Let's see now the time course of the current account under its possible different perspecitives for some euro area (EA) countries whose financial status and outlook are suffering (Greece, Spain, Italy).
Data have been collected from the IMF: World Economic Outlook October 2012 [here]. The synthetic matrix of the elaborated data for all the countries of the EA is downloadable here.
1. GREECE
The first country that we consider is Greece, which has been the earliest to be exposed to the financial crisis within the EA. Greece, often is represented as the bad model.
Figure1-3. The current account and its components (1991-2013): Greece.
Since 1991 the level of total investment (I) has always exceeded the amount of the national savings (NS). This excess of investment needed to be financed by asking for external loans. By observing the time series of the current account (CA) we see a great worsening of the net external position after 2004 (interestingly, in 2004 the Olympic games took place in Athen). The downward jump of the CA between 2005 and 2007 amounted to 10 percentage points of GDP ! This derived by the decrease of the national savings (-5%) which in that period overtook the increase of the investment (+2%). Since 2005 therefore it should have been clear that Greece was really in deep water. Besides, a warning signal had been already made evident by the CA dynamics from 1998 to 2000, when the net external position passed from -4.4% to -7.8%. It is worth pointing out the erososion of the national savings that from the 20% to GDP have fallen to 4.7% in 2011.
In Figure 2 the CA is represented along with the balance of trade (BoT) and the net income from abroad (NIA). From 2001 the NIA has steadily decreased and reached a minimum in 2008 (-3.26%). If we considder that NIA is the net interest on the external liabilities, we can realize at what extent the financial exposition have deteriorated. The deflation policy ("austerity") which have been adopted since 2010 have produced some effects on the side of the balance of trade: the contraction of the domestic demand have reduced the trade deficit from -8.72% (2009) to -3.64% (2012). But the debt service has not followed the same rate of change, in fact it remained almost stationary around 2.5% of GDP in the same period 2009-2012. Between 2000 and 2004 both the CA and BoT improved of 3 percentage points from -8.2% to - 5.2%, but the NIA worsened of almost 1.5 percentage points. That is, interest on the debt dragged away the 50% of the improvement in the balance of trade !
"In other words, since 2004 one could see quite clearly that Greece was deep in external debt: half of the improvement achieved on foreign accounts was eroded by the payment of interest abroad. The debt, in theory would have been virtuous, because addressed more to an increase in investment rather than to a decrease of savings" [1] (as shown in Figure 1).
By comparing the CA with the government structural balance (government savings GS) and the private savings after investment expenditures (PS - I) it is possible to represent the role of the public and/or private sector in the evolution of the current account balance. The government savings have been always negative in the period 1991-2013). During the years before the acception to the EA (2001), the private savings have been positive until 1998. Hence, between 1991 to 1998 the deficit of the CA was driven by the government deficit. The series of GS and PS-I appear quite symmetric with respect to a line parallel to the abscissa at the level -2.5%. Since 1993 GS began to increase while PS-I did otherwise. In the interval 1999-2001 GS was greater than PS-I. Therefore the deterioration of the CA in the period 1998-2000 that has been commented in Figure 1, was mainly due to the decline in the private savings. Yet the path of the private savings characterized the deterioration (9 percentage points) of the CA observed from 2004 to 2007. In fact, the loss in PS-I was of 7 percentage points, while the loss of GS was of 2 percentage points.
Therefore, the events that have driven down the foreign debt of the country were determined by a decline in net private savings, while the public remained essentially unchanged or slightly increasing.
2. SPAIN
The course of the CA of Spain during the period 1991-2013 is similar to the one showed for Greece: CA have always run in the negative area, with two deep downward jumps in the intervals 1997-2001 and 2003-2007.
Figure 4-6. The current account and its components (1991-2013): Spain.
The total investment have been always larger than the national savings. The growth rate of the investments presented two accelerations: one in the period 1998-2000 and the second in the period 2002-2007, meanwhile the rate of the national savings remained stationary around 20% during 1991-2002 and afterward it began to decrease. Therefore the CA has reflected these dynamics by loosing 5 percentage points in 1997-2001 and 10 percentage point in 2003-2007. The effect of the crisis is well represented by the retreat of the investment rate since 2009. This has allowed the change of direction of the CA course which is now approaching the equilibrium line of 0% to GDP .
The balance of trade had been positive only in the period 1994-1997. A first decline of BoT (a loss of almost 4 percentage points between 1997 and 2000) had been only partially recovered by the increase of export during 2000-2002 (the BoT passed from -3.1% to -1.7%). In fact, the payment for interest on the foreign debt which was necessary for supporting the expansion of investment, doubled (from 0.8% to 1.5%). The second downward jump that occurred in the period 2003-2007 reflected both the accrual of external debt (from 5% to 10% of GDP) and the worsening of NIA. The sudden stop (since 2008) of the foreign capitals has caused the fall of investment and of the domestic demand. As the import volumes have been drastically reduced, so the balance of trade has improved.
"What is the problem in Spain? It started with a classic housing buble financed by foreign capital, and as a textbook would predict, once the inflow of foreign capital stopped and the bubble burst, unemployment soared and the financial system went bust as well" [2]
The external debt keeps on rising because the CA is still in deficit. Therefore the service of the debt has not changed proportionally to the quick current account adjustment. In the last three years the rate of NIA has shifted to -2% of GDP.
3. ITALY
Although (or because of) the severe deflation measures adopted in the latest years, for Italy it is not yet time to have a rest. In the bailout-lottery of the EA, Italy and Spain share the troublesome position of nominated but unwilling players. Italy represents the third economy and the second manifacturing industry in Europe and the default of Italy would drag through the mud the whole EA.
Figure 7-9. The current account and its components (1991-2013): Italy.
The national savings showed a slight downward trend until 2007 (passing from 22.5% to 20%). The global crisis since 2008 has caused a downward shift of the saving rates at the average level of 17.1% ±0.9% in the last period 2008-2012. The total investment rates have gone beyond the saving rates since 2002 and the gap has become growing up to around 3% (2008-2012). Accordingly, the current account balance has performed deficits since 2002 and has reached its minimum peak at -3.55% in 2010.
By analyzing the trade components of the current account we can note a quick upward jump from 1992-1993 (from -0.6% to +3%) and a further step up until 1996 (+4.45%). These peaks were facilitated by the temporary exit of Italy from the European Monetary System [3] (EMS). The consequent devaluation of the italian currency determined the positive performance of the italian export. The EMS agreement ceased in May 1998 and in 1999 it was substituted by the European Exchange Rate Mechanism (ERM) with narrower fluctuation bands (±1.5%). The balance of trade began to decrease and passed into the negative area after 2004. Since that year, the accrual of external debt grew up to -1.8% in 2006. A further sharp decrease in the balance of trade occurred in 2009. As we have observed for Spain and Greece, the patterns of the current account and of the balance of trade have change direction since the last three years. We can also see that the current account showed a relative minimum in 2008 when it was determined by the increase of the payments of the interest on the external debt rather than by the gap on trade. The deflation policy adopted since 2011 allowed the stabilization of the quote of interest around -0.64%.
"What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else's currency, with all the loss of flexibility that implies. [P. Krugman [here]]" [4]
Net private savings decreased at the average rate of -0.5% per year over the whole period of observation 1991-2013, while the government savings showed the symmetric pattern. All the efforts of the governement policies in the last two years have been addressed to get the primary budget surplus and by that way to stabilize the public debt. But the increase in the primary surplus in relation to GDP is attributable to the growth in revenue, which "rose from 46.6 in 2011 to 48.1% last year and exceeded the previous record of 1997 (47.4 %). Bank of Italy, writes in the monthly bulletin [here]. A further increase in 2014 will allow the "stabilization of the ratio of debt to GDP even if the latter's growth was modest." The erosion of the savings rates for Italy may be explained [5] by the level of the interest rates.
4. EXTERNAL DEBT VS. GOVERNMENT DEBT
By the effect of equation [here]
CA = (X - M) + NIA = NS - I
the accumulation of the net external positions over the time produces the stock of external debt (ED), i.e., ED=sum of the CAs over the time.
Gross external debt represents for a country the outstanding amount of the actual current liabilities that require payment of principal and/or interest to non residents at some point in the future [6].
The stock of gross external debt informs the potential weakness of an economy in terms of accumulated imbalances, and the analysis of the net external debt signals the existence of such criticalities. In fact, large external debt deficits along with large interest payments may be considered as reliable indicators of the likely impairment in the solvency of a country. When the ratio of the net external debt to GDP exceeds the percentage of 50% the probability of external debt crisis is high. Moreover, countries were the ratio of the net interest payments to GDP is higher than 3% are highly exposed to the risk of external solvency issues (e.g., Argentina in 2001, Hungary, Ukraine and Iceland in 2008, Greece in 2010).
Then the rule is:
the combination of a net external debt ratio greater than 50% with a ratio of the net interest payments to GDP greater than 3% provides a significant indicator for potential external debt stress [6,7]
Let's see what has happened in the external debt variables compared with the government debt for the three countries. The difference between the gross external debt and the government debt enables us to estimate the minimum [8] portion of the whole external debt that is due to the private sector activity.
Figure 10-12. External Debt vs. Government Debt (1991-2011): Greece, Spain, Italy
Source: IMF:World Economic Outlook October 2012 and [6]
The brown shaded area points out the time period when the gross external debt has remained above the gross government debt. The dotted line is drawn in correspondence of the accession of the country to the EA (indicated with the letter E in the abscissa axis).
The gross governemnt debt in Greece has been stationary until 2005 around 100% but it took off in 2008. In 2011 it scored the 165% to GDP !! Greece entered the EA in 2001, when the ratio of the net external debt to GDP was already the 46.5%. The year after this ratio passed the 50% warning limit. In 2011 it reached the value of 86% !! The gross external debt overtook the gross government debt since 2007. In 2009 the difference between gross external debt and the gross government debt was around 55%.
Spain showed the best performance of the gross government debt that has been always kept below (or nearby) the 60% level. The dynamics of gross external debt reveal that the majority of the external debt is due to the private sector. This trend began since 1997, but in 2009 the difference between gross external debt and the gross government debt amounted to 110% !! In 2004 even the net external debt overtook the gross government debt and the safe limit of 50% and in 2009 it jumped to 93% !!
Italy is characterized by high level of gross government debt. The ratio to GDP have restarted increasing since 2008. On the contrary, the net external debt is still below the threshold of 50% and the majority of the external debt is due to the public sector.
5. CONCLUSIONS
- Non homogeneous savings rates among the EA countries cause dispersion among their current accounts balances, as the differences in the savings rates are not corrected by similar dispersion of investment rates.
- In a currency area without federalism the existence of long lasting [9] external imbalances (deficits or surpluses) is not sustainable because of the lack of funds transfer among countries. In the long run this condition produce accumulation of external assets and debts that will end with solvency crises.
- The peripheral countries of EA are experiencing the situation which is known as cycle of Frenkel [10]. In countries with fixed exchange rates, sudden stops of capital inflows are expected to drain the foreign reserves, forcing the currency depreciation which facilitates the shifting of the current account toward surplus. But the sudden stop effect has not (yet) induced the peripheric countries to exit the EA and devaluate their currencies [11].
- the combination of a net external debt ratio greater than 50% with a ratio of the net interest payments to GDP greater than 3% can be considered a warning signal of a possible external debt crisis.
- not all the countries which adhered the EA have took advantage from the common currency. On the base of the Marshall-Lerner conditions [12] some of them had better to leave the EA.
- the inflows of external capital in the long run deteriorate the balance of payments of the borrower countries.
1. Bagnai A., (2012). Premiata armeria Hellas: prima parte. Goofynomics.blogspot.it, 16 February
2. Reinhart C., (2008). Eight hundred years of financial folly. VoxEU.org, 19 April.
3. The EMS forced Italy to defend the exchange rate of the lira against the ECU (European Currency Unit). After the realignment occurred at the beginning of 1987, the member countries had committed themselves to avoid alterations. In this way it was supposed that the disinflation policies would have been credible. Inflation rate was around 6%, and since the effect of the disinflation measures did not operate in Italy, the change around 1540 Italian Lira for ECU soon proved overrated. The foreign trade balance worsened. The Lira tended to depreciate. The commitment of the monetary authorities to maintain the fixed exchange rate and the influx of foreign capital helped to maintain this balance for a certain period. But it was an unstable equilibrium. In fact, for many reasons (the fact that the foreign debt continued to grow, and the fact that in 1991 the United States went into recession) this balance at the beginning of 1992 broke. Inflows of foreign capital began to wane and the downward pressure on the exchange rate intensified. Incidentally, Italy had recently rejoined the narrow-band transmission and had liberalized capital movements, which did not help things. The Bank of Italy to support the fixed exchange rate applied two strategies: a) using the official reserves for buying back the stock of italian currency that the market did not raise; b) using the leverage of the interest rates for attracting foreign investors to buy bonds in italian currency. Eventually, after that the Bank of Italy had immolated 100 trillions lira in September 1992, Italy had to float the lira.
4. Krugman P., (2011). Legends of the fail. The New York Times, 10 November.
5. When the differential between the interest rate and the GDP nominal growth is positive there would be an incentive to save and to accumulate more financial assets. [Artus P., (2012). What causes the dispersion of savings rates between euro-zone countries. Flash Economics. Economic Research, 27 March, N° 220].
6. Dias, J.D., (2010). Directorate General Statistics, European Central Bank, Final Version, 12 October 2010. "External debt statistics of the euro area." Initiatives to address data gaps revealed by the financial crisis. Bank for International Settlements, Basel 25-26 August 2010.
7. Manasse P., Roubini N., (2005). Rules of thumb for sovereign debt crises. IMF Working Paper [here]
8. because it is likely to expect that the government debt is not fully financed by non residents.
10. here
11. Hale, G., (2013). Balance of payments in the european periphery. Federal Reserve Bank of San Francisco. Economic Letters, 14 January.
12. here
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