Euro Area Policies: Selected Issues
Author: International Monetary Fund
Publication Date:
03 Aug 2004
eISBN:
9781451812954
Language:
English
Keywords:
ISCR; CR; China; euro; exchange rate; productivity growth; Euro area policy; area pass-through; U.S. dollar; euro-dollar rate; flexibility scenario; Exchange rates; Current account imbalances; Real exchange rates
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This Selected Issues paper on Euro Area Policies underlies global rebalancing of accounts. From a growth-accounting perspective, slower growth in the capital-labor ratio seems to be the main driver behind the deceleration in labor productivity. The increase in bilateral trade was accompanied by a large bilateral EU trade deficit. China’s market share seems to have increased mainly at the expense of other East Asian countries. EU trade with China increased at more than twice the rate of total EU external trade, and China became the EU’s second largest trading partner.

Abstract

This Selected Issues paper on Euro Area Policies underlies global rebalancing of accounts. From a growth-accounting perspective, slower growth in the capital-labor ratio seems to be the main driver behind the deceleration in labor productivity. The increase in bilateral trade was accompanied by a large bilateral EU trade deficit. China’s market share seems to have increased mainly at the expense of other East Asian countries. EU trade with China increased at more than twice the rate of total EU external trade, and China became the EU’s second largest trading partner.

IV. Global Rebalancing Of Current Accounts: A Euro-Area Perspective47

Core Questions, Issues, and Findings

  • What role has the euro area’s current account and currency played during the period of widening imbalances and exchange rate swings? Counterpart imbalances to U.S. deficits were largely found outside the euro area. The euro, however, figured prominently in exchange rate fluctuations and, by some accounts, was the most variable currency. (¶8-13)

  • What fundamental driving forces are consistent with this global pattern of external developments since the mid 1990s? Accelerating productivity but, more importantly, declining risk premia on assets in the United States relative to partner countries appear to have been key underlying determinants. Accounting for the uneven pattern of counterpart imbalances, differences in relative size and trade patterns and a greater willingness to hold U.S. assets in the rest of the world help explain differences with the euro area. (¶16-22).

  • What factors would facilitate a relatively benign global rebalancing scenario from the euro area’s vantage point? Rebalancing prompted by an unwinding of recent shocks that boosted domestic demand and potential output growth in partner countries relative to the United States holds the promise of an orderly resolution to global imbalances. (¶23-24).

  • What alternative global rebalancing scenarios or key risks would present more challenging circumstances from the area’s perspective? An adjustment entailing excessive reliance on exchange rates would present a more challenging scenario and provide little in the way of meaningful global rebalancing. Limited exchange rate flexibility in the rest of the world would further complicate the adjustment process. (¶25-26).

  • What area-specific policy lessons can be drawn from the implications of various global adjustment scenarios? Policies that raised potential growth would well position the economy to face the ramifications of global rebalancing. This would provide a solid footing for moderating inflation, boosting domestic demand, attracting foreign capital, and coping with a strengthening currency. If precipitous changes in exchange rates were to occur, a more aggressive easing of euro area monetary policy would be warranted. (¶23-26).

A. Introduction

190. Concerns regarding global current account imbalances still loom large. While foreign exchange market turbulence appears to have subsided in recent months, concerns about the implications of large, persistent external imbalances remain very much in place. In particular, the issue of long-run sustainability of the massive U.S. current account deficit leaves open the prospect of a further significant decline in the value of the dollar. History suggests that external deficits of 5 percent of GDP (or larger) are rarely sustained for significant periods and inevitably involve real depreciation (and slower growth) during the subsequent adjustment process.48

191. This chapter examines the potential implications—from the perspective of the euro area—of global adjustment in current account imbalances. Using a three-country version of the IMF’s Global Economic Model (GEM), the analysis proceeds in two steps. First, the analysis provides a coherent macroeconomic framework, within the dynamic general equilibrium approach, for understanding recent external developments and identifying fundamental drivers in that process. Second, the structural model provides a useful framework for examining alternative scenarios regarding the possible nature of the rebalancing process and the policy implications for the euro area.

192. The basic issue is that the area’s prospective role in the needed global adjustment of current account imbalances remains fairly uncertain. Two stylized viewpoints emerge:

  • From a benign standpoint, neither the euro area’s net external position—which has remained close to balance, nor the euro—which has moved back in line with its historical averages—appear significantly misaligned with medium-term fundamentals. This might suggest that the area’s external balance could remain relatively stable, perched “on the middle of a see-saw,” as forces tilt back and allow major imbalances elsewhere to unwind. The euro’s value, correspondingly, would remain broadly stable, with appreciation against the dollar offset by depreciation against other currencies.

  • From a more cautious view, however, the euro is the second leading global currency behind the U.S. dollar.49 Hence, it is very difficult to envision the euro staying on the sidelines throughout the process, particularly if market sentiment on the dollar were to weaken. Recent gyrations in the euro’s value against the dollar and other major currencies only underscore the concerns associated with this view.

193. The consequences of global rebalancing for the euro area will ultimately depend on the nature of the adjustment. Contingent on the nature of the rebalancing process, the impact on growth and welfare ranges from relatively benign to more disruptive. Ascertaining in advance the central forces that will shape the course of the adjustment process will be difficult. Global adjustment invariably reflects a multitude of shocks and transmission mechanisms from multiple sources. Discerning among alternative adjustment trajectories and their likelihoods would serve as an important input to a risk assessment of global imbalances.

194. One approach that may help anticipate the rebalancing process is to better understand the key drivers underlying past macroeconomic developments that have generated the current constellation of external balances and exchange rates. This would provide a starting point or set of candidate shocks that, if they were to unwind, could facilitate a steady reversal of the capital flows that have largely supported the prevailing external alignment.

195. A key feature of recent external developments, that requires explanation, has been the asymmetric global pattern of adjustment during the period of widening imbalances. In considering possible driving forces, it is important to note that the expanding U.S. current account deficit did not find its counterpart adjustments distributed evenly across partner countries. At the same time, the relative stability or volatility of currency swings did not coincide closely with the pattern of changing imbalances. From the euro area’s vantage point, two observations are salient.

  • The euro area’s net external position has showed little counterpart movement to the burgeoning U.S. current account deficit. Rather, other countries in the rest of the world saw the biggest offsetting adjustments to the widening saving-investment gap in the United States. Trade imbalances exhibited a similar global allocation pattern.

  • In foreign exchange markets, however, the euro has remained very much “in play.” The relative stability of area’s external position has not been associated with relatively stability for the value of its currency. The euro, both against the U.S. dollar and in multilateral terms, has experienced dramatic swings, and by some measures, has been the most variable currency in recent years.

196. The remainder of the chapter is organized as follows. Section B recaps major global developments in current accounts and currency markets, highlighting the asymmetric pattern of adjustment. Section C investigates, using GEM, key fundamental drivers that could help explain the uneven pattern of external imbalances and exchange rate movements. Section D explores the implications of an unwinding of these forces on the euro area economy and possible policy implications associated with this or other possible rebalancing scenarios.

B. Recent External Developments

197. Widening and persistent external imbalances have been a prominent feature of the global landscape in recent years, but the pattern of imbalances has not been symmetric. Led by the United States, whose current account deficit increased five-fold from 105 billion dollars in 1995 to over 540 billion dollars in 2003, external imbalances have grown dramatically over the past decade. Interestingly, however, the counterpart, on a net basis, to the massive U.S. deficit was largely found outside the world’s second largest economy—the euro area (Figure 1). In the figure, to ensure adding-up of current accounts consistent with the model described later, the global discrepancy was allocated to the rest of the world’s balance.50 Excluding the global discrepancy, however, would yield a similar uneven adjustment pattern. Moreover, global trade imbalances exhibited a very similar distribution, suggesting that the asymmetry was not simply a statistical artifact.51 In contrast to the experience of the mid-1980s, when a strong dollar and large external deficit in the United States essentially found their counterparts among other G-7 economies, the current external configuration has broadened the list of players. From a stock perspective, this pattern of net borrowing has produced a further divergence in net international indebtedness between the United States and the rest of the world, with, again, the euro area remaining relatively stable.52

Figure 1.
Figure 1.

External Imbalances

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: ECB; WEO, IMF.1/ Billions of U.S. dollars. Rest of the world calculated as residual (includes global discrepancy).2/ ECB concept.3/ Sum of country data.

198. Growing current account imbalances reflect significant shifts in the pattern of saving and investment in the United States and the rest of the world. By definition, the current account imbalance is equal to the difference between national income and expenditure or between national saving and investment. Figure 2 shows the evolution of saving and investment levels (in percent of GDP) in the three regions since the mid-1990s. The 45-degree line represents zero current balance—i.e., where saving equals investment. The vertical or horizontal distance from this line, correspondingly, represents the shortfall or excess of saving relative to investment, where the region below (above) the diagonal represents a current account deficit (surplus). Note that the euro area has remained near balance, while the other two regions experienced widening imbalances, led initially by changes in investment and later by changes in saving.53

Figure 2.
Figure 2.

Saving-Investment Balances, 1995-2003 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: ECB; WEO, IMF.1/ Rest of the world calculated as residual (includes global discrepancy).2/ Sum of country data until 1997; ECB concept after 1997.

199. In currency markets, nominal effective exchange rates—including the multilateral value of the euro—have exhibited substantial swings in recent years. Figure 3 displays multilateral exchange rates—where an increase denotes an appreciation—for the euro area, the United States, and the rest of the world. In the case of the rest of the world, its multilateral rate is derived residually to ensure consistency among exchange rates. Namely, with n currencies, there exists only n-1 independent exchange rates (i.e., nth currency problem). In the case where n equals 3, observing two effective exchange rates is sufficient to determine the third rate based on an “adding-up” constraint (i.e., linear dependence) among multilateral exchange rates.54 As evident from Figure 3—and in contrast to the relative stability of its external position—the euro area’s exchange rate has swung widely, reaching its nadir near end-2000 before steadily regaining its value through a two and a half year-long appreciation.

Figure 3.
Figure 3.

Effective Exchange Rates, 1995 - 2003

(Log levels; January 1995 = 0)

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: IMF Information Notice System and staff estimates.

200. The pattern of exchange rate behavior that emerged in the second half of the sample is materially different; the euro, in effective terms, became the most variable currency. Correlations among effective exchange rates are shown in Table 1. As evident in the table, the euro, on a multilateral basis, has displayed significant negative correlation—i.e., counterpart movements—with the other two currencies.55 In terms of relative volatility, the U.S. and euro area rates are both significantly more variable than the benchmark rate in the rest of the world (normalized to unity). Since 1999, however, the correlation structure among multilateral rates has changed substantially. The effective exchange rate for the rest of the world had a slight positive correlation with the United States’ effective rate and a very strong negative correlation with the euro area’s effective rate. The pattern of relative volatilities also changed dramatically. The euro area had the world’s most variable multilateral exchange rate as relative volatility in the U.S. rate declined sharply.

Table 1.

Correlations Between Effective Exchange Rates

(Log levels; January 1995=0)

article image
Sources: IMF Information Notice System and staff estimates.

201. The properties of multilateral exchange rates derive from the underlying behavior of bilateral exchange rates—particularly those involving the euro. The bilateral rates vis-à-vis the U.S. dollar are shown in Figure 4, where an increase denotes an appreciation for the “home” country—i.e., either the euro area or the rest of the world. Again, the exchange rate for the rest of the world is derived implicitly, given the observed paths for the euro-dollar exchange rate and their respective multilateral rates, and the weights of bilateral rates entering the effective exchange rate baskets. After 1999, note that while the euro continued its slide against the dollar, the rest of the world’s exchange rate with the dollar remained more stable, trading sideways in a narrower range. Greater bilateral exchange rate stability between the dollar and currencies in the rest of the world, in turn, has eliminated the negative correlation between U.S. and RW multilateral rates in Table 1.

Figure 4.
Figure 4.

Exchange Rates versus U.S. dollar, 1995-2003

(Log levels; January 1995 = 0)

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: IMF Information Notice System and staff estimates.

202. Overall, the euro-dollar exchange rate has been 2½ times more volatile than other bilateral exchange rates. Table 2 reports the variance-covariance matrix of bilateral exchange rates; diagonal elements show variances and the off-diagonal elements show covariances—all normalized relative to the variance of the dollar-RW rate. Over the entire sample, the euro-dollar rate was by far the most variable bilateral exchange rate. After 1999, the relative volatility in the euro-dollar and the euro-RW exchange rates were significantly amplified. In effect, the other currencies increasingly moved in tandem against the euro, reflected by the large positive covariance term between the euro-dollar and euro-RW exchange rates. Greater cross-rate stability between the dollar and currencies in the rest of the world, in turn, has allowed the volatility of bilateral exchange rates involving the euro to translate into greater variability in the multilateral exchange rate for the euro area seen in Table 1.

Table 2.

Variance-Covariance Matrix of Bilateral Exchange Rates

(Log levels; January 1995=0)

article image
Sources: IFS and staff estimates.

C. Understanding Recent External Developments and Global Asymmetries

203. To better understand the fundamental forces driving the underlying dynamics, the analysis relies on the macroeconomic framework provided by the IMF’s Global Economic Model. GEM is a dynamic, stochastic general equilibrium (DSGE) model with explicit microfoundations based on the “new open economy macroeconomics” paradigm.56 Replete with nominal and real frictions, the model, suitably calibrated, can produce plausible impulse-response patterns consistent with a broad set of macroeconomic times-series evidence. Following a brief description of the model, the remainder of this section uses the GEM framework to (1) explore possible driving forces behind recent external developments, and (2) investigate possible sources of underlying asymmetries in the global pattern of external adjustment to those shocks.

204. To understand global asymmetries in external adjustment, the use of a threecountry version of the model is crucial. This allows for more than one international counterparty to a given domestic macroeconomic shock. Depending on the nature of interdependence among the three economies, factors influencing asymmetric global adjustment—consistent with recent developments—can then be investigated. The basic structure of the three-country model is described graphically in Figure 5. The relative size of each economy, as in percent of world output, is represented by the figure in and the relative size of the circles in the figure; the United States and the euro area, for example, each comprise roughly one-quarter of the world economy, respectively. The arrows in the figure represent total trade flows—i.e., sum of imports and exports of goods and services—between each pair of trading partners. Trade flows between the United States and the euro area, for example, comprise roughly 1 percent of world GDP. The ratio of total trade flows to economic size provides a measure of trade openness.

Figure 5.
Figure 5.

Three-Country Global Economic Model: Relative Size and Trade Patterns

(In percent of world GDP)

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: DOTS, WEO, ECB and staff estimates.

205. From the U.S. perspective, accelerating productivity and declining risk premia appear to be important drivers behind the macroeconomic developments from the mid-1990s until 2000. Hunt and Rebucci (2003), using a two-country version of GEM, find that a relative increase in total factor productivity in the tradable goods sector combined with a persistent decline in the risk premium—i.e., increased investor appetite—for dollar assets reproduce many of the U.S. stylized facts. Namely, these exogenous drivers account for a strengthening dollar (in both nominal and real terms), an investment-led current account deficit, moderating inflation, and higher U.S. output and consumption growth.57 The channel through which faster productivity growth affects the exchange rate is the familiar Harrod-Samuelson-Balassa (H-B-S) effect. Accelerating productivity alone, however, is insufficient quantitatively to generate the degree of real appreciation in the dollar and the extent of deterioration in the U.S. current account. Consequently, a relative decline in the perceived riskiness of U.S. assets was also incorporated into the Hunt and Rebucci (2003) analysis to explain the remaining “half” of historical trajectories for these external variables.

206. A closer examination of productivity performances in Europe and the United States lends support to the view that a relative acceleration in U.S. total factor productivity (TFP) occurred in the second-half of the 1990s. During a long period of economic catch-up, the euro area experienced faster labor and total factor productivity growth compared to the United States, as income per capita converged toward U.S. levels.58 After the mid-1990s, however, relative productivity growth in the euro area slipped. For the first time during the post-war period, average productivity growth fell below par with the United States. See Table 3. Aggregate TFP growth performance switched from a small differential in favor of the euro area to a ½ percent differential in favor of the United States more recently. This suggests a cumulative gain in relative terms of roughly 4 to 5 percent in the level of U.S. TFP since 1995. If these aggregate gains were concentrated primarily in the tradables sector, the relative gain in TFP at the sectoral level, given the tradables goods share in the overall economy, would be in the range of 10-15 percent.

Table 3.

Income and Productivity Growth

(In percent)

article image
Sources: European Commission, OECD, and staff calculations.

207. Relative productivity developments, however, fall far short of directly accounting for movements in current accounts and exchange rates. Multifactor productivity as the single driver falls short for several reasons. First, though aggregate TFP measures for the rest of the world are not readily available, real GDP and GDP per capita accelerated in the rest of the world in the second half of the 1990s, registering faster concurrent growth than in the other two economies. Prima facie, a 10 or 15 percent relative gain in U.S. productivity thus likely represents an upper bound. Other factors further working in the same direction include:

  • Aggregate versus sectoral productivity developments. Examining sectoral data reveals that a large portion of the aggregate U.S.-euro area productivity differential stems from differences in specific sectors—including, IT-using and non-IT services—some of which have large non-traded components.59 Productivity gains in non-traded goods while reinforcing the positive consumption, investment, and growth effects, would tend to undercut the effects on external variables—i.e., exchange rate appreciation and widening current account deficit.

  • Modest productivity effects on external variables. Lastly, the effects of productivity in standard models on external balances and exchange rates are generally quite modest. See Box 1. Moreover, numerous empirical studies find that nominal exchange rate fluctuations rather internal relative price movements are the major source of real exchange rate variation in the short to medium term.60

Productivity Effects on External Variables: Theory and Evidence

Conventional wisdom posits a roughly proportional relationship between relative prices and productivity. Following De Gregorio, et al (1994) and others, the relationship between the real exchange rate and total factor productivity can be written as:

q^=q^t+(1-α)⁢q^N=q^T+(1-α)⁢[λNλT⁢a^t-a^N](1)

where ʌ denotes percent change, q is the real exchange rate—i.e., the ratio of consumer prices, qT is “external” real exchange rate—i.e., the relative price of tradable goods, qN is the “internal” real exchange rate—i.e., the relative price of non-tradable to tradable goods at home and abroad, aT and aN are respective TFP levels in the traded and non-traded sectors in the home country relative to its partners. Finally, a is the share of tradable goods in consumption; λT and λN are respective labor shares in sectoral output. Assuming PPP holds in traded goods—i.e., q^T is zero, the impact of higher TFP growth in tradables on the CPI-based real exchange rate depends on consumption and labor shares.

Under the same standard assumptions, a unit elastic relationship between qN and relative labor productivities lT, lN obtains directly:

q^N=l^T-l^N,(2)

suggesting a less-than-proportional response in the CPI-real exchange rate q based on equation (1).

Recent empirical studies broadly support these theoretical implications. In a large panel of countries, Lee and Tang (2003), for example, find that labor productivity is positively associated—albeit less than proportionately—with appreciating real exchange rates, but the empirical relation between TFP and relative prices is weaker. Using time-series analysis to examine the dollar-euro real exchange rate, Alquist and Chinn (2002) find an unusually high elasticity (i.e., between 2 and 5) on labor productivity, leading them to conclude that other factors must also be at work. Schnatz, et al (2003) find more plausible elasticities between 1-2, but also conclude that labor productivity cannot account for the majority of movements in the euro-dollar rate.

In GEM, the long-run elasticity on the CPI-based real exchange rate with respect to TFP is typically below one across different parametrizations of the model; see Hunt and Rebucci (2003). Likewise, the current account implications of productivity shocks are also typically small.

208. Financial considerations—modeled here as changes in the risk premium—are also likely to have played an important, if not central, role. As discussed above, the magnitude of observed swings in currencies and current accounts is difficult to attribute directly to productivity. Following others, including Hunt and Rebucci (2003), the analysis thus also relies on relative changes in risk premia on U.S. financial assets to better account for external developments. Specifically, a shock representing a persistent decline in the perceived relative riskiness, or, equivalently, an increase in the relative risk-adjusted return, on U.S. assets is considered. The shock acts to increase investor appetite for U.S. financial instruments, inducing the pattern of net capital flows consistent with Figure 1. This factor can also be viewed as a complementary asset-market component to the increase in relative U.S. productivity.61 This relative shift in risk premia also likely reflects, in part, fallout from the Asian financial crisis in 1997-98. Coupled with expansionary U.S. fiscal policies in later years when domestic investment rates receded, these shocks provides an initial short list of fundamental drivers for the analysis.

209. A first attempt to explain the asymmetric pattern of external adjustment, in response to common external shocks, would begin by investigating underlying differences in economic structures and cross-border linkages. Major considerations that could affect the nature of interdependence among the three economic regions would include the following.

  • Asymmetric size, openness, and trade patterns. Differences in size, openness, and trading relationships between “countries,” summarized in Figure 5, could help determine differences in trade responses. Note that a disproportionately larger share of trade transacts with the rest of the world.

  • Differential exchange rate pass-through behavior. To the extent that pass-through from exchange rates into prices is incomplete, the trade balance may respond more modestly than otherwise.62 Arguments for why euro area pass-through may be lower than in the rest of the world include the following.63

    • The importance of the European destination market and the larger international role of the euro—e.g., as an invoice currency—in the pricing of traded goods suggest that area-wide import and export prices may be more stable in euro currency terms and subject to more “pricing to market.” This argument, however, would apply a fortiori to the U.S. dollar.64

    • Less-differentiated goods—e.g., commodities—with slimmer margins and less pricing to market, typically have higher pass-through and comprise a higher share of trade in the rest of the world.65

    • Lower inflationary environments lead to lower pass-through—i.e., Taylor (2000) hypothesis.66

  • Differences in Foreign Asset Substitutability. From the financial side, the degree of substitutability between home and foreign—specifically, U.S.—assets may differ between the euro area and other countries. In particular, several studies have pointed toward a greater willingness in emerging market economies to hold U.S. assets for a given rate of risk-adjusted return, particularly with respect to official holdings.67 This may reflect, among other things, the more dominant role of the U.S. dollar as a international and “safe-haven” currency. On a related but distinct issue, foreign central banks may also place greater emphasis on exchange rate stability, as suggested by figure 4.68

  • Other possible asymmetric factors. Differences in consumption behavior, reflecting underlying differences in liquidity constraints, substitution elasticities, etc, may also affect external response patterns. Other factors could include the role of initial conditions (e.g., initial net foreign asset position), which have been shown to affect current account dynamics.69

210. Dynamic simulations indicate that differences in relative size and trade patterns help explain uneven adjustment patterns across the three regions. Figure 6 illustrates the effects of a 10 percent increase in U.S. multifactor productivity, a persistent 1 percentage point decline in the risk premium on dollar assets, and a 1 percentage point (of GDP) increase in U.S. fiscal spending. The figure further shows the changing external adjustment patterns in response to these shocks by progressively adding structural elements that affect interdependence among the three economies. As a reference point, the first panel (Figure 6A) begins with a symmetric structure in terms of identical size and trade patterns between countries. Not surprisingly, a symmetric response pattern emerges—i.e., the euro area and rest of the world are equal counterparts to the resultant dollar appreciation and U.S. external deficit. Compared to this counterfactual configuration, the second panel (Figure 6B) shows that empirical trade patterns and relative size differences go some way toward explaining the uneven pattern of external adjustment in U.S. partners. Disproportionately high trade with the rest of the world places it center stage as counterpart to the U.S. deficit. Meanwhile, the similar degree of multilateral exchange rate depreciation remains intact in these two regions.

Figure 6.
Figure 6.

Explaining Asymmetric External Adjustment to Common Shocks

Citation: IMF Staff Country Reports 2004, 235; 10.5089/9781451812954.002.A004

Sources: ECB; WEO, IMF and staff estimates.1/ Deviations from baseline; in percent of GDP.2/ Deviations from baseline; in percent. Increase represents an appreciation.

211. Financial considerations, related to the greater willingness to hold U.S. dollar assets in the rest of the world, also help generate asymmetric responses. Greater willingness by foreigners to hold U.S. financial instruments in the rest of the world sharpen differences in response patterns with the euro area from common external shocks (Figure 6D). Higher substitutability between domestic and foreign assets in the rest of the world induce larger relative shifts in financial flows in response to changes in relative (riskadjusted) rates of return in the United States.70 Differential rates of pass-through also have some role in explaining asymmetric adjustment. Greater local currency price stability and, consequently, lower pass-through in euro area import prices tend to mute the net external trade balance response. The fact, however, that the degree of external adjustment was indeed large in the United States places a limit on the pass-through mechanism in explaining multilateral differences given that U.S. pass-through is also relatively low, if not lower than in Europe.

D. Global Rebalancing Scenarios

212. A reversal in direction, at least in relative terms, of past shocks that have supported the present external alignment would drive an orderly global rebalancing process. Faster productivity growth outside the United States and a reversal in the perceived risk profiles between U.S. and foreign assets would prompt an unwinding of current account imbalances. Specifically, a gradual, persistent increase in TFP growth in tradable goods sector in the euro area and the rest of the world, converging toward U.S. productivity levels, would generate a relative acceleration in output and domestic demand beyond U.S. borders, and, correspondingly, significantly reduce global current account imbalances. See Table 4. A deceleration in U.S. productivity—“falling back to the pack”, combined with rising risk premia on U.S. assets, would also generate a similar reallocation of capital flows but lead to lower U.S. and global growth.

Table 4.

Benign Global Rebalancing Scenario: Implications for the Euro Area1

(Deviation from baseline; in percent)

article image

Table reports the simulated effects of a 7 percent increase in TFP in the euro area and rest of the world, and persistent 0.75 percentage point decline in risk premia on non-dollar assets.

In percentage points.

A - (minus) indicates a depreciation of the euro.

213. Provided that the factors underpinning asymmetric adjustment remain intact, the implications for the euro area’s external balances would be modest, despite the multilateral appreciation in the euro and substantial bilateral appreciation against the dollar. In accord with past events, this rebalancing process would produce significant swings in exchange rates—including in the value of the euro—but without a major realignment in the area’s current account position, reminiscent of the external developments described in section B. The area-wide trade balance, reflecting stronger exchange rates and import growth, registers an initial decline, despite higher productivity in tradable goods production. Nevertheless, the greater boost to area-wide demand, through higher consumption (from higher permanent income) and higher investment (from higher returns to capital), tend to raise euro area output. Macroeconomic policies react to, rather than lead, the rebalancing process. For example, euro area monetary policy—represented by a forward-looking Taylor rule targeting inflation—would ease interest rates to accommodate the disinflationary impulses from the shock.

214. Factors that would complicate the rebalancing process include efforts to limit exchange rate flexibility. Swings in area-wide growth, exchange rates, and the external balance would become more pronounced if either (1) monetary authorities in the rest of the world limited their exchange rate flexibility (vis-à-vis the dollar) during the adjustment process, or (2) their greater willingness to hold U.S. assets dissipated as part of that process.71 Table 5 in the appendix revises the baseline adjustment scenario in the instance where monetary authorities in the rest of the world limited their nominal exchange rate flexibility against the dollar. The policy response would involve a significant monetary easing in the rest of the world and set in motion greater oscillatory (boom-bust) dynamics in domestic activity and external balances across regions. From the area’s perspective, effective euro appreciation would be larger initially due to additional bilateral appreciation against other currencies falling in tandem with the weakening dollar. Deteriorating international competitiveness would hurt the area’s external balance and growth at the outset. Strong growth, higher inflation and real appreciation in the rest of the world, however, would eventually work to reverse these effects.

Table 5.

Limited Exchange Rate Flexibility Scenario: Implications for the Euro Area1

(Deviation from baseline; in percent)

article image

Table reports the simulated effects of the same shocks in Table 4 but with limited exchange rate flexibility in the rest of the world.

In percentage points.

A - (minus) indicates a depreciation of the euro.

215. Greater reliance on exchange rates—led by changes in asset market sentiment—without underlying reallocations in the global pattern of domestic demand and potential output growth, would also present a more challenging situation for the euro area with little effect on global rebalancing. A sharper initial increase in the perceived relative riskiness of U.S. assets—reflecting souring sentiment on the dollar—would lead to sharper currency movements. Without fundamental shifts toward relatively higher domestic demand and potential output growth in U.S. partner countries, however, this narrow adjustment scenario would prove ineffectual in reducing global imbalances, with an effect on the U.S. current account that is de minimis. See Table 6. But the consequences for the euro area would be significant, especially if the euro were to bear the brunt of the currency realignment as markets exited out of the dollar. Note that the overall degree of effective euro appreciation is the same (at annual averages) in Table 4 and Table 6, but the former depicts a broad decline in the dollar compared to a broad advance in the euro in the latter table, producing very different outcomes with respect to global rebalancing. Area-wide monetary policy should ease more aggressively in this latter instance.

E. Concluding Remarks

216. Using the coherent, dynamic framework provided by the IMF’s Global Economic Model, this paper has sought to analyze the macroeconomic implications of global current account rebalancing from the vantage point of the euro area. While this multilateral issue inherently involves many complexities and uncertainties, including the nature of economic interdependence and the underlying shock processes, several general lessons can be drawn.

  • Accounting for asymmetric global adjustment in response to recent shocks, the role of financial factors appears important. The differential impact in partner countries from recent external shocks—represented by accelerating productivity, declining risk premia, and fiscal expansion in the United States—partly reflects differences in relative size and trade patterns. But other factors are also required. The greater willingness on the part of countries in the rest of the world to hold U.S. assets also helps account for differential responses with the euro area.

  • A rebalancing scenario prompted by an unwinding, at least in relative terms, of recent shocks consistent with generating the current external configuration holds the promise of an orderly resolution to global imbalances. If the fundamental forces that appear to have driven recent external developments “operated in reverse,” many positions, including current account imbalances, would unwind. Namely, relative productivity gains and increased investor appetite for financial assets outside the United States could effect a broad-based decline in the value of the dollar and narrow the U.S. external deficit. If the factors that underpin asymmetric adjustment held firm, the implications for the euro area’s current account would be relatively mild. Decelerating productivity in the United States would generate a similar reallocation pattern, other things equal, but lend less support to global growth.

  • An adjustment more narrow in scope—specifically, one entailing excessive reliance on exchange rates to shoulder the burden—would present a more challenging scenario for the euro area and provide little in the way of meaningful global rebalancing. If global adjustment was largely conducted by asset markets—such as souring market sentiment on the dollar—without a supportive underlying reallocation of domestic demand and potential output growth, the implications for the euro area economy could become more disruptive, but the reduction in global imbalances would be minimal. From the area’s perspective, the current account and growth implications would be especially acute if the euro were to bear the brunt of the currency realignment. Limiting exchange rate flexibility in the rest of the world would further exacerbate the adjustment process, leading to a larger swings in domestic and net external demand across regions. Also, if the greater willingness to hold U.S. assets in other countries were to give way, the impact on the euro area would be amplified.

  • From the euro area’s perspective, policies that enhanced potential growth would well position the economy to face the ramifications of global adjustment in current account imbalances. Policies that raised the growth potential of the economy would provide a solid footing for boosting domestic demand, attracting foreign capital, and mitigating the competitiveness implications of a strengthening currency. Supported by an accommodative monetary stance, consistent with the disinflationary impulses in play, this policy mix would help facilitate a more benign resolution to global imbalances from the area’s perspective. If either precipitous changes in market sentiment were to occur, or external factors underpinning asymmetric adjustment were to give way, or exchange rate flexibility elsewhere were to be impeded, a more aggressive easing of area-wide monetary policy would be warranted.

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47

Prepared by Hamid Faruqee.

49

See ECB (2003) for analysis on the euro’s role as an “international currency.”

50

In dollar terms, the global current account discrepancy averaged -$110 billion from 1997-2003, with a peak value of -$175 billion in 2001. Adding-up (i.e., current account summing to zero) thus requires a larger surplus in the rest of the world by these amounts.

51

The global discrepancy for trade balances is opposite in sign, suggesting the rest of the world surplus is larger still when the trade discrepancy is excluded. See Marquez and Workman (2001).

52

Decumulating (accumulating) net external assets are associated with depreciating (appreciating) currencies over the longer term. See Faruqee (1995), Gagnon (1996), Lane and Milesi-Ferretti (2002) for empirical evidence.

53

In 2003, the U.S. external deficit absorbed 10 percent of gross saving in the rest of the world, excluding the euro area. On sustainability assessments of the U.S. external deficit, see for example IMF (2002a, b), Obstfeld and Rogoff (2000) and Mann (2002, 2003).

54

See, for example, Isard and Faruqee (1998).

55

Note that in a two-currency world, by necessity, effective exchange rates would be mirror inverses, and, hence, would have perfect negative correlation of -1. In a three-currency setting, there are (at most) two independent bilateral exchange rates that underpin multilateral rates. Provided that various bilateral rates are not perfectly correlated (i.e., no fixed parities), the correlations between effective rates should be between 0 and -1.

56

See Laxton and Pesenti (2003) for a technical description. See the survey by Lane (2001) on the “NOEM” approach.

57

To better match persistent time profiles, Hunt and Rebucci (2003) also include uncertainty and learning about the underlying shock process. This refinement was omitted but could be added to the present analysis.

58

See Chapter I.

59

See Chapter I.

61

Bonds, but not equities, are traded internationally in the model—omitting the direct effects of stock markets on current accounts seen in other frameworks like Mercereau (2004).

62

See Obstfeld (2002) for a review.

63

In the model, differential pass-through is introduced through the pricing-to-market component and adjustment cost parameters in price-setting.

64

See Bachetta and Van Wincoop (2002), Devereux, Engel and Storgaard (2003) for analytical discussions. See Bekx (1998), Faruqee (2004) for empirical evidence.

65

See Campa and Goldberg (2003), Knetter (1993).

66

See Choudhri and Hakura (2002) for cross-country evidence.

67

See Dooley, Folkerts-Landau, and Garber (2004).

69

See Thoenissen (2003). These issues are left for future research.

70

This effect is introduced in the model by modifying the parameters representing financial frictions on non-resident holdings of foreign assets, affecting the degree of substitutability. See Benigno (2001).

71

See discussion in Eichengreen (2004).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Euro Area Policies: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 235
Publisher:
International Monetary Fund
ISBN:
9781451812954
ISSN:
1934-7685
Pages:
156
DOI:
https://doi.org/10.5089/9781451812954.002

External Imbalances

Saving-Investment Balances, 1995-2003 1/

(In percent of GDP)

Effective Exchange Rates, 1995 - 2003

(Log levels; January 1995 = 0)

Exchange Rates versus U.S. dollar, 1995-2003

(Log levels; January 1995 = 0)

Three-Country Global Economic Model: Relative Size and Trade Patterns

(In percent of world GDP)

Explaining Asymmetric External Adjustment to Common Shocks