1. Current Account Imbalances in the Euro Area
Alan Ahearne, Birgit Schmitz, and Jürgen von Hagen
North American Summer Meeting
of the
Econometric Society
in Pittsburgh
19-22 June 2008
Birgit Schmitz
IIW Institute for International Economics
University of Bonn

2. Motivation stylized facts
Test
Motivation stylized facts
Euro area had small current account deficits in the past 20 years
But individual countries have seen rising imbalances especially since the start of EMU
These imbalances were accompanied by strong and persistent changes in real exchange rates

3. Motivation stylized facts
European current account balances in % of GDP

4. Motivation stylized facts
Surplus countries Deficit countries
Current Account Balances
-12
-10 -8 -6 -4 -2 2 4
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Ireland
Greece
Spain
Portugal
per cent of GDP

5. Motivation stylized facts
Countries with large real appreciations Countries with large real depreciations

6. Motivation research question
Can these imbalances be explained by fundamental economic factors?
Line of argument:
Current account imbalances are the mirror image of capital flows
In an efficient capital market, capital should flow from relatively rich to relatively poor countries
We should observe that current account imbalances can be explained by differences in per capita incomes
With complete international capital market integration, a country‘s rate of investment should be uncorrelated with its rate of savings
We should find that the savings retention coefficient is not statistically different from zero

7. Motivation preview of results
Capital tends to flow from high-income to low-income euro area economies
These flows have increased since the start of EMU for insiders but not for outsiders
Feldstein-Horioka regressions show that investment has been decoupled from domestic savings in the euro-area countries but not in non-EMU countries
Our results provide new evidence for the view that EMU has increased capital market integration within the region, but not for outsiders.

8. Literature Review current accounts
Empirical determinants in general
Short and medium term determinants: Chinn and Prasad (2003), Chinn and Ito (2005), Gruber and Kamin (2005), Chinn and Lee (2006)
Important variables are: government balance, initial stocks of net foreign assets, financial deepening, trade openness, demographic profiles, real effective exchange rates
For the EU, Euro Area, new member countries
Bussiere, Fratzscher and Müller (2006), Abiad, Leigh and Mody (2007), Arghyrou and Chortareas (2006) , De Santis and Lührmann (2006), Lane and Milesi-Ferretti (2006)

9. Literature Review financial integration of EU
Quantity based measures
European Commission (2006), ECB (2007), Abiad, Leigh and Mody (2007),
Feldstein and Horioka (1980), Blanchard and Giavazzi (2002)
Price based measures, portfolio weights
Baele et al.(2004), ECB (2005), De Santis and Gérard (2006), Martin (2007)

10. Estimation Strategy I data and variables
Sources: Ameco database (EU Commission), Direction of Trade Statistics (IMF), IFS (IMF)
Period/Frequency: Annual data from on EU-15
Dependent Variable: annual trade balances as a ratio
of GDP, distinction between intra-Euro area and extra Euro area trade
Independent Variables: GDP per capita, EMU-dummy, Non-EMU dummy 1, Non-EMU Dummy 2
Control Variables: fiscal balance, real oil price, average EU GDP per capita, real effective exchange rate, time dummies, constant
Estimators: OLS, GLS with control of heteroskedasticity between countries and country-specific autocorrelation of residuals

11. Estimation Strategy I descriptive statistics
Average trade balances Dispersion of trade balances

12. Estimation Results I dependent variable: intra Euro area trade

13. Estimation Results I dependent variable: intra Euro area trade

14. Estimation Results I dependent variable: intra Euro area trade

15. Estimation Results I dependent variable: extra Euro area trade

16. Estimation Results I dependent variable: extra Euro area trade

17. Empirical Results I current account equations
Intra-EU trade balances are a positive function of per capita income in EU-15
This effect becomes stronger for insiders after the start of EMU and weaker for outsiders
For Extra-EU trade balances the EMU effect is not visible for insiders, for outsiders there is a positive effect after the start of EMU
The evidence suggests that EMU has increased capital market integration in Europe.

18. Estimation Strategy II data and variables
Sources: Ameco database (EU Commission)
Period/Frequency: Annual data from on EU-15
Dependent Variable: gross investment rate
Independent Variables: gross savings rate, EMU-dummy, Non-EMU dummy
Control Variables: time dummies, constant
Estimators: OLS, GLS with control of heteroskedasticity between countries and country-specific autocorrelation of residuals

19. Estimation Results II dependent variable: gross investment rate

20. Estimation Results II dependent variable: gross investment rate

21. Empirical Results II investment-saving equations
The coefficient on the gross savings rate is lower than in Feldstein and Horioka, but in line with Blanchard and Giavazzi
The interaction term with the EMU dummy is significantly negative, the interaction term with the non-EMU dummy is negative but not statistically significant
The combined effect for EMU insiders is not statistically different from zero
Thus, domestic investment is decoupled from domestic savings in euro area countries which is in line with more financial integration in the euro area

22. Test
Conclusions
Current account imbalances in the euro area reflect efficient capital flows
The empirical evidence shows that the introduction of the euro has greatly improved capital market integration and efficiency
Thus, the imbalances show that EMU works smoothly
For the outsiders, EMU may have brought some degree of capital market disintegration
Fiscal policy is not necessarily the right policy response to these current account imbalances