Euro Area Policies: Selected Issues

International Monetary Fund. European Dept.

doi:10.5089/9781484347850.002.A002

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Euro Area Policies: Selected Issues

Author: International Monetary Fund. European Dept.

Publication Date:: 25 Jul 2013

eISBN:: 9781484347850

Language:: English

Keywords:: ISCR; CR; bank; export; euro; lending; aggregate export price deflator; area economy; GDP Deflators of trading partners; periphery country; area demand; Price adjustments; Current account; Labor costs; Global

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This Selected Issues paper on Euro Area Policies 2013 Article IV Consultation highlights the monetary transmission mechanism and monetary policies. The European Central Bank has announced the Outright Monetary Transactions framework to address severe distortions in sovereign bond markets and safeguard monetary transmission. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads. Weak growth and high levels of private balance sheet debt in the periphery are weighing on the health of bank balance sheets.

Abstract

Rebalancing the Euro Area: where do we Stand and where to Go?¹

Relative price adjustments and current account improvements are taking place. But more needs to be achieved to correct the imbalances within the euro area. 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. Going forward, converging to net foreign asset positions considered safe elsewhere will prove challenging.

A. Introduction

1. Background: Intra-euro area imbalances have been a key feature of the euro area, reflecting deteriorating competitiveness and domestic demand booms in some euro area economies (Greece, Ireland, Portugal, and Spain) and rising external surpluses in export-oriented economies (Germany, Netherlands) in the run-up to the crisis. Extensive collective efforts—such as the European Stability Mechanism (ESM), OMTs, and Banking Union—have helped restore the stability of the common currency area. But 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.

2. What does rebalancing mean? Even before the crisis, there were significant structural differences amount EMU members, including in labor markets, productivity, production structure, competitiveness and specialization (Eichengreen, 2007). While there were few signs of convergence in the structure and performance of euro area economies, demand booms associated with intra-euro area capital inflows and the loss of export competitiveness in the periphery contributed to the accumulation of very large net foreign asset liabilities in these economies. Meanwhile, the core accumulated sizeable surpluses. Those have largely remained since the crisis, while current account deficits in the periphery economies have narrowed significantly. But it is an open question as to what extent the narrowing of current accounts in deficit countries reflects depressed demand domestically or more structural developments. 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.

3. Objectives: This note takes stock of the extent of the external adjustment in euro area countries; examines a battery of price and non-price indicators; analyzes the determinants of recent export performance and current account adjustments; and discusses the remaining gaps and expected path of adjustment going forward, as well as some policy implications.

4. Key findings: Current account reversals and unit labor cost adjustments have been significant in the euro area periphery since the crisis, owing to both cyclical and structural factors. However, there is limited evidence of resource re-allocation from non-tradable to tradable sectors. 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) to converge to sustainable levels of net foreign liabilities could prove very challenging. Structural reforms will play an important role in the reallocation of resources to the tradable sector and associated relative price adjustment, while boosting non-price and price competitiveness. By focusing also on non-price competitiveness, structural reforms would improve overall productivity and trend growth without unduly weighing on domestic demand.

B. How much Adjustment has Occurred?

5. Adjustment in external balances: Euro area periphery countries have experienced large current account adjustments since the crisis (text figure and Panel 1). Between 2008 and 2012, the current account balance 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 have significantly contributed to the reversal of the euro area current account balance, which reached 1.2 percent of GDP in 2012, the largest surplus since 2000.

6. Drivers: The current account reversals in the deficit 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, exports had a larger contribution to the current account improvement than the decline in imports. In Ireland, the rebound of exports was associated with a rise of imports, likely as a result of the large import content of exports.

7. Relative price adjustments: The adjustment in relative prices has proceeded, although to a varying degree across different measures of cost competitiveness (Figure 1).

Real effective exchange rates. Most periphery countries have experienced large ULC-REER depreciations since 2008. While Germany’s REER has remained on a downward trend since the inception of the euro, REERs of periphery euro area countries are now close to their long-term average or back at the level that prevailed at the inception of the euro, mostly as a result of large declines of ULCs. On the other hand, CPI-based REER have generally adjusted less since the start of the crisis.
Unit labor costs. Since 2008 there have been large corrections of ULCs in the periphery (Ireland, Spain, Greece, and Portugal), while unit labor costs have started to increase in Germany (ECB 2012). In France and Italy, ULCs have continued to rise on their pre-crisis trend. Sectoral evidence suggests that unit labor costs have fallen across sectors, and the decline has often been larger in tradable sectors than in non-tradable sectors, except in Italy, France and Germany (Box 1).
Relative price adjustments vis-à-vis euro area trading partners and the rest of the world. Consumer price adjustments have been relatively modest, perhaps as a result of VAT hikes. They were mostly achieved vis-à-vis non-euro area trading partners (with the exception of Ireland which exhibit large consumer price adjustments). Greece, Italy and Spain experienced an increase in consumer prices relative to their euro area trading partners. However, since CPIs are not always a good measure of relative production costs, we also consider a GDP deflator-based REER.² In contrast to CPIs, relative GDP deflators have declined substantially in Spain, Greece, Ireland and Portugal, in particular vis-à-vis non-euro area trading partners.
Wages. Since 2008, wages have declined in many periphery countries relative to the euro area average. The adjustments have been particularly important in Ireland, Greece or Portugal. Manufacturing wages declined the most in Ireland and Greece and grew at a similar pace as the euro area average in other periphery countries.

8. Drivers of ULC reversals: 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 (negative value means increasing output and negative contribution to ULCs).³ ULCs have corrected in the periphery since 2008, although the sources of reversals have varied across countries.

In Spain, productivity gains were achieved largely through labor shedding exceeding 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 evidences of good relative price adjustment, e.g., labor costs came down along with labor shedding, in the context of a moderate growth recovery.
In Greece and Portugal, combinations of wage declines and large labor shedding were the main drivers of ULC adjustments.
Meanwhile, in Germany, labor costs rose mainly because of higher wages, but its effect on ULC was mitigated by relatively strong output growth.
At the sectoral level, periphery countries experienced large declines in tradable sectors ULC, with the exception of Italy. However, the decline was mostly driven by large labor productivity gains, as reductions in employment exceeded the decline in output. Ireland is the exception, as tradable output also expanded (Box 1).

9. Export performance: Evidence suggests that labor cost adjustments have modestly improved price competitiveness.

Volumes. Export growth picked up significantly after the crisis, mostly as a result of a rebound in external demand (section III). Germany, Ireland and Spain experienced relatively solid export recoveries. But export recoveries have been (and are forecasted to remain) weak in Italy, Greece, Portugal, and France.
Export prices. Substantial unit labor cost and wage adjustments have not been followed by gains in price competitiveness.⁴ In Greece, Ireland, Portugal, and to some extent in Spain, the margins of exporters have risen since the crisis. This could be because exporters have attempted to increase profitability, reversing the pre-crisis trends of margin erosion. By contrast, the erosion of exporters’ margins in Italy and France has continued since the crisis. In Germany, exporters increased 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 Spain, Ireland, and to some extent in Germany, but it has declined in Greece and Portugal, and has remained stable in France and Italy.
Non-price competitiveness. Indicators of market shares suggest that in general, competitiveness on that front has not improved since the crisis. Most euro area countries (including periphery countries, but also core countries) have lost market shares in the world market. This loss in world market shares could be explained by unrelated global developments in world trade, such as growing trade among emerging markets. However, several euro area countries, including Italy, Ireland, France and Germany, have also lost market shares within the euro area since the crisis. By contrast, market shares of Greece and Portugal or Spain have remained stable.

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

11. Adjustment across sectors: There is only limited evidence that adjustment between tradable and non-tradable sectors has so far taken place.⁵

Both price and quantity adjustments are needed. To rebalance, periphery countries must reallocate resources from non-tradable sectors to tradable sectors; such a reallocation must be associated with a decline in the price of non-tradable 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 non tradable 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.
But adjustments have yet to take hold in the tradable sector. ULCs have declined both in tradable and non-tradable sectors. In addition, export margins have increased in several countries with declining labor shares,⁶ making these sectors in principle more attractive for producers. But, as a result, exports prices have not adjusted much compared to 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 non-tradable), 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. Evidence from bank credit in Ireland and Spain suggests however a sharper decline in the non-tradable sectors and recent data point to a pick-up of credit in the tradable sector.

C. What Explains the Performance of Exports since the Start of the Crisis?

12. Empirical analysis: We analyze 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:

\begin{matrix} \log {Export}_{ijt} = α \cdot \log {Demand}_{jt} + β_{nonEA} \cdot \log {NER}_{ijt} + γ \cdot \log Rel . {CPI}_{ijt} + ε_{ijt} & (1) \end{matrix}

where 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 CPI between euro area country i and trading partner j.⁷

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

\begin{matrix} Δ \log ExportG & S_{it} = \\ α \cdot ({Share}_{EA}) \cdot Δ \log ({Demand}_{{EA}_{it}}) + α \cdot ({Share}_{nonEA}) \cdot Δ \log ({Demand}_{{nonEA}_{it}}) + β_{nonEA} \cdot \\ ({Share}_{nonEA}) \cdot \log {NEER}_{ijt} + γ \cdot ({Share}_{nonEA}) \cdot \log nonEARel . {CPI}_{ijt} + γ \cdot ({Share}_{EA}) \cdot \\ \log EARel . {CPI}_{ijt} + RES & (2) \end{matrix}

Where:

- Share_EA is the share of euro area countries in total exports of goods
- Share_nonEA is the share of non-euro area countries in total exports of goods
- Demand_{EA_it} is a quarterly weighted average of euro area trading partners domestic demand where trade weights are the shares of bilateral exports to country i in total exports of goods to the euro area.
- Demand_{nonEA_it} is a quarterly weighted average of non-euro area trading partners domestic demand where trade weights are the shares of bilateral exports to country i in total exports of goods to the euro area.
- NEER_ijt is the nominal effective exchange rate.
- RES is the residual.

14. Export demand: Since the start of the crisis, euro area countries have experienced significant differences in the demand for their export. For example, between 2008 and 2012, total trading partners’ demand for Germany’s export grew by 4.7 percent, compared to 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. These differences reflect the country’s initial geographical specialization. Germany’s relatively large share of exports outside the euro area and in fast growing emerging markets contributed to relatively stronger rebound in exports. In contrast, export demand growth was more sluggish in periphery countries as a result of either specialization in slower growing markets outside the euro area (Italy and especially Greece) or lower share 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.

15. Determinants of export performance: 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).

Initial trade specialization is important. It helps understand 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 relatively stronger rebound in exports, and made its export performance less dependent on intra-euro area demand than that of Southern EA countries. In the case of Greece, specialization in slow-growing markets has constrained export growth.
Demand from the rest of the world is the main pull factor. It contributed to 47 percent and 42 percent of the relatively strong rebound of Germany’s and Spain exports, and to 80 percent of France’s exports. 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 there is uncertainty about the precise effect. When measured with CPIs, relative price adjustments (vis-à-vis euro area trading partners or others) appear to have had a small effect on the exports of the periphery, France, and Germany. Although the small contributions of relative prices are partly a result of the relatively small elasticity of exports to relative prices, the impact also depends on the relative price considered. As demonstrated in Section II, CPI adjustments have been relatively small (either relative to euro area trading partners or relative to non euro area trading partners), although relative price adjustments as measured by GDP deflators have been more substantial.⁸ In this case, the contribution to export performance of GDP deflator adjustments was large for Germany, Spain and Portugal. For the latter two countries, the changes in relative prices account for 20 and 35 percent of real exports growth 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, 17 percent and 28 percent of the exports of Germany, Spain, and Portugal.
Weak euro area demand was a drag. The euro area crisis had a direct impact on the export performance of euro area countries, as 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. The export performance of Greece was significantly weaker than predicted by the developments of 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 non-price competitiveness) or a substantial loss in non-price competitiveness. In contrast, in Spain, Portugal, and Germany, the unexplained residual is relatively large and positive, suggesting that non price factors could have helped support export performance.

D. External Adjustment: Cyclical or Structural?

16. Nature of adjustment: A key remaining question is whether recent current account adjustments reflect cyclical or structural factors, or a mixture of both.

17. Regression analysis: Panel regression analysis allows us to assess the contribution of structural and cyclical factors to the evolution of current accounts. Our approach builds on the existing literature, based on the standard inter-temporal approach to the current account emphasizing saving and investment decisions (Chinn and Prasad (2003), Lee and al. (2008), Christiansen et al. (2009)). In particular, we follow the method used in the IMF’s 2012 External Balance Assessment (EBA) analysis of 50 AEs and EMs, with the period coverage extended to 1986-2012. The standard fundamental determinants of savings and investment decisions include: (i) demographics (population growth; old age dependency ratio; and aging speed); (ii) initial wealth (lagged NFA); (iii) long-term growth and neoclassical catch-up (five-year ahead real GDP growth and gap to US GDP per capita); (iv) other structural factors (cyclically adjusted fiscal balance, public health spending);⁹ and cyclical factors (output gap, global capital market conditions, commodity terms of trade).

18. Potential output: 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 going forward (and thus exceeds 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 inter-temporal effect of changes in productivity growth (case (A)), but not the effect of changes in productivity levels (case (B) on the chart). The gap relative to the US GDP per capita level captures the neoclassical convergence term, which has the opposite effect on the current account (e.g., a lower GDP per capita relative to the US results in a lower current account balance). Therefore, it is not well suited to capture the impact of an unexpected drop in potential output. We include as additional explanatory variable the PPP potential output level per capita relative to the world average to account for this effect.

19. “Periphery factors”: We also account for common factors underlying the evolution of external balances in the euro area periphery 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 countries in the periphery of the euro area 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 EMU.¹⁰ These factors led to a surge of intra-euro area capital flows, contributing to domestic asset bubbles and worsening external positions.¹¹ In the aftermath of the crisis (and particularly since 2011), the periphery of the euro area has 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, we include time effects in the regression that are common to all periphery countries.

20. Findings: The empirical results suggest that both cyclical and structural factors have contributed to the recent improvement in current account balances (appendix table).¹² 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, etc.) has generally been more modest.¹³ However, “periphery 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 (e.g., Italy).

E. The Adjustment Going Forward

21. Additional adjustment: Further adjustment in relative prices would be needed to complete the adjustment (based on current account or REER targets). According to the forthcoming 2013 IMF External Sector Report, additional adjustment of real exchange rates by 5-10 percent is desirable for the GIIPS.

22. Structural adjustment: 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. More specifically,

Re-allocation of labor to traded sectors. The reallocation of labor from non-traded to traded sectors has not occurred so far (section II). As the recession lingers in the periphery, human capital and potential output are lost, making structural adjustment even more difficult to achieve when relative prices start adjusting.
Moving up the value chain. Countries of the periphery produce goods that are closer substitutes of goods produced by fast-growing emerging market economies (such as China), hence facing additional structural challenges to their external rebalancing (Figure 4). Evidence from Trade Correlation Index (TCI) suggests that this is the case for several euro area members (Italy, Portugal, Slovakia, Slovenia, and Spain), e.g., a relatively high correlation of the composition of a country’s merchandise exports with China.¹⁴ This means that internal devaluation in these countries (relative to other euro area countries) would help export competitiveness only to a limited extent, since competitiveness gains 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 (a third of world market share) and most euro area members have relatively higher service export ratios, in particular Greece (tourism and transport) and Ireland (Insurance and IT). Some service 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 service exports are more sensitive to non-price factors (labor and product market regulations or other regulations such as taxes) (Figure 5).
Structural reforms. While relative price adjustment is important to rebalance and enhance competitiveness, it may be insufficient to fully eliminate the external deficits and reverse the net external position, given the weak demand in the euro area. In this regard, pursuing structural reforms effectively at the national level would not only help in the long run, but can also help maximize the benefits of recent policy actions in the euro area to spur growth. Indeed, staff analysis of the impact of non-price indicators on export performance since the crisis suggests that, after accounting for external demand and real effective exchange rates, lower business costs or lower employment protection are associated with stronger export growth (text box). Meanwhile, increasing productivity in non-tradable sectors in surplus economies, 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.

Text Box: The Role of Non-price 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

Δ x_{t} = α μ_{t} + β Δ (P_{t} / P_{t}^{*}) + δ y_{t} + ε,

where export growth is a function of relative prices (expect β to be negative) and external demand y_t, with μt capturing non-price factors such as costs of doing business, regulatory compliance, etc.

Panel regressions are performed over 2008-2012 for 13 euro area economies using a combination of 23 measures of non-price indicators chosen from (i) the World Bank: costs of starting a business; costs of enforcing contracts and costs of insolvency; (ii) the OECD: levels of regulation (PMR); employment protection (EPL); state control; barriers to entry and entrepreneurship; trade and investment.

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 non cost indicators, two stand out: lower business cost and lower employment protection come out positively as factors explaining export growth. Other non-price costs are generally less significant, but their importance for long-term adjustment may not be well captured given the post-crisis period considered.

Table 1.

Euro area economies export regressions: selected results

^{^1/}Selected variables are listed.

Source: IMF Staff estimations.

Table 1.

Euro area economies export regressions: selected results

Dependent variable: real export growth Specification ^1/	Unrestricted Panel				Quantile
External demand	0.97	0.94	0.98	1.01	1.01
	(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)
R²	0.79	0.77	0.82	0.80	0.56
Obs	70	70	70	126	70

^{^1/}Selected variables are listed.

Source: IMF Staff estimations.

Table 1.

Euro area economies export regressions: selected results

Dependent variable: real export growth Specification ^1/	Unrestricted Panel				Quantile
External demand	0.97	0.94	0.98	1.01	1.01
	(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)
R²	0.79	0.77	0.82	0.80	0.56
Obs	70	70	70	126	70

^{^1/}Selected variables are listed.

Source: IMF Staff estimations.

23. Reducing external liabilities: Going forward, 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 unit labor costs appreciations or to achieve current account surpluses.

Outlook. Under the baseline WEO projections, and assuming no valuation effects, the NFA positions of Greece, Ireland, Portugal, and Spain will remain below -80 percent by 2018. Moreover, to undo half of the worsening of the NFA during 2000-12, it will take respectively 15 years for Greece, 11 years for Ireland, 37 years for Portugal and 12 years for Spain under the current baseline. Reaching the EU Commission scoreboard threshold (of -35 percent of GDP) will take even longer. In contrast, for Germany, the NFA is expected to continue growing under the current baseline.

Table 2.

NFA Positions in the Core and Periphery: Projected Adjustments

Notes:

^{^1/}2011 instead of 2012;

^{^2/}Implied by WEO projections, assuming no valuation effects;

^{^3/}Assuming constant real GDP growth, inflation and current account balance from 2018 onward;

^{^4/}European Commission Macroeconomic Imbalance Procedure scoreboard target of -35 percent of GDP.

Table 2.

NFA Positions in the Core and Periphery: Projected Adjustments

	NFA/GDP 2000	NFA/GDP 2012	NFA/GDP 2018^2/	Numbers of years to:
	NFA/GDP 2000	NFA/GDP 2012	NFA/GDP 2018^2/	Reverse half of 2000-12 decline of the NFA /GDP ^3/	Reach EC scoreboard threshold^3/4/
France ^1/	18	-15	-20	.	.
Germany	3	42	75	.	.
Greece	-39	-117	-105	15	32
Ireland	-8	-98	-71	11	18
Italy	-13	-25	-25	.	.
Portugal	-38	-120	-121	37	73
Spain	-32	-95	-83	12	20

Notes:

^{^1/}2011 instead of 2012;

^{^2/}Implied by WEO projections, assuming no valuation effects;

^{^3/}Assuming constant real GDP growth, inflation and current account balance from 2018 onward;

^{^4/}European Commission Macroeconomic Imbalance Procedure scoreboard target of -35 percent of GDP.

Table 2.

NFA Positions in the Core and Periphery: Projected Adjustments

	NFA/GDP 2000	NFA/GDP 2012	NFA/GDP 2018^2/	Numbers of years to:
	NFA/GDP 2000	NFA/GDP 2012	NFA/GDP 2018^2/	Reverse half of 2000-12 decline of the NFA /GDP ^3/	Reach EC scoreboard threshold^3/4/
France ^1/	18	-15	-20	.	.
Germany	3	42	75	.	.
Greece	-39	-117	-105	15	32
Ireland	-8	-98	-71	11	18
Italy	-13	-25	-25	.	.
Portugal	-38	-120	-121	37	73
Spain	-32	-95	-83	12	20

Notes:

^{^1/}2011 instead of 2012;

^{^2/}Implied by WEO projections, assuming no valuation effects;

^{^3/}Assuming constant real GDP growth, inflation and current account balance from 2018 onward;

^{^4/}European Commission Macroeconomic Imbalance Procedure scoreboard target of -35 percent of GDP.

F. Concluding Remarks

24. Summary: 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. Going forward, converging to net foreign asset positions considered safe elsewhere will prove challenging.

25. Policies: Further policy actions in both surplus and deficit economies are necessary to rebalance the euro area. Structural policies will improve flexibility and smooth the adjustment process across sectors, including by fostering job creation and access to credit, boost competitiveness and enhance regional integration (by for instance introducing a single labor contract across countries and portable unemployment benefits and pensions).

In surplus economies, increasing productivity in non-tradable 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 deficit economies, continuing structural adjustment would deliver a shift of resources to tradable sectors where consumption booms led to excessive growth in non-tradable sectors in the run-up to the crisis.
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 therefore help support the internal reallocation of resources.

Box. ULC Developments in Tradable and Non-tradable Sectors^1/

Relative price adjustments are taking place in tradable and non-tradable sectors, although it is quite uneven at the national level. In particular,

Several periphery countries experienced large reversal of ULCs in traded goods sector than in non-traded ones, namely Ireland, Portugal, and Greece. However, saving in ULCs are sometimes achieved by large scale labor shedding, e.g., in Greece and Portugal.
Ireland has been a good example of external adjustment, e.g., output in the tradable sectors is now recovering and supporting growth.
Spain has a bigger drop in ULC of its non-traded goods sector and has relatively sticky labor costs. Most of the adjustment is through output loss and unemployment.
Divergence of competitiveness in the large economies: France and Italy’s ULC of tradable trade continues to rise since the crisis, reflecting deterioration of external competitiveness.

^1/Traded sector: manufacturing. Non-traded: construction, whole sale and retail, hotel, transportation. See ECB (2012)

Appendix. 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 DG Statistics http://sdw.ecb.europa.eu/browseExplanation.do?node=2120786

Traded and non-traded sectors

No standard definition can be derived from NACE2 (European Classification of Economic Activities, rev. 2) to have a clear cutoff line between traded and non-traded sectors. This note applied the definition used by an ECB Occasional Paper (ECB 2012) as follows:

Tradeable sector: Manufacturing.

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

Appendix table

Contributions to Current Account Adjustment: 2007-2012

(Percentage of GDP)

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, social spending.

Appendix table

Contributions to Current Account Adjustment: 2007-2012

(Percentage of GDP)

	CA	Cyclical	Demograph	LT development and growth	NFA	Other structural	Potential output	Periphery effect	Unexplained
Greece	10.19	5.13	0.43	-0.11	-0.02	0.25	0.45	3.38	0.69
Ireland	7.63	2.48	0.19	-0.19	-1.49	-0.76	0.58	3.38	3.43
Italy	-0.23	1.48	0.61	0.07	-0.03	0.98	0.45	.	-3.79
Portugal	7.60	0.70	0.33	0.38	0.04	0.15	0.31	3.38	2.31
Spain	8.02	2.14	1.02	0.58	0.04	-0.66	0.33	3.38	1.20
France	-0.73	0.02	-0.17	0.46	-0.61	-0.06	0.36	.	-0.74
Germany	-2.02	-0.53	0.57	0.76	-0.05	0.17	0.19	.	-3.13

Appendix table

Contributions to Current Account Adjustment: 2007-2012

(Percentage of GDP)

	CA	Cyclical	Demograph	LT development and growth	NFA	Other structural	Potential output	Periphery effect	Unexplained
Greece	10.19	5.13	0.43	-0.11	-0.02	0.25	0.45	3.38	0.69
Ireland	7.63	2.48	0.19	-0.19	-1.49	-0.76	0.58	3.38	3.43
Italy	-0.23	1.48	0.61	0.07	-0.03	0.98	0.45	.	-3.79
Portugal	7.60	0.70	0.33	0.38	0.04	0.15	0.31	3.38	2.31
Spain	8.02	2.14	1.02	0.58	0.04	-0.66	0.33	3.38	1.20
France	-0.73	0.02	-0.17	0.46	-0.61	-0.06	0.36	.	-0.74
Germany	-2.02	-0.53	0.57	0.76	-0.05	0.17	0.19	.	-3.13

References

Bems, Rudolfs and Robert C. Johnson, 2012. “Value-Added Exchange Rates,” NBER Working Papers 18498.
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Blanchard, Olivier and Francesco Giavazzi, 2002, “Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle?” Brookings Papers on Economic Activity, vol. 2002, No. 2, pp. 147–186.
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Borio, Claudio, Piti Disyatat and Mikael Juselius, 2013, “Rethinking Potential Output: Embedding Information about the Financial Cycle”, BIS Working Papers No.404, Basel.
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Chen, Ruo, Gian-Maria Milesi-Ferretti and Thierry Tressel, 2012, “External Imbalances in the Euro Area”, IMF Working Paper No. 12/236, Washington DC.
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European Central Bank, 2012, “Competitiveness and External imbalances within the Euro Area”, ECB Occasional Paper No 139, Frankfurt.
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Eichengreen, Barry, 2007, “The Breakup of the Euro Area”, NBER Working Paper 13393, Cambridge, MA
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The G20, “G20 Leaders Declaration”, Las Cabos, Mexico, June 2012.
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International Monetary Fund, Regional Economic Outlook: Europe. May 2011.
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Kang, Joong Shik and Shambaugh C. Jay 2013, “Progress Toward Internal Devaluation in the GIPS and the Baltics,” manuscript, IMF.
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Prepared by Thierry Tressel and Shengzu Wang (EURAE).

GDP deflator based REER are good proxies for value-added REER that reflect the vertical integration of trade. See e.g., Rudolfs Bems & Robert C. Johnson, 2012. “Value-Added Exchange Rates,” NBER Working Papers 18498.

Figure 2 also shows contribution to declining ULCs from its peak for several EA deficit economies.

Some measurement errors could exist since the proxy of export price is the unit export value for goods actually sold, which may not fully capture pricing-to-market behaviors or cover transaction prices.

See Appendix for a definition of traded and non traded sectors.

Labor shares in the 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 the periphery such as Spain, labor share has been declining since the crisis, reflecting both labor shedding and rising profit margins in the tradable sectors.

An alternative analysis (work in progress) uses relative GDP deflators as indicators of relative price adjustment.

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

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

See for instance Blanchard and Giavazzi (2002), Blanchard (2004), and Chen, Milesi-Ferretti and Tressel (2012).

International Monetary Fund, Regional Economic Outlook: Europe. May 2011.

The assessment is based on the output gap and potential output estimates of each WEO vintage. There is an ongoing debate on how potential output and output gap should be estimated in real time, included to better capture financial cycles. See for instance Borio C., Disyatat, P., and M. Juselius, 2013, “Rethinking Potential Output: Embedding Information about the Financial Cycle”, BIS WP 404. Our analysis does not enter in those considerations.

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 CA balance (as the distance to the TFP frontier increases), the decline in potential output has the opposite effect (as consumption falls by the permanent component of the reduction in income). In the case of Greece, the first effect decreases the CA to GDP ratio by 0.11 percentage points, while the second effect increases the CA to GDP ratio by 0.45 percentage points. See appendix table for details.

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

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Euro Area Policies: Selected Issues Paper

Author: International Monetary Fund. European Dept.

Volume/Issue:: Volume 2013: Issue 232

Publisher:: International Monetary Fund

ISBN:: 9781484347850

ISSN:: 1934-7685

Pages:: 72

DOI:: https://doi.org/10.5089/9781484347850.002

Keywords
Rebalancing the Euro Area: where do we Stand and where to Go?1
References

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Euro Area: Contribution to Growth

(Percent)

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EA17: current account and its components

Percentage of GDP

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Contributions to change in current account:

(2008-2012, percentage of GDP)

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Euro Area: Current Account and Its Components

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Relative Price Adjustments Based on CPI, 2008Q3-2012Q4)

(Percent)

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Relative Price Adjustments Based on GDP Deflators, 2008Q3-2012Q4

(Percent)

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Euro Area: REER and ULC Developments

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Annual Wage Inflation: Total Economy

Relative to EA 17

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Annual Wage Inflation: Manufacturing

Relative to EA 17

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ULC Total Economy Growth Relative to EA 17: Since 2008

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Real Exports

(100=2000)

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Change in ratio of export deflator to tradeable ULC

(Goods, in percent)

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Export Prices / GDP Deflators of Trading Partners

(Percent change)

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Change in share of exports to World

(In percentage points)

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Change in share of world exports to euro area

(in percentage points)

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Export Demand Growth, 2008-2012

(Percent)

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Share of Euro Area in Total Exports

(Exports of goods)

(percent)

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Contributions to Changes in Unit Labor Cost

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Determinants of Quarterly Export Performance

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Cumulative Contributions to Export Performance GDP Deflator Based Relative Prices, 2008Q3-2012Q4

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Cumulative Contributions to Export Performance CPI Based Relative Prices, 2008Q3-2012Q4

(Percentage points)

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External Adjustment

Contributions to change of CA 2007-2012

(Percent of GDP)

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Correlation of Trade Specialization Index: 1995 and 2011

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Export shares as pecentage of GDP: 2008-2012

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Service Exports in the Last Decade: Trends and Shares

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Net Foreign Asset Postion

(Percent of GDP)

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Contributions to ULC Changes: 2000-07

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Contributions to ULC Changes: 2008-12

Appendix table

Contributions to Current Account Adjustment: 2007-2012

(Percentage of GDP)

	CA	Cyclical	Demograph	LT development and growth	NFA	Other structural	Potential output	Periphery effect	Unexplained
Greece	10.19	5.13	0.43	-0.11	-0.02	0.25	0.45	3.38	0.69
Ireland	7.63	2.48	0.19	-0.19	-1.49	-0.76	0.58	3.38	3.43
Italy	-0.23	1.48	0.61	0.07	-0.03	0.98	0.45	.	-3.79
Portugal	7.60	0.70	0.33	0.38	0.04	0.15	0.31	3.38	2.31
Spain	8.02	2.14	1.02	0.58	0.04	-0.66	0.33	3.38	1.20
France	-0.73	0.02	-0.17	0.46	-0.61	-0.06	0.36	.	-0.74
Germany	-2.02	-0.53	0.57	0.76	-0.05	0.17	0.19	.	-3.13

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Abstract

Rebalancing the Euro Area: where do we Stand and where to Go?1

A. Introduction

B. How much Adjustment has Occurred?

C. What Explains the Performance of Exports since the Start of the Crisis?

D. External Adjustment: Cyclical or Structural?

E. The Adjustment Going Forward

F. Concluding Remarks

Appendix. Technical Notes

Decomposition of ULC changes

Traded and non-traded sectors

References

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Rebalancing the Euro Area: where do we Stand and where to Go?¹