Current-account deficits are widely acknowledged to have posed significant policy problems in several Eurozone countries.1 Since the onset of the crisis, their adjustment has been associated with sharp contractions in consumption and investment, entailing high economic and social costs. But a deficit in any country requires a surplus in another to finance it. The high deficits in the Eurozone periphery prior to the crisis were matched by high surpluses in 'core' countries, most notably Germany. However, policy debates are particularly confounded as regards the role these surpluses played in the buildup of Eurozone imbalances and whether their reduction may support ongoing rebalancing. This is critical as the shape of the adjustment will also have implications for growth prospects in individual countries and the Eurozone as a whole.
Current-account surpluses: Not a non-issue
Like deficits, surpluses arise naturally from economic interactions between countries. They can simply be the result of an appropriate allocation of consumption and savings across time. However, surpluses, just like deficits, may also reflect misallocations of resources: if surpluses are driven by market distortions or misguided policy interventions, including weaknesses in financial supervision, their reduction could be welfare-enhancing. In addition, surpluses may also be suboptimal from the Eurozone perspective: high surpluses may have spillover effects on partners through an array of financial, trade and other interlinkages.
Financial flows and imbalances in the Eurozone
A recent report by the European Commission (2012),2 to which we contributed together with other colleagues, argues that the accumulation of current-account imbalances in the Eurozone before the crisis is more than simply a story of diverging labour costs and productivity. Much of the widening in surpluses and deficits was driven by the convergence in interest rates after the introduction of the euro. A global decline in interest rates and ample supply of liquidity were accentuated by the financial euro-bias and progress in establishing a single financial market. Improved access to cheap capital stimulated domestic demand in the periphery that outstripped production and thus led to current-account deficits.
Our analysis shows that these deficits were largely financed by the excess savings of the surplus countries, both directly and indirectly. Moreover, the core economies (in particular Germany and France) intermediated large financial flows from non-EU investors to the deficit countries (Figure 1). Most of this financing took the form of debt and was channelled through the bond and inter-bank markets. All this resulted in credit-driven booms, reductions in savings, excessive investment in non-productive activities in the periphery, and excessive risk concentration in the financial systems of the core countries.
Figure 1. Total gross financial flows among groups of countries (bn. euros; average 2004-06)3
Source: European Commission (2012).
The financial interlinkages were particularly strong before the crisis. Simulations based on flows in 2006-07 show that capital exports due to a 1% of GDP increase in savings in Eurozone surplus countries were associated with an increase of net capital imports by 1.8% of GDP in Greece, 0.6% in Spain, 0.5% in Portugal and almost 0.2% in Italy (Figure 2). While these linear simulations do not allow drawing conclusions about the causality between surpluses and deficits, they highlight the importance of financing from surplus countries for funding the current-account deficits in the periphery.
Figure 2. Change in current accounts due to 1% of GDP reduction in S-I gap in surplus countries/DE
Source: European Commission (2012).
The role of financial factors demonstrates that weaknesses in financial surveillance can magnify the risks from cross-border investment. The cost for the creditors has been huge. Germany's cumulated valuation losses on foreign assets and financial derivatives have exceeded EUR 460 billion since 2007 (Figure 3). Much of these staggering losses, which to a large extent accrued to investment in US mortgage-backed securities, affect debt assets and are irrecoverable.4
Figure 3. NIIP vs cumulated financial account balance – Germany
World trade, exchange rates and Eurozone imbalances
In addition, external developments compounded the effects of intra-Eurozone factors (Chen et al. 2012). Rapidly evolving competition from emerging countries, enlargement of the EU or increases in commodity prices were, on the whole, more favourable for the exports and terms of trade of the core EU economies. This was partially due to the product and geographic composition of their exports and stronger non-price competitiveness.
The surpluses coupled with wage and price restraint in the core might also have contributed to a nominal appreciation of the euro. However, there is no clear indication that the euro is currently under- or overvalued. The impact of the euro exchange rate on rebalancing is not straightforward but it is important as increasing shares of both deficits and surpluses are with non-Eurozone (and non-EU) countries.
A dynamic stochastic general equilibrium (DSGE) model-based decomposition of the German trade surpluses confirms that the shock to international financial flows and external shocks were the main driving forces in the build-up of surpluses, while the contribution of wage restraint and labour-market reforms in Germany was much more moderate (Figure 4 and Ratto, M et al. forthcoming).
Figure 4. Decomposition of the trade balance (% of GDP)
Source: European Commission (2012).
Structural weaknesses and current-account surpluses
The global factors and financial integration, nevertheless, leave an important share of past current-account divergence unexplained. Rather than to wage restraint, both the dynamic stochastic general equilibrium and an econometric analyses point to the importance of exogenous increases in savings of households and companies and the associated weak demand in the surplus countries. However, it is not clear whether increased household savings are related to fundamentals such as demographic change5 or whether they represent a decline in consumer confidence. Similarly, it is not entirely clear why higher corporate savings have not induced higher investment.
While relatively rare, existing analyses on the drivers of surpluses point to several structural factors specific to individual economies. For example, there is some evidence that the structure of the German banking system might have made local banks prefer channelling domestic savings abroad rather than extend more credit to domestic residents. Remaining weaknesses in product markets, particularly in services, tend to depress domestic demand and hence imports. Moreover, investment has been remarkably low in non-tradeables, particularly the construction sector.
To the extent that market and policy failures contributed to excessive savings or low investment in the surplus countries, it would be in their self-interest to reduce surpluses, by addressing these weaknesses and removing the obstacles hampering domestic demand. While these structural improvements are desirable in their own right, their positive spillovers on other Eurozone economies could be tangible. Adjustment towards more moderate surpluses would thus be desirable from both national as well as Eurozone perspectives.
The role of surpluses in European rebalancing
The rebalancing in the Eurozone and the EU is ongoing, although most adjustment has taken place in the deficit countries (Buti and Turrini 2012, Figure 5). On a positive note, favourable conditions for stronger domestic demand are broadly in place in most surplus countries, although the existing uncertainty about near growth prospects weighs on investment. The different paces of fiscal consolidation and wage developments between the core and the periphery help in calibrating the contribution to the rebalancing by the core and periphery economies.
Figure 5. Current-account balance in the Eurozone
In view of the links between surpluses and deficits, a more symmetric rebalancing would make the adjustment more sustainable and help reduce its social costs. An increase in demand in the Eurozone surplus countries would improve the trade balance of the peripheral economies, but the impact should not be overestimated. The surplus countries are the main trading partners for the Eurozone deficit countries, but the reverse does not apply. Consequently, the positive effect of an increase in imports of the surplus countries is spread across a number of other economies and benefits mostly those closely interconnected with their supply chains (Irigoyen and Monteagudo 2013).
On the other hand, there is no reason to expect full symmetry in the intra-Eurozone rebalancing. The Eurozone current account does not need to be balanced and, in fact, its structural characteristics suggest it could have a moderate surplus. The EU is a very large, but open economy, with intensive trade and financial interactions with the rest of the world.
All these elements sum up to a cautious 'yes' in response to the question of whether the surpluses in the Eurozone should be reduced. Surpluses are detrimental to the welfare of the population to the extent they are driven by structural weaknesses affecting demand; e.g. in the financial sector, services, or construction. Addressing these issues through structural reforms, while letting wages and prices respond flexibly to market signals, would be welfare-enhancing for the surplus countries. Moreover, strengthening macroprudential surveillance is key, in particular if slow domestic credit supply is coupled with excessive risk-taking abroad by the financial sector. Adjustment in the surplus countries could thus contribute to the rebalancing of external positions in the Eurozone, and provide some easing of the adjustment pressure in the deficit countries. However, reductions in surpluses may only contribute to, but not accomplish, the necessary rebalancing in the deficit countries.
Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.
Buti, M and A Turrini (2012), “Slow but steady? External adjustment within the Eurozone starts working”, VoxEU.org, 12 November.
Chen, R, G M Milesi-Ferretti and T Tressel (2012), “External Imbalances in the euro Area”, IMF Working Paper 12/236.
Darvas, Z (2012), “Rebalancing the Eurozone: Internal adjustments won’t be enough”, VoxEU.org, 5 September
Delbecque, B (2012), “Saving the euro requires restoring Spain’s competitiveness”, VoxEU.org, 30 July.
European Commission (2012), "Current account surpluses in the EU", European Economy No. 9.
Gaulier, G, D Taglioni and V Vicard (2012), “Tradable sectors in Eurozone periphery countries did not underperform in the 2000s”, VoxEU.org, 19 July.
Irigoyen, J M and J Monteagudo (2013), "Multiregional trade spillovers of economic activity in EU countries", mimeo, DG ECFIN, Unit B2 ‘Product market reforms’.
Ratto, M, W Roeger, J in ‘t Veld, L Vogel (2012), "The German Current Account Surplus: an analysis with an estimated DSGE model" (forthcoming).
Sinn, H,-W and A Valentinyi (2013), “European imbalances”, VoxEU.org, 9 March.
Wyplosz, Charles (2010), "Germany, current accounts and competitiveness", VoxEU.org, 31 March.
Bornhorst, F and A Ivanova (2011), “Current-account imbalances: Can structural policies make a difference in Germany?”, VoxEU.org, 15 August.
1 For different views on the current-account adjustment in the Eurozone and its implications published on this website, see, for example, Bornhorst and Ivanova (2011), Darvas (2012), Delbecque (2012), Gaulier et al. (2012), Sinn and Valentinyi (2013) or Wyplosz (2010).
2 This report was prepared as part of the analytical work underpinning the Macroeconomic Imbalance Procedure, which was launched in 2012 in the EU to prevent and correct excessive macroeconomic imbalances such as those that accumulated in the run up to the crisis.
3 The flowchart shows estimated financial flows among several regions: Eurozone surplus countries (EA surplus), the Eurozone peripheral countries including Greece, Italy, Ireland, Portugal and Spain (EA deficit), the remaining EU countries including those which joined the EU since 2004 (RoEU), and France, which is considered apart because it is an important intermediator of financing to the periphery and was both a surplus and deficit country during the last decade. The outside arrows show flows with the rest of the world (ROW).
4 These losses decompose into EUR 298 billion EUR on assets (taking into account the gains on central-bank reserve assets during 2007-11), and 165 bn EUR on financial derivatives. Estimates indicate that more than half of the assets losses stem from debt assets originating from outside the Eurozone (see European Commission, 2012, pp. 38-42).
5 Note, however, that demographic change was controlled for in the econometric analysis.