Do divergences in current account deficits accross euro area member states matter?

 

 

While the euro area is running an almost balanced current account, there are big divergences across member countries. Should this be a matter of concern? Does the euro induce or amplify these divergences? Are divergences a general phenomenon or driven by some specific countries? Are these divergences due to one-off effects or expected to last?

 

These are the questions addressed by the European Commission in their Quarterly Report on the Euro Area  published this week. The analysis is a follow-up of a recent extensive ECFIN study on how member states adapted to the euro area. We are presenting some of the arguments together with our comments.

 

The Commission’s verdict is that there is no immediate danger for the euro area as a whole; that the euro has increased divergences as member states benefited differently through a deeper and more liquid financial market; that divergences are mainly driven by the largest deficit countries Greece, Spain and Portugal; and that their deteriorating external deficit trend implies future readjustments costs that are a matter of concern.

 

Spain, Greece and Portugal started EMU with already high current account deficits of around 3%, 4% and 8% of GDP respectively. This external deficit deteriorated further in Spain and Greece, and experienced only a temporary relief in Portugal.  Current account deficits in these three countries now reached record heights of over 8% of GDP which is high even by international standards.

 

Divergent current account positions among member states in the euro area are not necessarily a problem as such. These trends are also observable in other OECD countries.

Divergences could be a natural consequence of different economic cycles or different development stages. These divergences are natural and would have existed even without the single currency.

 

But the Euro has also implied divergences. The euro area provides a deeper and more liquid financial market. Interest rates differentials fell sharply across member states that benefited Greece, Spain and Portugal relatively more than other member countries with already deep and low risk credit markets (i.e. Germany). A recent ECFIN study identified the cut in risk premia and the looser credit constraints as the two most important sources for deteriorating external deficits in Spain and Portugal. There are also signs of a euro bias in the sense that Portugal has shifted its foreign borrowing patterns away from non-EMU countries in favour of EMU member states (Spiegel, 2004)

 

Increased external borrowing also induced the surge in residential investment in these countries.  Several commentators have warned that the recent rise in housing prices indicate that a housing bubble is building up, which will eventually burst. Others, however, argued that the house price growth simply reflects a catch-up of an economy and that price levels are still far below other member countries (see Philip Lane  or Jaime Malet on this site). In fact, it was one of the predicted benefits of EMU to enable member countries with lower than average GDP per capita to borrow under better financial conditions in a larger market with significantly reduced exchange risk. There is some supporting evidence for this effect (BOX 5 on page 33) .

 

 

There is enough potential to reverse the current account deficit trend. Spain started already to partly offset increased private indebtedness through higher public savings, but the budget policy in Portugal and Greece contributed to a widening current account deficit in the order of around 1 percentage point of GDP (page 35). Real wage increases are still out of line with productivity growth especially in Portugal which will have to be corrected sooner or later. Productivity could certainly be enhanced through a stronger commitment to reforms.

 

The Commission’s main worry is that the currently observed current account deficit represents an overshooting that will have to be corrected eventually if competitiveness is to be restored.  They argue that the excessively high current account deficits are not sustainable. Adjustment costs can become substantial in terms of wage reduction or foregone economic growth. This, according to the Commission, is part of the recipe that Germany has chosen to follow in order to restore its competitiveness.

 

It is our view that Germany and these three countries could not differ more. Germany entered the monetary union with an overvalued currency, received much less benefits from an integrated financial market and had no catch-up process to fuel its economy.  While current account deficits of 10% or more will probably not prove sustainable, it is far from clear that countries with high current account deficits would have to choose Germany’s method of adjustment.

 

 mundschenk(at)eurointelligence.com

---