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Erico Matias TavaresSinclair & Co.

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The Eurozone’s UnresolvedSituation

Sep 28 2014 289 2 1

Can market forces prevail in the Eurozone?

With another round of central bank intervention coming four plus years after thestart of the Eurozone debt crisis, this is a question worth considering, at a timewhen the Southern Eurozone members - Italy, Spain, Greece and Portugal,which collectively account for over 30% of the GDP of the early adopters of theEuro as a whole – continue to struggle.

This is a complex topic for sure, but a simple economic indicator can be used tohelp frame the situation.

The Real Effective Exchange Rate, or “REER”, is a weighted average of acountry's currency relative to an index or basket of other major currenciesadjusted for the effects of inflation. A country with higher inflation will seek todevalue its currency to maintain competitiveness in relation to its trading partners(the reverse also applies of course, but these days nobody seems to want astrong currency). The REER therefore provides a gauge of that country’scompetitiveness in foreign markets.

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Under a fixed foreign exchange regime, policy options are much more limited. AEurozone member can become much less competitive relative to anothermember with a lower inflation rate. Stated differently, its REER will increase inthat situation. This dynamic provides an insight as to how the SouthernEuropean countries got into trouble in the first place, and some of the challengesassociated with its resolution.

Historical Context Leading Up to the 2008 Financial Crisis

The oil shocks of the 1970s had very damaging effects in the southerncontingent of the Eurozone, with inflation rates skyrocketing. Devaluations weretherefore a necessity to regain competitiveness, although these also provided aninflationary feedback loop. In contrast Germany, and to a lesser degree France,more or less kept inflation under control during this turbulent period.

Figure 1: Historical CPI Inflation in Selected Eurozone Countries, 1965-2001

Source: www.inflation.eu.

It is important to understand this context, as these economies evolved out of asystem that systematically used currency devaluation as a policy tool for manyyears.

In the 1980s, Portugal, Greece and Spain formally joined the EuropeanCommunity, having just transitioned to a democratic system in the prior decade.

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A program to promote economic convergence with the European “core” was thenimplemented. This included the establishment of trading bands with otherEuropean currencies in order to avoid wild swings and competitive devaluationsbetween trading partners, as well as facilitate greater economic integration goingforward.

As currency fluctuations narrowed, inflation at home would have to come down,otherwise the REER would increase as a reflection of higher prices for theirgoods and services abroad. Figure 2 shows this process of “convergence” in theSouthern European countries from 1995 up until the last business cycle peak in2007.

Figure 2: REER Yearly Index in Selected Eurozone Countries (1995 = 100),1995-2007

Source: Eurostat.

(a) Based on the current 18 countries of the Eurozone.

Portugal’s “currency” (speaking figuratively) had appreciated in real terms byalmost 15% over that period. Spain, Greece and Italy were not far behind. At thesame time, the REER of their core Eurozone partners went in the other direction,declining by almost 10%, and thus gradually eroding the cost advantage andcompetitive edge of Southern Europe.

As shown in Figure 3, this loss of competitiveness had a very negative effect onthe trade balance (goods and services exported minus imported) down south,

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with generally expanding deficits recorded over the period.

Figure 3: Trade Balance as % of GDP, 1995-2007

Source: Eurostat.

(a) Remaining founding members of the Euro combined.

Not even Italy, with its dynamic exporting sector in the northern part of thecountry, was able to buck the trend. On the other hand, the core countries as awhole were able to increase their trade balance throughout the period.

Figure 4 depicts the situation in absolute terms in 2007. Out of 188 countries inthe world, our Southern European friends made the top 10 list ranked by currentaccount deficits. Spain made it all the way to #2; Greece, at #6, had net importsof almost $4,000 per person, the highest by far in the ranking.

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Figure 4: Top 10 Countries Ranked by Current Account Deficit in 2007 (US$bn.)

Source: CIA World Factbook.

It should also be noted that China emerged as a trading powerhouse over thisperiod. By 2007 it already boasted the world’s largest current account surplus.Southern Europe’s industries like textiles and light manufacturing, whichhistorically had contributed significantly to their economies, were particularlyvulnerable to Chinese imports. This was much less so in the core countries,which stood to gain disproportionately more from trading with Asia. So thecomposition of the export sector is also an important consideration.

If we rank the Southern European countries in accordance with their trade deficitas % of GDP in 2007, we get the same domino sequence of economies tumblingdown during the 2010-11 Eurozone debt crisis: first Greece, then Portugal,followed by Spain, and narrowly missing Italy with the same virulence (Ireland isnot shown here, but the crisis there was rooted in a different economic model).

For all the talk about government finances, turns out that trade deficits actuallymatter – even inside a fixed currency regime like the Euro. Years of heavyborrowing by the private and public sectors led to inflation in the form of relativelyhigher price levels and burgeoning trade deficits, further undermining thecompetitiveness of the economy at a time when the international markets wereopening up.

At some point those imports become unsustainable and foreign lenders that

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provide the credit close the tap. And that’s precisely what followed.

After the 2008 Financial Crisis

Figure 5 shows how Southern Europe started to devalue in real terms asfinancial conditions deteriorated from 2008 onwards. The decline in REER isparticularly pronounced in Greece, Spain and Portugal, spurred on by deepausterity measures and a big curtailment of credit to the private sector.

Figure 5: REER Yearly Index in Selected Eurozone Countries (1995 = 100),2007-2013

Source: Eurostat.

(a) Based on the current 18 countries of the Eurozone.

And once again we see the trade deficits responding in tandem, as shown inFigure 6.

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Figure 6: Trade Balance as % of GDP, 2007-2013

Source: Eurostat.

(a) Remaining founding members of the Euro combined.

The decline in trade deficits as % of GDP has been very substantial, after thelarge chronic deficits of “happier times” [Note: GDP accounting changed in all ofthese countries over this period to include things like illegal drugs andprostitution, which in some cases added 3% to the final calculation. Hmmm…]

Services Inflation

Under a fixed exchange rates regime, REER changes are fundamentally drivenby differences in the inflation rate. We can break this down by: (i) goods inflation,which broadly reflects price changes in items that are easily traded acrossborders; and (ii) services inflation, for those which are not.

With open borders goods inflation should be fairly aligned across member states.As such, the key driver behind overall changes in competitiveness must beservices inflation. This is shown in Figure 7 below.

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Figure 7: Services Inflation by Eurozone Area, 1999-2014

Source: Eurostat, Clemente de Lucia (BNP Paribas).

Note: “Periphery” includes Greece, Spain, Portugal, Italy and Ireland; “Core”includes the Netherlands, Austria, Luxemburg, Belgium, Finland, Germany andFrance.

Going back to 1999, services inflation in the periphery was consistently higherthan in the core up until 2009. This is very much in line with the relativeperformance of the REER over this period, as outlined previously.

However, with fixed exchange rates and open borders, what is driving thissignificant services inflation differential?

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Figure 8: Relative GDP Performance vs Service Inflation Differential, 1998-2013

Source: Eurostat, Clemente de Lucia (BNP Paribas).

(a) Includes only the Eurozone founding members plus Greece.

(b) Difference between “Periphery” and “Core” services inflation rates inpercentage points.

Figure 8 shows that faster GDP growth in the periphery was accompanied byrelatively higher services inflation. With the onset of the Eurozone debt crisis in2009, the trend reversed and the periphery started to grow much slower, asshown in the shaded area. Services inflation responded accordingly. This makeseconomic sense of course: under similar conditions, countries growing fastershould experience higher price growth in non-tradable items.

Therefore, the lack of economic vitality in Southern Europe is adding significantdeflationary pressure.

The Eurozone’s Unresolved Situation

Can the Southern European economies restructure their economies with the aidof a declining REER, that is, their goods and services becoming relativelycheaper abroad, and reverse the trend that has led to a steady accumulation ofmassive trade deficits over a decade and a half?

Recent experience suggests that this could be possible. However, sustainingthat decline in the real value of the “currency” going forward will be very difficultfor the following reasons:

Deflation improves competitiveness outright by reducing the cost base ofthe country (e.g. lower salaries). But this is very problematic for SouthernEuropean economies, as the already stratospheric debt levels continue torise as the income needed to repay them goes down in nominal terms.Which is why the European Central Bank is so concerned with deflation.

The core Eurozone partners could conceivably endure relatively higherinflation to reduce their relative competitiveness, but this is also

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problematic: (i) as we have seen, this differential is largely driven byeconomic performance, meaning that Southern Europe could be failing toachieve the escape velocity needed to bring down debt ratios; (ii) theinflation rate differential needed to make a difference down south wouldlikely to be too high for the core countries; and (iii) core countries competeagainst many other countries.

Greece has already seen a massive correction in its REER, which is nowbelow the level in 1995. And yet the trade deficit remains stubbornly highcompared to its closer peers. It is unclear by how much more prices wouldneed to adjust to correct this. Sanctions against Russia, a major exportmarket for them, could not have come at a worse time.

Politically, devaluation is not on the table. In any event, foreign debtsresulting from a generational accumulation of trade deficits would explodein value overnight.

The inability of these countries to rebalance their foreign terms of trade highlightsa major flaw of the Eurozone construct, which is largely based on conventionalinternational economics thinking.

All the talk about free movement of labor, price adjustments and so forth breaksdown once we realize the adverse implications that the required adjustments willhave on debt ratios. It looks like we have hit one major economic SNAFU.

Figure 9: Eurozone Government Debt as % of GDP, 2013

Source: Eurostat.

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(a) Remaining founding members of the Euro combined.

Figure 9 reminds us of how extreme the debt situation has become in SouthernEurope, in this case just by looking at the public sector. In 2013, all the countriesadded together had a Government Debt as % of GDP ratio of 121.5%, muchhigher than their core Eurozone partners and more than double MaastrichtTreaty levels. The ratio increased by a staggering 40 percentage points in justfive years.

At these dizzying heights market forces just can’t be allowed to play out; and thedebt situation in the southern Eurozone complex remains unresolved. Debt is theone thing that has steadily grown over the last four years in these countries.

Sure, we can all live in a world where central banks continue to keep interestrates at absurdly low levels (again, the market is not allowed to function) andpaper over any sovereign blow-ups. However, the system becomes increasinglyunstable. Moreover, the economic fundamentals continue to deteriorate as thosecountries struggle to regain competitiveness under a massive debt burden. Andit is tackling that burden with non-conventional measures that eventually needsto be considered, but that’s a story for another time [Hint: that process starts withan “R”].

But OK, these are very pleasant countries to live in, with friendly people, greatfood and beautiful weather. For sure this can attract foreign companies andeventually develop such a productive economy that will mitigate any pricingdisadvantages and help pay off the debts right?

And that would be excellent, except for the fact that these are pretty difficultcountries to do business in. According to the latest “Doing Business Survey” bythe World Bank, here’s how they ranked out of 31 OECD countries: Portugal(#19), Spain (#27), Italy (#29) and Greece (#30). Add the strong likelihood ofhigher taxes and pension costs to pay for all the debts as they come due andyou might be better off just visiting.

If more goods and services don’t starting leaving these countries more and moreyoung people will, motivated by high unemployment at home and the prospect ofa better life elsewhere. At least someone is working towards a real resolution.

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Veronica Giordano 1J.P. Morgan Private Bank

Very interesting article. Unfortunately my daughter stopped reading at the time of" going forward". Tonight I finish it. Please keep feeding me w macro visions!!!!Gracias! Vero

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