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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. Page 3 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. 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