Current account imbalances in the euro area

1. Current Account Imbalances in
the euro area:
Catching up or competitiveness?
Ansgar Belke, University of Duisburg-Essen, DIW
Berlin and IZA Bonn
Christian Dreger, University of Frankfurt/Oder and
DIW Berlin
(2011)

2. Introduction and stylized facts
In the debate over the global imbalances the euro area has not
been investigated properly, differently from the case of the U.S.
• The U.S. accumulated large external deficits until the Great
Recession of 2008-09 while Asian countries realized big current
account surpluses
• The euro area kept a current account balance at the aggregate
level; however there are huge disparities across member states

3. Introduction and stylized facts
Countries like Spain, Greece and Portugal accumulated current
account deficits;
On the contrary, Germany and Netherlands experienced huge
surpluses
With the financial crisis, the imbalances have been reduced, but
as the economic conditions normalize they are expected to pick
up again
Public finances have also deteriorated, particularly in high deficit
countries

4. Introduction and stylized facts
Current account dynamics can be decomposed in catching up and
competitiveness factors:
Catching up: imbalances can reflect a convergence process among
countries with different gdp per capita.
Full balance not optimal in the short run: countries with lower gdp
per capita will seek to attract foreign capital due to future growth
perspectives. Viceversa for high income countries.
Moreover, with a greater financial integration, the elimination of
exchange rate risk and the lower interest rates might have boosted
investment/saving.

5. Introduction and stylized facts
Competitiveness: real exchange rate appreciations will redirect
demand from domestic to foreign goods. Deficit countries may have
become less competitive because domestic prices increased more
than foreign prices.
 Balassa-Samuelson hypothesis: increases in overall price level and
real exchange rate expected for deficit countries.
 Excessive nominal wage growth: excessive deficits because of
overheating problems due to overly optimistic expectations and/or
asset prices booms.
Governments can be forced to depreciate real exchange rate via
deflation policies, with adverse effects on the catching up process.

6. Introduction and stylized facts
This paper explores to which extent the euro area imbalances can be
traced back to catching up and competitiveness factors.
Panel integration and cointegration techniques are used, given the
presence of stochastic trends in the data.
After a review of the determinants of current account positions
according to the previous literature, it will be shown the econometric
methods used in the analysis and the empirical evidence drawn from
the data.

7. Determinants of current account
positions
The determinants of the current account position are selected from
the variables that have an impact on investment and saving decisions.
Typical regressions can include (Lee, Milesi-Feretti, Ostry, Prati and
Ricci, 2008):
• income per capita and income perspectives
• fiscal balance
• population growth
• old-age dependency ratios
• stock of net foreign assets
• real interest rate
• variables about institutional framework

8. Determinants of current account
positions
Real exchange rate captures the competitiveness channel. It influences
the foreign trade balance via the effects on import/export as well as
the return of domestic and foreign assets.
 Population growth and old-age dependency ratios are expected to
lower current account because of their adverse impact on saving.
 A restrictive fiscal policy will raise national savings and current
account balance, if not offset by a fall in private saving.
 Higher net foreign assets will raise current account balance, as they
increase net investment income balances.

9. Determinants of current account
positions
Higher growth opportunities (a lower relative per capita income)
and a real exchange rate appreciation should lower current account.
Higher social spending and welfare protection will reduce saving
rate and deteriorate current account balance.

10. Empirical literature
Current account imbalances in a global setting: Chinn and Prasad
(2003), Gruber and Kamin (2007), Bracke, Bussière, Fidora and Straub
(2008) and Lee, Milesi-Feretti, Ostry, Prati and Ricci (2008)
Current account imbalances in the euro area: Blanchard and Giavazzi
(2002) pointed out how with more integrated markets national
investment and saving appear to be increasingly uncorrelated.
Holinski, Kool and Muysken (2010) have argued that the imbalances
are actually caused by the behaviour of the private sector.
Arghyrou and Chortareas (2008) the real exchange rate affects the
current account position in most euro area member states.

11. Overall, a “great ratio” of the three most important variables to focus
on seems to be
 Current account balances
 A catching up variable
A measure for competitiveness
Other potential variables are not included in this setting because of
some caveats to their use within a cointegration framework and
because they are absorbed by the catching up and/or competitiveness
variables, at least in part.

12. Panel econometric methods
All variables are characterized by stochastic trends, therefore it
appropriate to use cointegration analysis. Since time series are
enriched by the cross section, inference relies on a bigger information
set.
Cointegration tests and panel unit root are based on the assumption of
independent panel members: this is rejected in the data.
Panel integration and cointegration tests that control for these
dependencies via a common factor structure will be used.

13. Panel econometric methods
CADF test (Cross-sectionally Augmented Dickey Fuller test) by
Pesaran (2007): the traditional ADF equation is extended with crosssection averages of lagged levels and first differences of the individual
series.
Regression is run for each panel member separately. To test for the
presence of a unit root, is it analyzed the t-ratio of the first order
autoregressive parameter.
To built a panel statistic, the t-values are pooled across individuals. A
standardized version of the test is asymptotically distributed as a
standard normal under the joint null hypothesis of non stationarity for
all individuals.
If the null is rejected, the series is stationary for at least one panel
member.

14. Panel econometric methods
To examine cointegration, panel and group mean statistics suggested
by Westerlund (2007) are applied.
The principle is to evaluate the null hypothesis of no cointegration by
inferring whether the feedback parameter in a conditional panel errorcorrection model is equal to zero.
If null is rejected, cointegration holds for all units in case of the panel
statistics and at least for one individual in the group statistics.
The tests behave asymptotically as standard normal. However, because
cross-section are not independent, critical values are obtained by
bootstrap methods.

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

17. Data and empirical results
Two main events are crucial in the overall evolution:
• The introduction of the common currency in 1999 that has
fostered financial market integration and the ability to run
huge and persistent imbalances.
• The second factor is the Eastern enlargement of the EU in
2004. For example, Germany has tighter relationships to
Eastern Europe than other euro area members.

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

19. Tests for cointegration

20. Tests for cointegration
Where Gτ and Gα are the group mean statistics and αi is the estimated
error correction parameter (Westerlund, 2008):
And Pτ and Pα are the panel statistics with the common error
correction parameter α and its standard error.

21. Tests for cointegration
The imbalances
determinants.
are
cointegrated
with
their
potential
Both determinants are required to ensure cointegration.
Thus, it exists an equilibrium relationship between the current
account positions, catching up and competitiveness factors.

22. (rgdp)
(rer)
As expected, the current account of a euro area member country
improves if the per capita income increases relative to the euro area.
• If the relative real exchange rate appreciates, the current account
will worsen.
• Competitiveness appears to be more important in driving the
external imbalances than the catching up component.

25. Interpretation
The significance of the catching up effect diminishes for the whole
panel, while the role of competitiveness is confirmed. Therefore, the
imbalances are increasingly related to changes in the real exchange
rate. The decline of the relevance of relative per capita incomes is be
cause of its insignificance for the deficit countries.
For the surplus countries and the states with relatively low imbalances,
the income effect is still more important than the effective real
exchange rate.
In contrast, competitiveness is of primary relevance for the deficit
states.
A rationale for this finding is that countries with huge surpluses like
Germany have particularly benefitted from the integration of markets
into the world economy.

26. Conclusions
In this paper, the imbalances are traced to catching up and
competitiveness factors using paneleconometric techniques.
In line with the inter-temporal approach to the current account, low
income countries tend to run deficits, while rich countries realize
surpluses.
However, the effect decreases, if early years are dropped from the
sample.
The competitiveness channel is more robust and shows the expected
sign: a real appreciation leads to external deficits.

27. Conclusions
To restore competitiveness, a reduction of unit labour costs is on the
agenda.
Since a deterioration of competitiveness is not a feasible strategy for
the surplus countries, an asymmetric response across countries is
required in order to reduce the imbalances.
Fiscal consolidation remains on the agenda for all member states.