Eurozone external adjustment and real exchange rate movements: The role of firm productivity distribution

Filippo di Mauro, Francesco Pappadà, 2 June 2014



A corollary of the Eurozone crisis has been an unusually large current-account surplus for the Eurozone as a whole, resulting from a combination of strong external demand and rapid readjustment of external accounts in the Eurozone countries that had previously accumulated large imbalances.

There is thus renewed interest in analysing drivers and patterns of external rebalancing, which – for Eurozone countries – has the additional dimension of readjustment within the Eurozone itself. The macroeconomic costs of external rebalancing may be divided conceptually into two parts: the decrease in domestic spending and welfare (the primary burden of a transfer), and the real exchange rate depreciation (the secondary burden of a transfer). While there is consensus in the literature on the need for a real exchange rate depreciation to rebalance a current-account deficit, the size of the needed depreciation is subject to more debate.1

In di Mauro and Pappadà (2014), we show that the results of the previous literature must be substantially revised when the country-specific distribution of firm productivity is taken into account. This is particularly important in Europe, as recent firm-level data (ECB CompNet 2014) suggest that firms’ productivity is highly heterogeneous across Eurozone countries and sectors. In particular, the data show that surplus countries such as Germany are characterised by a productivity distribution with a higher mean and substantially fatter tails compared to those of deficit countries such as Spain or Italy (see Figure 1).

Figure 1. Labour productivity distribution

Source: di Mauro and Pappadà (2014).

Conceptual underpinning

In di Mauro and Pappadà (2014), we study the macroeconomic implications of the Eurozone’s external rebalancing in a three-country general equilibrium model with a tradable and a non-tradable sector. In both sectors, firms are heterogeneous in terms of their productivity. The adjustment of the external accounts position of the deficit country is associated with a decrease in its demand for imports, and an increase in the demand for exported goods.

The higher relative demand for tradable goods produced by the deficit country leads to a decrease in the productivity threshold of exporting firms, and a simultaneous increase abroad. The changes in aggregate exports in response to the transfer therefore reflect extensive and intensive adjustments, as the sales of new heterogeneous exporting firms (extensive margin) contribute to the external account adjustment along with the sales (old and new) of existing exporting firms (intensive margin). The thickness of the right tail of the productivity distribution determines the extent to which the extensive margin of trade contributes to the increase in aggregate exports that drives the trade rebalancing. For a given external adjustment, the larger is the contribution of the extensive margin, the lower is the required change in relative prices.

External adjustment and real exchange rate movements

We calibrate our model using a novel firm-level database produced within a research network among European central banks (CompNet). We consider the larger Eurozone countries with external imbalances. In our three-country model, Germany is the surplus country, Spain is the deficit country, and the rest of the world is the third country. We then replace Spain by Italy as the deficit country. In our simulations, we reproduce the actual external adjustment process of Spain and Italy between 2007 and 2013 (the benchmark case), and we construct a counterfactual in which we keep the cross-country differences in the mean of productivity while switching off the differences in terms of productivity dispersion. This counterfactual is meant to capture the hypothetical consequences of the adjustment in a model in which only the differences in average productivity are considered. For both the benchmark and the counterfactual calibration, we compute the real exchange rate adjustment predicted by the model given the observed change in the trade balances of the deficit countries (respectively Spain and Italy) with respect to Germany and the rest of the world between 2007 and 2013.2

Table 1. External account rebalancing, 2007–2013

Source: di Mauro and Pappadà (2014).
Notes: Percentage changes in real exchange rates. A positive number refers to real exchange rate depreciation.

There are two main results:

  • A model that does not consider the differences in productivity dispersion (counterfactual) between surplus and deficit countries within the Eurozone may underestimate the required exchange rate depreciation in deficit countries.
  • Productivity distribution differences across deficit and surplus countries are informative on the extent to which real depreciations can be expected to be an effective source of readjustment.

The extent of the real exchange rate adjustment will also be contingent upon the substitutability of the products exported. As European deficit countries produce goods with lower high-tech content – and are thus subject to greater competition from developing countries – one may argue that the elasticity of substitution of their products is higher. In an extended version of the model, we allow for a higher elasticity of substitution for goods produced by deficit countries. Since Italian and Spanish firms are on average less productive than their German counterparts, a higher elasticity of substitution is detrimental to their exports as the cheaper goods produced by German firms are more attractive for consumers. As a consequence, this further reduces the extent of the extensive margin of trade with Germany and requires a larger real exchange rate depreciation.


In this column, we argue that cross-country differences in firm-level productivity distributions are fundamental to assessing the extent of real exchange rate movements associated with Eurozone external rebalancing. In this respect, our results are related to the literature that studies the impact of firm heterogeneity on productivity drivers. The policy conclusion of this literature is that a wide and skewed distribution of firm productivity provides an opportunity to raise aggregate productivity by inducing resource reallocation toward more productive firms.3 In turn, this would enhance the overall supply response of the economy in the phase of external readjustment, thus reducing the need for real exchange rate adjustment.

Unfortunately, CompNet firm-level data point to a rather unfavourable level and distribution of productivity for deficit countries. The hard implication is that – with such strong productivity heterogeneity persisting – the extent of the real exchange rate adjustment needed for rebalancing is far larger than what would be indicated by a model neglecting this dimension. This, in turn, points to the need to strike a more precise balance between relative price adjustment and other more structural policies.


Bartelsman E, J Haltiwanger, and S Scarpetta (2009), “Measuring and analyzing cross-country differences in firm dynamics”, in T Dunne, J B Jensen, and M J Roberts (eds.), Producer Dynamics: New Evidence from Micro Data, NBER Studies in Income and Wealth: 15–76.

Di Mauro, F and F Pappadà (2014), “Euro area external imbalances and the burden of adjustment”, ECB Working Paper 1681, forthcoming in the Journal of International Money and Finance.

ECB CompNet (2014), “Micro-based evidence of EU competitiveness: the CompNet database”, ECB Working Paper 1634.

Obstfeld, M and K Rogoff (2005), “Global current account imbalances and exchange rate adjustments”, Brookings Papers on Economic Activity, 36(2005-1): 67–146.

Obstfeld, M and K Rogoff (2007), “The unsustainable U.S. current account position revisited”, in R H Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, NBER Conference Report: 339–376.

1 See Obstfeld and Rogoff (2005, 2007) on the US current-account deficit.
2 As shown in the figures in the Appendix, Germany had consistent trade balance surpluses over the past decade, whereas Italy and Spain had trade balance deficits that have been reduced since the beginning of the Great Recession. In 2007, the bilateral trade deficits of Spain and Italy with respect to Germany were both at their highest level.
3 Wider and more skewed distributions of productivity are generally associated with countries and sectors where policies and institutional set-up are conducive to easier reallocation of factors. For more details, see Bartelsman et al. (2009).


Topics: Europe's nations and regions, Exchange rates
Tags: eurozone, exchange rates, exports, imbalances, productivity, rebalancing

Filippo di Mauro
Senior Adviser in the Research Department, European Central Bank; Chairman, CompNet
Postdoctoral Researcher, HEC Lausanne

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