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18 January 2012
Global Economic Perspectives
Economic adjustment in Euroland: where do we stand?
„
In this paper, we discuss the economic
adjustment achieved so far since the beginning of
the euro crisis and take stock of the funding of the
balance of payments imbalances through the euro
area central banks.
„
We find that the domestic demand and cost
adjustment needed to restore external balance
has begun, but is far from concluded. In the
meantime, the funding of continuing balance of
payments imbalances by the euro area central
banks is leading to a widening of the imbalances
within the Target2 inter-bank payment system.
„
„
It seems that exports (and by implication imports)
of Greece, Ireland, Portugal and Spain are not
sufficiently price sensitive to achieve external
balance through relative price changes. From this
follows that adjustment has to come mainly from
changes in domestic demand. Exports of Italy and
Germany, on the other hand, seem to be more
price sensitive, making external adjustment there
easier.
Based on a simple illustrative exercise, we find
that GDP will probably have to drop by
considerable further amounts in Greece, Portugal
and Spain to achieve external balance. Hence,
with the achievement of sustainable balance of
payments positions still not in sight for most of
the problem countries, EMU seems to remain at
risk for the foreseeable future.
In previous papers, we have argued that behind the euro
area’s public debt and banking crisis lies a balance of
payments crisis. A credit-driven expansion of demand
domestic demand in a number of EMU member countries
has led to a loss of external competitiveness and
unsustainable public and private sector debt in these
countries. In the present paper, we take stock of the
economic adjustment achieved so far since the beginning
of the crisis and take stock of the funding of the balance
of payments imbalances through the system of euro area
central banks. We conclude that achievement of
sustainable balance of payments positions is still not in
sight. Hence, EMU seems to remain at risk for the
foreseeable future.
member countries to borrow excessively to fund growth
based on public and private consumption and housing
investment. As strong domestic demand growth lifted
GDP growth during the first decade of EMU these
countries lost control over their labour costs, experienced
a loss of international competitiveness, and incurred large
external current account deficits. With the burst of the
global credit bubble the funding of both expiring public
and private debt as well as continuing savings-investment
deficits became very difficult and pushed EMU into crisis.
Since the beginning of the EMU crisis in early 2010 after
the disclosure by the Greek authorities that public deficits
and debt had been misreported for years, there has been
some economic adjustment. As can be seen from Chart 1,
domestic demand has contracted significantly in the
group of the most affected countries (Greece, Ireland,
Italy, Portugal and Spain). There are no signs so far, that
the decline in domestic demand has come to an end.
Chart 1: Domestic demand: GIIPS and Germany
99Q1 = 100
180
Greece
Portugal
Ireland
Spain
99Q1 = 100
180
Italy
Germany
170
170
160
160
150
150
140
140
130
130
120
120
110
110
100
100
90
90
99
00
01
02
03
04
05
06
07
08
09
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
The drop in domestic demand induced a significant
decline in GDP especially in Greece, where the crisis
began (Chart 2). Portugal followed Greece into recession
while Ireland after a severe recession in 2008-10
experienced a tepid recovery last year. In Italy and Spain,
which have been affected by the euro crisis only more
recently, GDP growth remained positive last year but is
set to turn negative this year as fiscal austerity and tight
credit conditions begin to bite.
Hang-over after the party
The fall of policy interest rates and the convergence of
capital market rates to the German level in a global lowinterest rate environment seduced a number of EMU
Deutsche Bank Securities Inc.
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18 January 2012
Global Economic Perspectives
Chart 2: GDP: GIIPS and Germany
99Q1 = 100
Greece
Portugal
Ireland
Spain
Chart 4: Current account balances: GIIPS and Germany
99Q1 = 100
Italy
Germany
% of GDP
% of GDP
Greece
Ireland
Italy
Portugal
Spain
Germany
170
10
160
160
5
5
150
150
0
0
140
140
-5
-5
130
130
120
120
-10
-10
110
110
-15
-15
100
100
-20
170
90
90
99
00
01
02
03
04
05
06
07
08
09
10
Recession caused a rise in unemployment and dampened
wage growth. In Ireland, Greece, and Spain this led to
easing of unit labour cost despite a slow-down in
productivity growth. Thus, at least a small part of the runup in unit labour costs during the first decade of EMU has
been reversed. Against this, unit labour costs remained
broadly stable in Italy and Portugal. Overall, however, the
large gap in unit labour costs between Germany and the
GIIPS countries has so far closed only little.
Chart 3: Unit labour costs: GIIPS and Germany
Greece
Portugal
160
Ireland
Spain
Italy
Germany
99Q1 = 100
160
150
150
140
140
130
130
120
120
110
110
100
100
90
90
99
00
01
02
03
04
05
06
07
08
09
10
-20
99
00
01
02
03
04
05
06
07
08
09
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
99Q1 = 100
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
The brief review of a few key indicators above and a more
detailed look at the individual countries suggests that the
economic adjustment in most euro area countries in
financial difficulties to the end of cheap and ample credit
has only begun. The exemption appears to be Ireland,
where adjustment seems to have progressed much
further than elsewhere. Most importantly, Ireland’s
current account balance has returned into surplus,
suggesting that domestic demand and unit labour cost
adjustment have reached a stage consistent with a return
to external equilibrium.
The struggle with balance of payments
deficits
The first round of the financial crisis in the US that
culminated in the default of Lehman Brothers led to a loss
of trust and funding difficulties for banks. In the euro area,
banks in weaker countries with external current account
deficits and, therefore, in need of foreign capital were
most affected and, hence, had to rely most heavily on
support from the ECB. As Chart 4 shows, the share of
ECB lending to the GIIPS countries began to increase as
of mid-2007, when news broke that French money market
funds had to be closed due to their exposure to US subprime mortgages.
The drop in domestic demand has led to a decline in
external current account deficits in all the GIIPS countries
(Chart 4). However, the degree of improvement has varied
significantly among the countries. While the current
account deficit turned into a surplus in Ireland and
improved markedly in Spain, it shrank only a little in
Greece and Portugal and remained broadly unchanged in
Italy. At the same time, the surplus of Germany has
remained very high.
Page 4
Deutsche Bank Securities Inc.
18 January 2012
Global Economic Perspectives
Chart 5: ECB standard refinancing plus emergency
lending assistance
To other euro area (ls)
Italy (ls)
Spain (ls)
GIP (incl. ELA, ls)
GIIPS as % of total (incl. ELA, rs)
EUR bn
900
%
90
800
80
700
70
600
60
500
50
400
40
300
30
200
20
100
10
0
0
07
08
09
10
Chart 7. More recently, there has been a clear “northsouth” division in the Target2 positions of euro area
central banks, with “northern” banks holding large claims
and “southern” banks liabilities towards the ECB (see
Table 1).
11
Note: Emergency lending assistance GR 40.1, IE 46.7 EUR bn, latest values
Sources: Eurostat, NCBs and Deutsche Bank Global Market Research
Chart 6: ECB lending to GIIPS banks and Target2 claims
of the Bundesbank against the ECB
EUR bln
700
EUR bln
700
CBPP+SMP+MROLTRO of GIIPS
T2-Bundesbank
600
600
Linear (CBPP+SMP+MROLTRO of GIIPS)
500
500
Linear (T2-Bundesbank)
400
The second round of the financial crisis began when the
new Greek government in September 2009 disclosed not
only that the budget deficit for 2009 would be much larger
than envisaged earlier in the year but also that previous
Greek governments had systematically lied about the true
state of Greek government finances. In the absence of a
well-defined framework for financial crisis management,
EU authorities reacted hesitatingly to the Greek fiscal
problems and were hence unable to avert a funding crisis
that in the event affected the entire group of GIIPS
governments. As risk premia on EMU governments rose
risk premia on banks holding bonds of these governments
rose as well, forcing them to rely ever more on ECB
funding. Thus, the share of the GIIPS countries in ECB
lending rose further, reaching 80% by the middle of 2011
(Chart 5).1
Central bank money borrowed by banks in the GIIPS
countries from the ECB has been used to fund net
payments to other euro area countries, most importantly
Germany, resulting initially from current account deficits
and, as capital started to leave these countries, more
recently also from capital account deficits. As the ECB
acts as the clearinghouse for inter-bank payments among
euro area countries in the payment system Target2, the
balances of euro area central banks vis-à-vis the ECB in
this system roughly reflect the cumulated balance of
payments of EMU member countries. The relationship
between borrowing from the ECB by the GIIPS countries
and Germany’s Target2 claims on the ECB is illustrated in
Chart 6. The evolution of Target2 balances of Germany
and the GIIPS countries over the past few years is given in
400
y = 0.3385x - 13240
300
300
y = 0.2282x - 8942.1
200
200
100
100
0
0
-100
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
-100
Sources: ECB and Deutsche Bank Global Market Research
Chart 7: Target2 balances of Germany and GIIPS
countries
mln EUR
mln EUR
500,000
500,000
400,000
Germany
Italy
Spain
Portugal
Greece
Ireland
400,000
300,000
300,000
200,000
200,000
100,000
100,000
0
0
-100,000
-100,000
-200,000
-200,000
03
04
05
06
07
08
09
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
1
As can be seen from Chart 5, the share of GIIPS countries in total ECB
lending eased somewhat towards the end of 2011. Unfortunately, this
does not reflect an easing of their funding problems. Rather, French banks
also started to have difficulties accessing the markets forcing them to turn
to the ECB.
Deutsche Bank Securities Inc.
Page 5
18 January 2012
Global Economic Perspectives
Table 1: Target 2 balances (EUR bn, around Q4 2011)
Germany
463.3
Netherlands
143.1
Luxembourg
97.5
Finland
66.0
Malta
-8.7
Slovakia
-11.0
Austria
-32.0
Belgium
-52.8
Portugal
-61.7
France
-98.5
Greece
-105.7
Ireland
-119.3
Spain
-150.8
Italy
-191.4
Sources: DBR, National Central Banks and Deutsche Bank Global Market
Research
It seems that central banks initially funded only current
account deficits through Target2. More recently, however,
funding had to be extended to capital account deficits.
This can be seen from Chart 8 which plots the
Bundesbank Target2 claims on the ECB and Germany’s
current account surplus vis-à-vis euro area countries
cumulated since the middle of 2007, when the first round
of the financial crisis started. Between mid-2007 and mid2011 Germany’s cumulated EMU current account surplus
was closely aligned with its Target2 claims on the ECB
suggesting that the Bundesbank largely funded German
net exports to EMU partner countries. Since mid-2011,
however, Target2 claims have surged. Although German
current account data versus EMU partner countries are
not yet available for the second half of 2011 there are no
signs of current account surpluses jumping higher in line
with Target2 claims. Rather, it is highly likely that
Germany’s current account surplus versus EMU partners
has diminished as these countries implemented fiscal
austerity programmes. Hence, it seems that since the
middle of last year the Bundesbank is funding capital
account deficits of EMU partner countries in addition to
their current account deficits.
500000
500000
300000
200000
200000
100000
100000
0
0
09
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
Page 6
Portugal
Greece
1.5
1.5
1.4
1.4
1.3
1.3
1.2
1.2
400000
TB
300000
08
1.6
1.6
600000
07
% of total
% of total
600000
CA
While Ireland has already succeeded in turning its external
current account into surplus, Greece, Italy, Portugal and
Spain still have more or less substantial deficits.
Unfortunately, however, it seems that exports of Greece,
Portugal and Spain are not very price sensitive. Hence,
there seems to be little room for boosting exports through
relative price changes in these countries. Italy seems to
be in a somewhat better position, suggesting some room
for boosting exports through price and cost cuts. These
points are illustrated in Charts 9-10, which show the share
of (nominal) exports of goods and services of the GIIPS
and Germany in total EMU exports. As can be seen from
Chart 9, there has been no discernible trend in the share
of either Greek or Portuguese exports in total EMU
exports since 1999 despite the sharp increase in unit
labour costs of these countries relative to Germany. Chart
10 shows a similar picture for Ireland and Spain. Against
this, the share of exports of Italy has declined from 13.1%
to 11.0% while that of Germany has increased from
27.3% to 31.4%.
mln EUR
Germany
400000
As we have explained in previous notes, the funding of
balance of payments imbalances through the euro area
central banks has shifted credit risk from the private to the
public sector. In addition, borrowing from the central bank
in the deficit countries to fund balance of payments
deficits leads to an accumulation of reserve money in the
balance of payments surplus countries, notably Germany,
which in the long-run could lead to higher inflation in these
countries To regain creditworthiness and, hence, to end
the risk transfer the balance of payments deficit countries
need to reduce private and public sector debt and restore
the competitiveness of their traded goods sector. This can
be achieved through a reduction of domestic demand
relative to supply and/or a decline in domestic prices
relative to foreign prices. The latter can be achieved by a
decline in domestic prices and/or an increase in foreign
prices. How much adjustment is needed, and through
which channels can adjustment be engineered?
Chart 9: Share of exports in total EMU exports
Chart 8: Germany: Current account (CA) and Target2
claims (TB) of the Bundesbank
mln EUR
How to restore equilibrium
1.1
1.1
99
00
01
02
03
04
05
06
07
08
09
10
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
Deutsche Bank Securities Inc.
18 January 2012
Global Economic Perspectives
Chart 10: Share of exports in total EMU exports
% of total
% of total
33
33
28
28
23
Italy
Spain
Germany
Ireland
18
13
13
8
3
00
01
02
03
04
05
06
07
08
09
10
Greece Ireland Italy Portugal Spain Germany
1. M/X
143.8
103.7 101.6
130.8
122.5
87.5
8
2. sd
111.4
103.4 100.4
109.0
105.8
94.6
3
3. sm
32.7
79.7
27.3
38.4
31.8
38.0
4. sx
22.7
92.0
26.9
29.3
26.0
43.4
5. gdp_simul -34.5
-0.9
-1.2
-21.8
-16.6
7.0
6. gdp_actual -9.2
-23.6
-0.8
-1.1
-1.6
10.0
11
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market
Research
If exports (and by implication imports) are rather
insensitive to relative price changes external adjustment
needs to be achieved by a reduction of domestic demand.
In the following analysis, we estimate how much GDP
would have to fall to achieve external balance in an
illustrative exercise based on two very simple
assumptions. First, we assume that exports remain
unchanged. Second, we assume that the ratio of imports
to domestic demand remains constant so that the decline
in imports needed to balance the external account induces
an identical decline in domestic demand. The results of
our exercise are given in Table 2. In the first line we show
the ratio of nominal imports of goods and services to
exports in the average of 2005-06. We assume that this
ratio has to be brought to 1 by a reduction of imports. The
second, third and fourth line of the Table show the ratio of
domestic demand, imports and exports to GDP. For
Ireland, where about 15% of GDP is accounted for by reexports of imports of subsidiaries of foreign companies,
we use GNP and adjust exports of goods and non-factor
services by subtracting net factor (i.e., mostly profit)
payments abroad. Note that the percentage change of
GDP is given by the weighted average of the change of its
demand components, i.e.,
gdp = sd dd + sx x – sm m,
where gdp, dd, x, and m are the percentage changes of
GDP, domestic demand, exports and imports, and sd, sx,
and sm are the shares of domestic demand, exports and
imports in GDP. Assuming that the ratio of imports to
domestic demand remains constant (which implies dd=m)
and exports remain unchanged (x=0), we can rearrange:
gdp = (sd-sm) m
Line 5 of the Table gives the result for gdp for m that
reduces M/X to 1. Line 6 shows the decline of actual GDP
Deutsche Bank Securities Inc.
Table 2: How to achieve external balance – an illustrative
exercise (in %)
23
18
99
from its peak to the latest available quarter (Q3 2011,
except for Ireland, where it is Q2 2011).
Sources: Eurostat, Haver Analytics and Deutsche Bank Global Market Research
Based on these assumptions and parameters, a reduction
of imports by 43.8% in Greece would require a drop in
GDP by 34.5%. So far, actual GDP has declined by only
9.2% from its peak, suggesting that a further substantial
decline in GDP would be needed to achieve external
balance. Our exercise shows the need for further
substantial reductions in GDP also for Portugal and Spain,
but hardly any further reduction in Italy. In Ireland, the
drop in GNP far exceeded our estimate of the required
decline. In Germany, GDP would seem to have to rise by
7.0% to equalize imports and exports. Since the beginning
of the financial crisis in 2007, German GDP has increased
by 10.0% while the ratio of imports to exports has risen
by five points from 85.0% to 90.0%. In contrast to the
assumption in our exercise, German GDP growth
benefited from a 16% increase in exports since the
beginning of 2007.
Conclusions
In this paper we discussed the economic adjustment
achieved so far since the beginning of the crisis and took
stock of the funding of the balance of payments
imbalances through the euro area central banks. We found
that domestic demand and cost adjustment needed to
restore external balance has begun but is far from
concluded. In the meantime, the funding of continuing
balance of payments imbalances by the euro area central
banks is leading to a widening of the imbalances within
the Target2 inter-bank payment system. Exports (and by
implication imports) of Greece, Ireland, Portugal and Spain
do not appear sufficiently price sensitive to achieve
external balance through relative price changes. Hence,
adjustment in these countries will have to come mainly
from changes in domestic demand. Exports of Italy and
Page 7
18 January 2012
Global Economic Perspectives
Germany, on the other hand, seem to be more price
sensitive, facilitating external adjustment. Based on a
simple illustrative exercise we found that GDP will
probably have to drop by considerable further amounts in
Greece, Portugal and Spain to achieve external balance.
Hence, with the achievement of sustainable balance of
payments positions is still not in sight for most of problem
countries, EMU seems to remain at risk for the
foreseeable future.
Thomas Mayer, (+49) 69910-30800
Page 8
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