Many analysts and observers have put forward that the euro crisis is a balance-of-payments crisis at least as much as a fiscal crisis (e.g. Carney 2012, Giavazzi and Spaventa 2011, Sinn 2012, Wolf 2011). The issue has gained further relevance with the widening of imbalances among EZ central banks within the Target2 settlement system and has important implications for both the short- and the long-term policy responses (Bornhorst and Mody 2012).
The prevailing view over the first ten years of the Eurozone’s life was that balance of payments would become as irrelevant in the monetary union as it is among regions within a country. Indeed current account adjustments after the crisis have been considerably slower in EZ countries like Greece, Portugal, and Spain than in non-EZ countries like Bulgaria, Latvia, and Estonia.
Private capital flows to southern EZ nations: Were there sudden stops?
Looking at the current account to assess whether there has been a balance-of-payment crisis may be a flawed approach, however, if countries receive significant official capital flows. Instead, we concentrate on private capital inflows to southern Europe (Greece, Italy, Ireland, Portugal, and Spain), using monthly financial account data, net of the changes in TARGET2 balances and of the inflow associated to disbursements under the IMF/EU programmes (the ECB’s Securities Market programme – which represents a third component of official capital inflows – is unfortunately impossible to disaggregate).
Figures 1a-1e show the cumulated private capital inflows as a proportion of the 2007 GDP, starting from the end-2001 net investment position of the country as recorded by Eurostat. All five countries experienced significant private capital inflows from 2002 to 2007-9, followed by unambiguous and rather sudden outflows.
What we are looking for is the ‘sudden and sizable’ reversals of capital flows that are a common feature of balance-of-payments crises in emerging countries – what Calvo (2004) called a “sudden stop” (also see Calvo and Loo-Kung 2008). To assess whether the outflows observed in Figure 1 qualify as a “sudden stop” in a formal sense, we use the methodology introduced by Calvo (2004). By setting the threshold for year-on-year changes in capital flows, the methodology yields a dating of episodes in which the drop in capital flows can be considered of exceptional magnitude. To avoid short-term variation, we also restrict our attention to episodes lasting at least three months.
Figure 1. Cumulated private capital inflows, 2001-11
Figure 2. Episodes of sudden stops, 2007-11
Figure 2 reports for each month the countries found to be in a sudden stop according to this method. Sudden stop episodes seem to be clustered in three periods:
- The global financial crisis with private capital starting to flow out of Greece early in 2008 and leaving Ireland from October (Tornell and Westermann 2011).
- Spring 2010, when the agreement of the IMF/EU programme marked the beginning of a third Greek episode that also triggered an impressive contagion effect affecting Portugal and Ireland.
- End-2011, with a third wave of sudden stops involving Italy1 and Spain – both put under increased scrutiny and pressure by sovereign bond market during the summer – and Portugal.
The role of official financing and TARGET2 debate
The observed private capital outflows have been counteracted by equally sizable public capital inflows, which have taken three forms in the Eurozone:
- EU/IMF assistance programmes;
- provision by the Eurosystem of liquidity to the banking sector (captured by the development of Target balances); and
- ECB purchases of sovereign bonds under the Securities Market programme.
Apart from Greece, in all other countries net new Target liabilities constitute the largest component of official capital inflows. They in turn result, in large part, from the reliance of the countries’ banking sectors on central bank liquidity provision. Since 2008, the five countries have accounted for a disproportionate part of liquidity allocation by the Eurosystem (Figure 3).
Figure 3. Share of countries affected by sudden stops in take-up of central bank liquidity, 2003-11
Public capital substitutes for private
Substitution of private capital inflows by public ones, especially Eurosystem financing, has provided a buffer against the drying up of private liquidity and, to some extent, has helped accommodate persistent current account deficits in a context where capital markets were not willing to accommodate them anymore. Reliance on Eurosystem financing primarily reflects the difficulty of the EZ banking system, which has become more and more reliant on central bank financing (Buiter et al. 2011). Weak banks in distressed countries ended up taking up a disproportionately large part of central bank refinancing and the steady divergence of intra-Eurosystem net balances are the mirror image of such an uneven redistribution of central bank liquidity.
Rather than focusing on Target2 imbalances per se, more attention should be devoted to curing their underlying causes. The proximate cause the Eurosystem can tackle is high demand for liquidity by weak banks, against collateral of declining quality. A tightening of the quality of required collateral is likely to reduce Target imbalances without hampering the functioning of the Eurozone, but such an option can only be contemplated if banks are adequately recapitalised and if the threat of a vicious circle of bank and sovereign insolvency is removed. This, in turn, requires that underlying factors that contribute to bank weakness are addressed:
- Bad loans on the balance sheets of banks must be provisioned and recapitalisation must take place wherever needed.
- Public finances must be made convincingly sustainable.
- On the macro front, persistent current account deficits can also be tackled through the “Excessive Imbalances Procedure” recently adopted as part of the Six-Pack legislation.
Private capital flows will only return after the disease has been addressed.
For the longer run, the evidence that the Eurozone has been subject to internal balance-of-payment crises should be taken as a strong signal of weakness and as an invitation to reform its structures.
- Contrary to common beliefs, a monetary union of this sort is closer to a fixed exchange rate system among independent countries than to a fully integrated economy, and any action casting doubt on the willingness to let capital flow freely and unlimitedly within the area would offer a dangerous target to speculation.
- The fostering of a pan-European banking industry and the creation of a banking union with centralised supervision and access to resources to recapitalise weak financial institutions should feature high on the policy agenda.
Only a closer integration of markets and policies will preserve the Eurozone from the risk of further attacks.
Authors' note: This column is based on the Bruegel Policy Contribution "Suddent Sops in the Euro Area", available at http://www.bruegel.org/publications/publication-detail/publication/718-sudden-stops-in-the-euro-area/
Bornhorst, Fabian and Ashoka Mody (2012) “TARGET imbalances: Financing the capital-account reversal in Europe”, VoxEU.org, 7 March 2012.
Buiter, Willem, Juergen Michels, and Ebrahim Rahbari (2011), “Making sense of Target imbalances”, VoxEU.org, 6 September
Calvo, Guillermo and Rudy Loo-Kung (2008), “Rapid and large liquidity funding for emerging markets”, VoxEU.org, 10 December
Carney, Mark (2012), "Remarks at the World Economic Forum", 28 January
Giavazzi, Francesco and Luigi Spaventa (2011), "Why the current account may matter in a monetary union: lessons from the financial crisis in the euro area", CEPR Discussion Paper No. 8008.
Sinn, Hans-Werner (ed) (2012), "The European balance of payment crisis", CESifo Forum volume 13.
Tornell, Aaron and Frank Westermann (2011), “Greece: The sudden stop that wasn’t”, VoxEU.org, 28 September.
Wolf, Martin (2011), "Merkozy failed to save the Eurozone", Financial Times, 6 December.
1 As in the case of Greece, the observation of October 2011 would not satisfy the criterion, but the y-on-y positive change is very small and followed by two observations below the second threshold, so we include it in the sudden stop.