Joong Shik Kang and Jay C. Shambaugh
On the eve of the global financial crisis, a number of euro area periphery countries (Greece, Ireland, Portugal, and Spain) along with the Baltic countries (Estonia, Latvia, and Lithuania) faced large and growing current account deficits. Our first research paper (Kang and Shambaugh, 2013) untangles some of the different developments across countries. Two main explanations in the literature are: (i) deteriorating export performance due to a steady deterioration of competitiveness and (ii) a domestic demand-driven boom stemming from excessive optimism, capital flow-driven cheap credit, as well as fiscal excess.
Conventional price indicators show deterioration of their competitiveness since the inception of the euro: significant appreciation of the CPI-based real effect exchange rates (REER) and sizable increase of unit labor costs (ULCs) in these countries increased sizably relative to other euro area countries. However, several quantity measures indicate that export performance remained stable before the recent global crisis. The exports-to-GDP ratio for many of these countries remained relatively stable or increased in the 2000s. The merchandise export market share declined in the 1990s, but was flat in the euro era (1999–2007) except for Ireland, whose economy was shifting toward a service economy. The Baltics’ market share grew throughout.
These patterns hint that other factors may have driven large current account deficits. The seemingly contradictory pattern between large increases in ULC (economy-wide) and non-deteriorating export sector performance can be partly understood by looking at ULC for tradable and non-tradable sectors separately. There was a limited increase in tradable sector ULC, consistent with the export sector maintaining its performance in most of these countries. But, a sizable increase in non-tradable sector ULC led to a large deterioration of economy-wide ULC. Thus, the trade balance may have deteriorated due to surging imports arising from a domestic demand boom while exports remained strong. In fact, the Baltics and, to some extent, Spain, Greece, and Ireland, experienced large capital inflows and optimism-driven booms, which raised ULCs in the non-tradable sector and increased imports.
However, the current account worsened far more than the trade balance in many of these countries (Figure 1). In fact, Portugal’s trade balance improved over this period. The current account moved for reasons beyond trade: declining transfers and rising net income payments contributed to a worsening current account balance even without much deterioration of the trade balance. This substantial deterioration of non-trade components of the current account has received less attention thus far in the literature than movements in the trade balance.
Figure 1.Current Account Development
Source: IMF, World Economic Outlook.
“However, several quantity measures indicate that export performance remained stable before the recent global crisis.”
In theory, a transfer of wealth from abroad should lead to an increase in consumption and investment and a shift toward trade deficit. A decline in these transfers should lead to a reduction in consumption and a return to trade account balance as the country adjusts to its lower income. However, that does not happen if there is habit persistence and households and firms maintain the same level of spending by borrowing when transfers decline. Output and ULC would remain flat, but the current account would deteriorate as consumption and imports do not decline. For example, in Portugal and Greece, loans replacing declining transfers led to a persistent failure to adjust to trade deficits that were present and led to growing current account deficits through both declining transfers and subsequently rising net income payments. In both countries, trade deficits have been in excess of 5 percent of GDP since the early 1980s. At many times, though, current accounts have been close to balance. When the transfers declined, however, the trade balances did not.
Additionally, by running persistent current account deficits, all of these countries saw rising net income deficits as they had to pay more to support their growing external debt as well as FDI-related income outflows. Nearly all of these countries had large current account deficits when the euro launched. As these deficits accumulated, the cost of financing external debt became a larger and larger feature of the current account. The net income balance worsened by an average of 2 to 3 percent of GDP over this period. Thus, even if countries returned trade balances to their 1999 levels, the current account deficits would be much larger than before.
Our second research paper (Kang and Shambaugh, 2014) discusses the need for relative prices to adjust for these countries, the progress that so far has been made, and the link between the different paths to the imbalances and the adjustment path.
Regardless of the underlying causes of external imbalances, as the crisis hit, they needed depreciation to reduce the large current account deficits. Although deterioration of competitiveness in their export sector was not a major factor behind large deficits, they still needed depreciation for a number of reasons. First, for some economies, the large trade deficits have been a persistent problem for several decades. Thus, while trade performance did not worsen during the 2000–07 period, it still needed to improve. Second, the persistent large deficits generated large net income payment needs, requiring improved export sector performance to meet these net income payment needs. Third, as output remains below potential, export improvements are needed to avoid a reemergence of external imbalance as they recover toward full potential output. Fourth, as unemployment rates still remain very high, the production and employment in the tradable sector need to be increased.
To achieve both internal and external balances, they need real depreciation in order to shift spending toward domestic goods and services, to reorient productive resources to the tradables sector, and to increase output to their potential levels. However, given that they use the euro (or fix their currency to the euro), depreciation has to be achieved via a fall in domestic prices relative to trading partners’ prices (“internal devaluation”). One way to achieve these goals is for tradable goods ULCs to fall. This makes them more attractive to produce relative to non-tradables and makes them less expensive than foreign tradable goods.
We find that there has been considerable variation across countries in the ULC adjustment process with some early adjusters (Ireland and the Baltics) cutting wages more rapidly and others only slowly improving productivity (largely through labor shedding). Comparing wage dynamics before and after the crisis, it is apparent that countries with large wage run-ups prior to the crisis have experienced more compressed wages after the crisis. Looking across sectors, in every country but Greece, ULCs have declined more in the tradables sector, and real outputs in the tradables sector are higher than the pre-adjustment levels (Figure 2). But, employment remains below the precrisis level even in the tradables sector in all countries, implying that internal devaluation is taking place, but against the backdrop of a prolonged period of low growth. Low global and regional growth is making the adjustment far more difficult.
Figure 2.ULC Adjustment Between Tradable and Non-Tradable Sectors
Peaks: GRC(09Q4), IRL(08Q4), PRT(09Q1), ESP(09Q2), EST(08Q4), LVA(08Q3), LTU(08Q3). Latest: IRI (12Q1), GRC (13Q1), Others (13Q2).
Sources: Haver Anlytics. IMF staff calculations.
ULCs in these economies have declined more relative to those in trading partners, with economy-wide ULC-based REER depreciating by about 10 to 25 percent since the beginning of the adjustments with nearly all the improvement coming from relative ULC changes, not the nominal exchange rate. GDP deflator-based REERs also depreciated, though somewhat less than ULC-base REERs, implying that relative prices have not declined as much as relative labor costs possibly due to larger profit margins. These price effects are also seen in the trade account. A rebound of real exports, together with import compression, has contributed to significant improvement in current account balances.
Have the relative price adjustments been sufficient enough to rebalance external accounts? Maybe not. Unemployment rates still remain very high in most of these countries. That is, the adjustment is not yet triggering benefits to the overall economy, partly because the adjustment is taking place within an environment of low growth, and partly because the adjustment itself is not generating enough demand to strengthen the economies. We find that output gaps could be quite large when we use the estimates of country-specific Okun’s law coefficients and even relatively high estimates of the steady state level of the unemployment rate, implying that cyclically-adjusted current account deficits could still be fairly sizable in many of these countries. Large output gaps would be good news for fiscal adjustment as there is more room for growth recovery, but it implies a greater need for relative price adjustment (either falling prices in these countries or faster price growth in trading partners) to avoid a reemergence of large external imbalance and to reach full employment.