Chapter

Chapter 3. Rebalancing: Where Do We Stand and Where to Go?

Author(s):
Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Author(s)
Thierry Tressel and Shengzu Wang 

Although relative price adjustments and current account improvements are taking place, more needs to be achieved to correct the imbalances within the euro area. Improvements in export performance remain dependent on external demand, including from within the euro area. Moreover, ongoing adjustment in current account balances is partly driven by cyclical factors, which suggests that more needs to be done to make the adjustment sustainable. Converging to net foreign asset positions considered safe elsewhere will prove challenging in the future.

Intra–euro area imbalances have been a key feature of the euro area, reflecting deteriorating competitiveness and domestic demand booms in selected euro area debtor economies (Greece, Ireland, Portugal, and Spain) and rising external surpluses in export-oriented core economies (Germany, the Netherlands) in the run-up to the crisis.1 Extensive collective efforts—such as the European Stability Mechanism, Outright Monetary Transactions, and banking union—have helped restore the stability of the common currency area. However, given downward pressures on demand (due to the need to achieve internal devaluations associated with public and private deleveraging) and the limited policy space, the challenge now for many euro area economies is to rebalance across domestic and external sources of growth (Figure 3.1).

Figure 3.1Contributions to Growth in the Euro Area

(Percent)

Sources: IMF World Economic Outlook; and IMF staff calculations.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

What does rebalancing mean? Even before the crisis, significant structural differences among Economic and Monetary Union members were apparent, including in labor markets, productivity, production structure, competitiveness, and specialization (Eichengreen 2007). Although few signs of convergence in the structure and performance of euro area economies were visible, demand booms associated with intra–euro area capital inflows and the loss of export competitiveness in selected economies contributed to their accumulation of very large net foreign asset (NFA) liabilities (Greece, Ireland, Portugal, Spain). Meanwhile, core economies accumulated sizable surpluses. Those surpluses have largely remained since the crisis, while current account deficits in the selected debtor economies have narrowed significantly. However, to what extent the narrowing of current accounts in selected debtor countries reflects depressed demand domestically or more structural developments remains an open question. Indeed, internal imbalances could still persist among euro area countries even if the euro area is broadly in balance with the rest of the world.

This chapter takes stock of the extent of the external adjustment in euro area countries, examines a battery of price and nonprice indicators, analyzes the determinants of recent export performance and current account adjustments, and discusses the remaining gaps and expected path of future adjustment, as well as some policy implications.

Current account reversals and unit labor cost (ULC) adjustments have been significant in euro area debtors since the crisis, owing to both cyclical and structural factors. However, evidence of resource reallocation from the nontradable to the tradable sectors is limited. Export performance is very dependent on external demand, which remains weak within the euro area. Looking ahead, relying only on relative price adjustments (which adversely affect households and firms) for convergence to sustainable levels of net foreign liabilities could prove to be challenging. Structural reforms will play an important role in the reallocation of resources to the tradable sector and associated relative price adjustment, while boosting nonprice and price competitiveness. By focusing also on nonprice competitiveness, structural reforms would improve overall productivity and trend growth without unduly weighing on domestic demand.

How Much Adjustment Has Occurred?

Euro area selected debtor countries have experienced large current account adjustments since the crisis (Figures 3.2 and 3.3). Between 2008 and 2012, the current account balances of Greece, Ireland, Portugal, and Spain improved by 11.6 percent of GDP, 10.6 percent, 11.1 percent, and 8.5 percent, respectively. These adjustments have contributed significantly to the reversal of the euro area current account balance, which reached 1.2 percent of GDP in 2012, the largest surplus since 2000.

Figure 3.2Euro Area Current Account

Sources: Haver Analytics; and IMF staff calculations.

Note: See Abbreviations and Acronyms section for composition of EA17. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 3.3Euro Area: Current Account and Its Components

(Percentage of GDP)

Sources: Eurostat; Haver Analytics; and IMF World Economic Outlook.

The current account reversals in debtor countries reflect a combination of lower imports and higher exports, as well as improved income balances in some economies. In Greece, the decline in imports was the main contributor to the current account improvement. In Spain and Portugal, the contribution of exports to the current account improvement was larger than the decline in imports. In Ireland, the rebound of exports was associated with a rise in imports, likely as a result of the large import content of exports.

The adjustment in relative prices has proceeded, although to varying degrees across different measures of cost competitiveness (Figure 3.4).

Figure 3.4Euro Area: Real Effective Exchange Rate and Unit Labor Cost Developments

Sources: Eurostat; Haver Analytics; and IMF staff calculations.

Note: CPI = consumer price index; NEER = nominal effective exchange rate; REER = real effective exchange rate; ULC = unit labor cost. See Abbreviations and Acronyms section for composition of EA17. Data labels in the figure use International Organization for Standardization (ISO) country codes.

  • Real effective exchange rates (REERs). Most debtor countries have experienced large ULC-based REER depreciations since 2008. Whereas Germany’s REER has remained on a downward trend since the inception of the euro, REERs of euro area debtor countries are now close to their long-term average or back to the level that prevailed at the inception of the euro, mostly as a result of large declines of ULCs. Consumer Price Index-based REERs, however, have generally adjusted less since the start of the crisis (Figure 3.5, panel 1).
  • Unit labor costs. Since 2008 there have been large corrections of ULCs in selected debtor economies (Ireland, Spain, Greece, and Portugal), while ULCs have started to increase in Germany (ECB 2012). In France and Italy, ULCs have continued to rise on their precrisis trend. Sectoral evidence suggests that ULCs have fallen across sectors, and the decline has often been larger in tradable sectors than in nontradable sectors, except in France, Germany, and Italy (Box 3.1, Figure 3.1.1).
  • Relative price adjustments compared with euro area trading partners and the rest of the world. Consumer price adjustments have been relatively modest, perhaps as a result of value-added tax hikes. They were mostly achieved vis-à-vis non–euro area trading partners (with the exception of Ireland, which exhibited large consumer price adjustments). Greece, Italy, and Spain experienced increases in consumer prices relative to their euro area trading partners. However, since the consumer price index (CPI) is not always a good measure of relative production costs, this analysis also considers a GDP deflator-based REER (Figure 3.5, panel 2).2 In contrast to the CPI, relative GDP deflators have declined substantially in Greece, Ireland, Portugal, and Spain, in particular in comparison with non–euro area trading partners.
  • Wages. Since 2008, wages have declined in many external debtor countries relative to the euro area average. The adjustments have been particularly important in Greece, Ireland, and Portugal. Manufacturing wages declined the most in Ireland and Greece and grew at a similar pace as the euro area average in other debtor countries (Figure 3.6).

Figure 3.1.1Contributions to Unit Labor Cost Changes

(Percent)

Sources: Eurostat; Haver Analytics; and IMF staff calculations.

Note: NT = nontradable; T = tradable; ULC = unit labor cost.

Figure 3.5Relative Price Adjustments, 2008:Q3–2012:Q4

(Percent)

Sources: IMF Direction of Trade Statistics, Effective Exchange Rate Facility, and World Economic Outlook.

Figure 3.6Annual Wage Inflation: Manufacturing Relative to EA17

Sources: Eurostat; and IMF staff calculations.

Note: See Abbreviations and Acronyms section for composition of EA17. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Box 3.1.Unit Labor Cost (ULC) Developments in Tradable and Nontradable Sectors1

Relative price adjustments are taking place in both the tradable and nontradable sectors, although quite unevenly at the national level:

  • Several external debtor countries (Greece, Ireland, and Portugal) experienced larger reversals of ULCs in the tradable goods sector than in the nontradable sectors. However, saving in ULCs is sometimes achieved by large-scale labor shedding, as in Greece and Portugal.
  • Ireland has been a good example of external adjustment, for example, output in the tradable sector began recovering in 2011, supporting growth.
  • Spain experienced a larger drop in ULCs in its nontradable goods sector and has relatively sticky labor costs. Most of the adjustment has been through output loss and unemployment.
  • Competitiveness in the large economies has diverged: France’s and Italy’s ULCs of tradables have continued to rise since the crisis, reflecting deterioration of external competitiveness.
1 Tradable sector comprises manufacturing. Nontradable sector comprises construction, wholesale and retail, hotel, and transportation (ECB 2012).

The evolution of ULC can be broken down into contributions from labor costs and from labor productivity. Labor productivity reflects changes in employment (a positive value means increasing ULC), and in output (a negative value means increasing output and negative contribution to ULCs). Figure 3.7 also shows the contribution to declining ULCs from their peak for several euro area external debtor economies. ULCs have corrected in many debtor countries since 2008, although the sources of reversals have varied across countries (Figure 3.8).

  • In Spain, productivity gains were achieved largely because labor shedding exceeded the decline in output, and the decline in wages relative to the euro area average was small.
  • In Italy, the poor performance of labor productivity is explained by labor hoarding in a period of output decline.
  • Ireland shows evidence of good relative price adjustment, for example, labor costs and labor shedding came down, in the context of a moderate growth recovery.
  • In Greece and Portugal, a combination of declining wages and large labor shedding was the main driver of ULC adjustments.
  • Meanwhile, in Germany, labor costs rose mainly because of higher wages, but the effect on ULC was mitigated by relatively strong output growth.
  • At the sectoral level, debtor countries experienced large declines in tradable sector ULC, with the exception of Italy. However, the declines were mostly driven by large labor productivity gains, given that reductions in employment exceeded the decline in output. Ireland is the exception, as tradable output also expanded (Box 3.1).

Figure 3.7Contributions to Changes in Unit Labor Cost

(Percentage change, year over year)

Sources: Eurostat; and IMF staff calculations.

Figure 3.8Unit Labor Cost Total Economy Growth Relative to EA17

Source: Eurostat.

Note: The distance between the dot and the bar represents the change from 2008 to the latest available date, in general 2012:Q4. ULC = unit labor cost. See Abbreviations and Acronyms section for composition of EA17. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Evidence suggests that labor cost adjustments have modestly improved the price competitiveness of exports.

  • Volumes. Export growth picked up significantly after the crisis, mostly as a result of a rebound in external demand. Germany, Ireland, and Spain experienced relatively solid export recoveries, but export recoveries have been (and are forecasted to remain) weak in France, Greece, Italy, and Portugal (Figure 3.9).
  • Export prices. Substantial ULC and wage adjustments have not been followed by gains in price competitiveness.3 In Greece, Ireland, Portugal, and, to some extent, Spain, exporters’ margins have risen since the crisis. This increase could have occurred because exporters have attempted to increase profitability, reversing the precrisis trends of margin erosion. By contrast, the erosion of exporters’ margins in France and Italy has continued since the crisis. In Germany, exporters increased their price margins before the crisis, perhaps to reverse previous trends, but margins seem to have declined somewhat in recent years. Price competitiveness (relative to production costs in export markets) has improved in Ireland and Spain, and to some extent in Germany, but it has declined in Greece and Portugal, and has remained stable in France and Italy.

Figure 3.9Real Exports

(Index, 2000 = 100)

Source: IMF World Economic Outlook.

Nonprice competitiveness. Indicators of market shares suggest that in general, competitiveness has not improved since the crisis. Most euro area countries (both external debtors and creditors) have lost market share in the world market. This loss could be explained by unrelated global developments in world trade, such as growing trade among emerging markets. However, several euro area countries, including France, Germany, Ireland, and Italy, have also lost market shares within the euro area since the crisis. By contrast, the market shares of Greece, Portugal, and Spain have remained stable (Figure 3.10).

Figure 3.10Evolution of Price and Nonprice Competitiveness: 2000–07 and 2008–12

Sources: IMF Direction of Trade Statistics and World Economic Outlook.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

The evidence suggests that although ULC adjustments have had large impacts on real disposable income, gains in price competitiveness have played a more limited role in supporting net exports. Although wages (relative to the euro area average), GDP deflators, and employment have declined in selected debtor countries, consumer prices have remained sticky, adjusting much more slowly (with the exception of Ireland), and even in the opposite direction (as in Greece). Hence, rising unemployment and wage adjustments are causing significant reductions in households’ real disposable income, dampening domestic demand in the selected debtor countries. At the same time, the wage and employment adjustments have not clearly resulted in price or nonprice competitiveness gains because exporters have used part of the wage moderation to reconstitute their profit margins in Greece, Ireland, and Portugal.

Only limited evidence suggests that adjustment between the tradable and nontradable sectors has so far taken place.4

  • Both price and quantity adjustments are needed. To rebalance, debtor countries must reallocate resources from nontradable sectors to tradable sectors; such a reallocation must be associated with a decline in the price of nontradable goods relative to tradable goods. But external adjustment also requires a drop in tradable prices to improve external competitiveness. Sectoral labor reallocation to tradable sectors would then respond to improved profitability (resulting from cuts in costs and improvement in relative prices of tradable versus nontradable products), along with higher export demand (resulting from the absolute decline in tradable prices). This will ensure a structural change in the external balance, associated with lower imports and higher exports, but such reallocation could take time and be impeded by rigidities.

Adjustments have yet to take hold in the tradable sector. ULCs have declined in both tradable and nontradable sectors. In addition, export margins have increased in several countries with declining labor shares,5 making these sectors, in principle, more attractive for producers. As a result, however, export prices have not adjusted much compared with trade partners, which could prevent export demand from picking up. Indeed, evidence from sectoral labor flows and value-added growth show that labor (and output) have declined across sectors (both tradable and nontradable), and that the decline has often been more pronounced in the tradable sector (with the exception of Ireland), reflecting the general collapse in domestic demand (Figure 3.11, panels 1 and 2). Evidence from bank credit in Ireland and Spain suggests, however, a sharper decline in nontradable sectors and recent data point to a pickup of credit in the tradable sector (Figure 3.11, panels 3 and 4).

Figure 3.11Adjustment in the Tradable and Nontradable Sectors

Sources: Eurostat; Central Bank of Ireland; Bank of Spain; and IMF staff calculations.

Note: Index of national stocks constructed from transactions. Tradable sector comprises manufacturing; nontradable sectors comprise construction, trade, travel and food, and real estate.

What Explains the Performance of Exports Since the Start of the Crisis?

This section analyzes the determinants of export performance in the euro area using standard panel export regressions. The sample comprises 11 euro area countries during the period 1990–2010. The export regressions are estimated in levels to capture a stable, long-term relationship between real exports and a set of determinants. Specifically, the following regression is estimated for bilateral exports of goods vis-à-vis the top 20 export partners:

In equation (3.1) the dependent variable is the log of real exports of goods from country i to country j during year t (converted into real values using the aggregate export price deflator); the determinants are, respectively, the log of real domestic demand (total volume of domestic demand) in country j during year t; the log of the bilateral euro nominal exchange rate for non–euro area trading partner j; and the log of the relative consumer price index between euro area country i and trading partner j.6

The regression coefficients are used to decompose the quarterly performance of real exports of goods and services as follows:

In equation (3.2)

  • ShareEA is the share of euro area countries in total exports of goods.
  • SharenonEA is the share of non–euro area countries in total exports of goods.
  • DemandEAit is a quarterly weighted average of euro area trading partners’ domestic demand; trade weights are the shares of bilateral exports to country I in total exports of goods to the euro area.
  • DemandnonEAit is a quarterly weighted average of non–euro area trading partner domestic demand; trade weights are the shares of bilateral exports to country i in total exports of goods to the euro area.
  • NEERijt is the nominal effective exchange rate.
  • EA and nonEARel.CPI are the relative prices of euro area and non–euro area countries.
  • RES is the residual.

Since the start of the crisis, euro area countries have experienced significant differences in the demand for their exports. For example, between 2008 and 2012, total trading partners’ demand for Germany’s exports grew by 4.7 percent, compared with 2.8 percent for France, 1.8 percent for Spain, 1.7 percent for Italy, 0.5 percent for Greece, and –0.3 percent for Portugal (Figure 3.12). These differences reflect each country’s initial geographic specialization. Germany’s relatively large share of exports outside the euro area and to fast-growing emerging markets contributed to a relatively stronger rebound in exports. In contrast, export demand growth was more sluggish in external debtor countries as a result of either specialization in slower-growing markets outside the euro area (Italy and especially Greece) or lower shares of exports to non–euro area countries (Spain, Portugal). In all countries, demand from other euro area countries has been declining during the period, contributing to slower export growth (Figure 3.13).

Figure 3.12Export Demand Growth, 2008–12

(Percent)

Sources: IMF, Direction of Trade Statistics database; IMF, World Economic Outlook database; and IMF staff calculations.

Figure 3.13Share of Euro Area in Total Exports of Goods

(Percent)

Source: IMF, Direction of Trade Statistics database.

Export demand from the rest of the world and changes in nominal effective exchange rates provided the strongest contributions to export performance, while weak demand from within the euro area dampened exports (Figure 3.14).

  • Initial trade specialization is important: It helps explain the extent to which euro area countries’ exports have rebounded. Germany’s relatively large share of exports outside the euro area and in growing markets contributed to its relatively stronger rebound in exports, and made its export performance less dependent on intra–euro area demand than that of southern euro area countries. For Greece, specialization in slow-growing markets (Figure 3.15) has constrained export growth.
  • Demand from the rest of the world is the main pull factor: It contributed to 47 percent and 42 percent, respectively, of the relatively strong rebound of Germany’s and Spain’s exports, and to 80 percent of France’s exports rebound. It cushioned the headwinds on Italy’s exports and was the main driver of Portuguese exports (including to fast-growing African countries).
  • Relative price adjustments also matter, although the precise effect is uncertain: When measured using the CPI, relative price adjustments (vis-à-vis euro area trading partners or others) appear to have had a small effect on the exports of the debtor countries, Italy, France, and Germany. Although the small contributions of relative prices are partly a result of the small elasticity of exports to relative prices, the impact also depends on the relative price considered. As demonstrated in the earlier section “How Much Adjustment Has Occurred?” CPI adjustments have been relatively small (either compared with euro area trading partners or non–euro area trading partners), although relative price adjustments as measured by GDP deflators have been more substantial (Figure 3.16).7 In this case, the contribution to export performance of GDP deflator adjustments was large for Germany, Portugal, and Spain. For the latter two countries, the changes in relative prices account for 20 percent and 35 percent of real export growth, respectively, between 2008:Q3 and 2012:Q4.
  • The nominal exchange rate also played a role: The nominal effective exchange rate contributed as much as external demand to France’s exports, and to 30 percent, 28 percent, and 17 percent of the exports of Germany, Portugal, and Spain, respectively.
  • Weak euro area demand was a drag: The euro area crisis had a direct impact on the export performance of euro area countries because demand from euro area trading partners declined during the early phase of the crisis in 2008–09 but also more recently. The impact was particularly large for Italy and Portugal.
  • Unexplained factors: Greece’s export performance was significantly weaker than predicted by the developments in external demand and relative price adjustments. There could be various explanations, such as lower-than-average demand or relative price elasticities (which could be related to structural impediments and nonprice competitiveness) or a substantial loss in nonprice competitiveness. In contrast, in Germany, Portugal, and Spain, the unexplained residual is relatively large and positive, suggesting that nonprice factors could have helped support export performance.

Figure 3.14Determinants of Quarterly Export Performance

Sources: IMF Direction of Trade Statistics, Effective Exchange Rate Facility, and World Economic Outlook; and IMF staff calculations.

Note: CPI = consumer price index; EA = euro area; NEER = nominal effective exchange rate; RoW = rest of world. Contributions to quarterly real export growth of intra–euro area demand, demand from the rest of the world, the nominal effective exchange rate, and relative price adjustments (based on CPIs) vis-à-vis euro area trading partners and non–euro area trading partners. Demand and price elasticities are those estimated in regression (1), as shown in equation (3.1). Moving averages of each variable over four quarters are considered.

Figure 3.15Trade Correlation Index: 1995 and 2011

Sources: United Nations Conference on Trade and Development; and IMF staff calculations.

Note: The Trade Correlation Index is a simple correlation coefficient between economy A’s and economy B’s trade specialization index. The resulting coefficient can take a value from −1 to 1. A positive value indicates that the economies are competitors in the global market because both countries are net exporters of the same set of products. Consequently, a negative value suggests that the economies do not specialize in the production or consumption of the same goods, and are therefore natural trading partners. See Abbreviations and Acronyms section for country abbreviations.

Figure 3.16Cumulative Contributions to Export Performance, 2008:Q3–2012:Q4

(Percentage points)

Source: IMF staff calculations.

Note: CPI = consumer price index; NEER = nominal effective exchange rate; RoW = rest of world.

External Adjustment: Cyclical or Structural?

A key remaining question is whether recent current account adjustments reflect cyclical or structural factors, or a mixture of the two.

Panel regression analysis allows the contribution of structural and cyclical factors to the evolution of current accounts to be assessed. The approach builds on the existing literature, based on the standard intertemporal approach to the current account emphasizing saving and investment decisions (Chinn and Prasad 2003; Lee and others 2008; Christiansen and others 2009). In particular, this analysis follows the method used in the IMF’s 2013 External Balance Assessment analysis of 50 advanced and emerging market economies, with the coverage period extended to 1986–2012. The standard fundamental determinants of saving and investment decisions include (1) demographics (population growth, old-age-dependency ratio, and aging speed); (2) initial wealth (lagged NFA); (3) long-term growth and neoclassical catch-up (five-year-ahead real GDP growth and gap to U.S. GDP per capita); (4) other structural factors (cyclically adjusted fiscal balance, public health spending);8 and cyclical factors (output gap, global capital market conditions, commodity terms of trade).

The standard regression is augmented to capture the impact of changes in potential output on the current account. An unanticipated and permanent decline in the level of potential output should cause a decline in consumption and investment, thereby resulting in an improved current account balance. Indeed, consumption adjusts immediately by the permanent amount of the decline in productivity, also reflecting lower investment in the future (and thus exceeding the initial decline in output), causing a temporary increase in saving, while investment also declines.

The standard current account regression does not capture this effect well. The expected growth term captures the intertemporal effect of changes in productivity growth (case (A) in Figure 3.17), but not the effect of changes in productivity levels (case (B) in Figure 3.17). The gap relative to the level of U.S. GDP per capita captures the neoclassical convergence term, which has the opposite effect on the current account (for example, a lower GDP per capita relative to the United States results in a lower current account balance). Therefore, it is not well suited to capturing the impact of an unexpected drop in potential output. The purchasing-power-parity potential output level per capita relative to the world average is included as an additional explanatory variable to account for this effect.

Figure 3.17Permanent and Temporary Output Losses

The analysis also accounts for common factors underlying the evolution of external balances in the euro area external debtors that are over and above the impact of observed cyclical and structural determinants. These common patterns could be structural or cyclical in nature. The literature has shown that euro area external debtors experienced common current account patterns related to the reduction in risk premiums, the removal of exchange rate risks, overly optimistic convergence expectations, and regulatory factors after the creation of the Economic and Monetary Union (for instance, Blanchard and Giavazzi 2002; Blanchard, Giavazzi, and Sa 2005; Chen, Milesi-Ferretti, and Tressel 2012). These factors led to a surge of intra–euro area capital flows, contributing to domestic asset bubbles and worsening external positions (IMF 2011). In the aftermath of the crisis (and particularly since 2011), the euro area debtor countries have experienced sharp reversals of these private capital flows (Laeven and Tressel 2013). To control for these unobserved (and difficult to measure) determinants of the current account, time effects that are common to all debtor countries are included in the regression.

The empirical results suggest that both cyclical and structural factors have contributed to the recent improvement in current account balances (Table 3.1 and Figure 3.18).9 Cyclical factors have played a significant role in the current account reversals of Greece, Ireland, and Spain. The impact of measured structural factors (potential output, demographics, and others) has generally been more modest.10 However, “other debtor factors”—which arguably reflect both structural and cyclical underlying forces—account for a significant portion of the external adjustments. The unexplained part of the adjustment remains large in some cases (for example, Italy).

Table 3.1.Contributions to Current Account Adjustment: 2007–2012(Percentage of GDP)
CACyclicalDemographyLT Development and GrowthNFAOther StructuralPotential OutputOther Debtor EffectUnexplained
Greece10.195.130.43−0.11−0.020.250.453.380.69
Ireland7.632.480.19−0.19−1.49−0.760.583.383.43
Italy−0.231.480.610.07−0.030.980.45−3.79
Portugal7.600.700.330.380.040.150.313.382.31
Spain8.022.141.020.580.04−0.660.333.381.20
France−0.730.02−0.170.46−0.61−0.060.36−0.74
Germany−2.02−0.530.570.76−0.050.170.19−3.13
Note: Cyclical includes contribution of output gap, financial conditions, and commodity terms of trade. Potential growth includes the contributions of neoclassical catch up term and expected medium-term growth. Other structural include contributions of the fiscal balance, capital controls, and social spending. CA = current account; NFA = net foreign assets.
Note: Cyclical includes contribution of output gap, financial conditions, and commodity terms of trade. Potential growth includes the contributions of neoclassical catch up term and expected medium-term growth. Other structural include contributions of the fiscal balance, capital controls, and social spending. CA = current account; NFA = net foreign assets.

Figure 3.18External Adjustment: Contribution to Change of Current Account, 2007–12

(Percent of GDP)

Sources: IMF Direction of Trade Statistics, Effective Exchange Rate Facility, and World Economic Outlook; and IMF staff calculations.

The Adjustment Going Forward

Further adjustment in relative prices would be needed to complete the euro area rebalancing (based on current account or REER targets). According to the IMF “2013 Pilot External Sector Report” (IMF 2013), additional adjustment of real exchange rates by 5–10 percent is desirable for selected debtor countries (Greece, Ireland, Italy, Portugal, and Spain).

To improve competitiveness, resources need to be reallocated to more productive sectors, countries need to move up in the value chain, and labor markets need to become more flexible:

  • Reallocation of labor to traded sectors—The reallocation of labor from nontradable to tradable sectors has not occurred as of end-2012 (see section “How Much Adjustment Has Occurred?”). As the recession lingers in the selected debtor economies, human capital and potential output are lost, making structural adjustment even more difficult to achieve when relative prices begin to adjust.
  • Moving up the value chain—Many debtor countries produce goods that are close substitutes for goods produced by fast-growing emerging market economies (such as China), hence facing additional structural challenges to their external rebalancing (Figure 3.15). Evidence from the Trade Correlation Index suggests that this is the case for several euro area members (Italy, Portugal, the Slovak Republic, Slovenia, and Spain), for example, a relatively high correlation of the composition of a country’s merchandise exports with China.11 This means that internal devaluation in these countries (relative to other euro area countries) would help export competitiveness to a limited extent, given that competitiveness gains to help the adjustment may have to be vis-à-vis emerging markets.
  • The role of service exports—The euro area is the largest service exporter in the world (one-third of world market share), and most euro area members have relatively high services export ratios, in particular Greece (tourism and transport) and Ireland (insurance and communications and information technology) (Figure 3.19). Some services exports (such as tourism) have stronger links within the euro area and may benefit more from internal devaluation through ULC improvements and wage cuts. Other services exports are more sensitive to nonprice factors (labor and product market regulations or other regulations such as taxes) (Figure 3.20).
  • Structural reforms—While relative price adjustment is important to rebalancing and enhancing competitiveness, it may be insufficient to fully eliminate external deficits and reverse the net external position, given weak demand in the euro area. Therefore, pursuing structural reforms effectively at the national level would not only help in the long term, but can also help maximize the benefits of recent policy actions in the euro area to spur growth. Indeed, IMF staff analysis of the impact of nonprice indicators on export performance since the crisis suggests that, after accounting for external demand and REERs, lower business costs or lower employment protection are associated with stronger export growth (Box 3.2). Meanwhile, increasing productivity in nontradable sectors in creditor economies would improve disposable incomes and consumption in these economies and lead to higher external demand, which could support the rebalancing efforts of the debtor countries.

Figure 3.19Export Shares as Percentage of GDP: 2008–12

Source: Haver Analytics.

Note: See Abbreviations and Acronyms section for composition of EA17. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 3.20Service Exports 2000–11: Trends and Shares

Sources: United Nations Conference on Trade and Development; and IMF staff calculations.

Note: Bubble size represents the share of each sector in total services exports.

X-axis: Change in country’s world market share of a specific market from 2000 to 2011.

Y-axis: Relative growth rate of sector exports to total world growth in exports of that sector from 2000 to 2011 (in percentage points).

CIT = communications and information technology.

In the future, achieving convergence of NFAs to more stable levels to reduce external vulnerabilities will prove very challenging. Reducing net external liabilities to levels considered healthy elsewhere would likely require much larger relative price adjustments than implied by the need to reverse ULC appreciations or to achieve current account surpluses.

Box 3.2.The Role of Nonprice Factors

A simple approach is applied to assess export growth performance beyond the effect of world demand and relative price changes.

Model: The underlying panel regression takes the form

in which export growth is a function of relative prices (expect β to be negative) and external demand yt, with μt capturing nonprice factors such as costs of doing business, regulatory compliance, and so forth.

Panel regressions are performed over 2008–12 for 13 euro area economies using a combination of 23 measures of nonprice indicators chosen from the World Bank (costs of starting a business, costs of enforcing contracts, and costs of insolvency) and the OECD (levels of regulation [product market regulation index], employment protection [employment protection legislation index], state control, barriers to entry and entrepreneurship, and barriers to trade and investment index).

Results: The largest elasticity is attributed to external demand. Relative price matters, with the relative price elasticity ranging from 0.3 to 0.5 across various specifications (also confirmed by quantile regression on medians). Among the noncost indicators, two stand out: lower business cost and lower employment protection are positive factors explaining export growth (Table 3.2.1). Other nonprice costs are generally less significant, but their importance for long-term adjustment may not be well captured given the postcrisis period considered.

Table 3.2.1.Euro Area Economies Export Regressions: Selected Results
Dependent Variable: Real Export Growth Specification1Unrestricted PanelQuantile
External demand0.970.940.981.011.01
(13.76)(23.36)(14.43)(20.78)(12.50)
ULC-REER change−0.40−0.47−0.41−0.42
(−2.73)(−3.21)(−4.26)(−2.38)
CPI REER change−0.32
(−3.27)
Cost to start a business (WB)−0.26
(−2.36)
Employment protection (OECD)−2.66
(−1.75)
R20.790.770.820.800.56
Obs70707012670
Source: IMF staff estimations.

Selected variables are listed.

Source: IMF staff estimations.

Selected variables are listed.

  • Outlook. Under the baseline World Economic Outlook projections, and assuming no valuation effects, the NFA positions of Greece, Ireland, Portugal, and Spain will still be below –80 percent by 2018 (Figure 3.21). Moreover, to undo half of the deterioration of the NFA position that occurred during 2000–12 will take 15 years for Greece, 11 years for Ireland, 37 years for Portugal, and 12 years for Spain under the current baseline (Table 3.2). Reaching the European Commission scoreboard threshold (–35 percent of GDP) will take even longer. In contrast, for Germany, the NFA is expected to continue growing under the current baseline.

Figure 3.21Net Foreign Asset Position

(Percent of GDP)

Note: Net foreign assets as a ratio of GDP implied by IMF World Economic Outlook projections, assuming no valuation effects in the future.

Table 3.2.NFA Positions: Projected Adjustments
Numbers of Years to:
NFA/GDP 2000NFA/GDP 2012NFA/GDP 20182Reverse Half of 2000-12 Decline of the NFA/GDP3Reach EC Scoreboard Threshold3,4
France118−15−20
Germany34275
Greece−39−117−1051532
Ireland−8−98−711118
Italy−13−25−25
Portugal−38−120−1213773
Spain−32−95−831220
Note: EC = European Commission; NFA = net foreign assets.

2011 instead of 2012.

Implied by WEO projections, assuming no valuation effects.

Assuming constant real GDP growth, inflation, and current account balance from 2018 onward.

European Commission Macroeconomic Imbalance Procedure scoreboard target of −35 percent of GDP.

Note: EC = European Commission; NFA = net foreign assets.

2011 instead of 2012.

Implied by WEO projections, assuming no valuation effects.

Assuming constant real GDP growth, inflation, and current account balance from 2018 onward.

European Commission Macroeconomic Imbalance Procedure scoreboard target of −35 percent of GDP.

Conclusion

Relative price adjustments and current account improvements are taking place, but improvements in export performance remain very dependent on external demand, including from within the euro area. Moreover, ongoing adjustment in current account balances is partly driven by cyclical factors, which suggests that more needs to be done to make it sustainable. From here on, converging to NFA positions considered safe elsewhere will prove challenging.

Further policy actions in both creditor and debtor economies are necessary to rebalance debtor countries internally and externally. Structural policies will improve flexibility and smooth the adjustment process across sectors, including by fostering job creation and access to credit, boosting competitiveness, and enhancing regional integration (by, for instance, introducing a single labor contract across countries and portable unemployment benefits and pensions).

  • In creditor economies, increasing productivity in nontradable sectors would improve disposable incomes and consumption in these economies and lead to higher external demand, which could support the rebalancing efforts of the deficit countries. In addition, reducing euro area uncertainty would support a recovery in private investment, which would help narrow current account surpluses (notably in Germany).
  • In debtor economies, where consumption booms had led to excessive growth in nontradable sectors in the run-up to the crisis, continuing structural adjustment would shift resources to tradable sectors.
  • At the euro area level, repair of bank balance sheets and implementation of the banking union will enhance the allocation of credit to more productive sectors and firms, and thereby help support the internal reallocation of resources.
Annex 3.1. Technical Notes

Decomposition of ULC Changes

ULC = labor cost/labor productivity, where labor cost = compensation per employee/total employees (in persons), and productivity = real output (or gross value added)/total employment. See ECB Directorate General Statistics (http://sdw.ecb.europa.eu/browseExplanation.do?node=2120786).

Tradable and Nontradable Sectors

No standard definition can be derived from NACE2 (European Classification of Economic Activities, rev. 2) to have a clear cutoff line between the tradable and nontradable sectors. This chapter uses the definition in ECB (2012) as follows:

Tradable sector: Manufacturing.

Nontradable sectors: Construction; Wholesale and retail trade; Travel and food service; Financial and insurance; Real estate.

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This chapter is based on Euro Area Policies: 2013 Article IV Consultation—Selected Issues, “Rebalancing the Euro Area: Where Do We Stand and Where to Go,” IMF Country Report 13/232, 2013.

1

France and Italy are also included in the analysis for the sake of comparison. While Italy also suffered severe market pressure and an erosion of external competitiveness, its current account deficit and net external liability position in percent of GDP were much smaller than those of the debtor countries.

2

GDP-deflator-based REERs are good proxies for value-added REERs that reflect the vertical integration of trade (for example, Bems and Johnson 2012).

3

Some measurement errors could exist because the proxy for export prices is the unit export value for goods actually sold, which may not fully capture pricing-to-market behaviors nor cover transaction prices.

4

See Annex 3.1 for a definition of the tradable and nontradable sectors.

5

Labor shares in gross value added have been declining in the past decade in the euro area, with sharp spikes during the 2008–09 crisis period when output and trade collapsed. In external debtor countries such as Spain, labor share has been declining since the crisis, reflecting both labor shedding and rising profit margins in the tradable sectors.

6

An alternative analysis uses relative GDP deflators as indicators of relative price adjustment.

7

We replicate the analysis, using the same relative price elasticities, but with GDP deflators instead of the CPI as measures of relative prices. Using the same elasticities allows us to assess the impact of using GDP deflators instead of the CPI on the contribution of each variable to export performance.

8

Other factors considered structural but of little relevance for this analysis include capital controls, reserves accumulation, and whether the country is a financial center. The regression also includes the oil trade balance for a few countries in which it exceeds 10 percent of GDP.

9

The assessment is based on the output gap and potential output estimates of each World Economic Outlook vintage. There is an ongoing debate about how potential output and the output gap should be estimated in real time, including to better capture financial cycles. See, for instance, Borio, Disyatat, and Juselius (2013). The analysis in this chapter does not include those considerations.

10

The impact of a decline in the output level on the current account is theoretically and empirically ambiguous as noted above: while the neoclassical effect tends to lower the current account balance (as the distance to the total factor productivity frontier increases), the decline in potential output has the opposite effect (because consumption falls by the permanent component of the reduction in income). For Greece, the first effect decreases the current-account-to-GDP ratio by 0.11 percentage point, while the second effect increases the current-account-to-GDP ratio by 0.45 percentage point. See Table 3.1 for details.

11

It is also interesting to see that Greece’s top three competitors in the world market are Italy, Portugal, and Spain (Figure 3.15), with very low correlations of trade specialization with China or Hong Kong SAR.

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