that all countries move back closer to their long-term sustainable growth path. This sustainable path is determined by the intertemporal aspects of the current account rather than its cross-country comparisons. In the context of these long-term dynamics, current account surplus countries need to assess though whether the risks associated with investing domestic savings abroad are adequately reflected in its financial intermediation system and whether there are policy options that could make investing at home more attractive.
The BoJ Has Finally Moved
The policy decision in the October 4-5 monetary policy board meeting was more than what the market expected, and slightly earlier than our reading (we had looked for a cut at the month-end MPM). We applaud the policy decision, although there are some ambiguities in the official statement. Fundamentally, we see the decision as positive for JGBs and equities, as it is the first step in the enlargement of the asset purchase program.
There are three key pillars in the statement:
1. rate cut (although somewhat cosmetic, in our view);
2. clarification of commitment to policy duration (this is also somewhat ambiguous in terms of the definition); and
3. enlargement of the scope of asset purchases.
1. Rate Cut
This is similar to the ongoing Fed's program, where the policy rate is in a range from zero to 0.10%. As the interest rate paid on excess reserves has not been cut from 0.10%, we are uncertain as to what degree the actual overnight unsecured call rate will fall. That said, we believe that it is likely to edge down to 0.06-0.07% on a weighted-average basis, as the BoJ has officially announced it as a ‘real' zero rate policy. The term rates, on the other hand, are unlikely to move down significantly, in our view. They are likely to fall to 0.10% and stay at that level, including the GC rate and TB yield, unless the BoJ cuts the rates paid on the excess reserves. Going forward, whether or not the BoJ will cut the rate paid on the excess reserves is likely to be a new topic of policy discussion, we think.
2. Clarification of Commitment to Policy Duration
The BoJ clarified that it will maintain the ongoing super-accommodative policy stance, in line with the policy board members' understanding of medium- to long-term price stability. As the understanding falls in the positive range of 2% or lower, and the midpoint of most of the policy board members is 1%, this is a enhancement of the commitment to policy duration, which we may call a soft inflation-targeting framework with the target rate at around 1% in terms of the core CPI rate, based on our interpretation. Thus, the policy duration has been prolonged quite a lot. We believe that this is very positive for the longer end of the yield curve, in which the policy effect should be stronger than the cosmetic rate cut.
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