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It is more than usual to read articles examining the Euro boom years which tend to suggest that capital inflows from the core funded the credit expansion in the periphery. Although that line of reasoning is not wrong when examining capital flows between countries, I do not think it is entirely correct in the case of a monetary union such as the Eurozone.

The main reason is the fact that the Eurosystem is structured in such as way that it is accommodating of capital flows between Eurozone members through overdrafts at the NCBs and unlimited Target2 credit. Banks as suppliers of credit and creators of deposits do not need a pre-existing stock of funds, nor to they need to pre-finance any outflows to other Euro members.

More specifically imagine the following example depicting the normal flow of credit and cross-border flows:

  1. A bank customer in Greece applies to a Greek bank for a loan to fund a new investment project (which will require German manufactured capital goods).
  2. The bank extends the loan and credits the corresponding customer’s bank account. No actual funds are needed by the bank apart from the 2% reserve requirements (which is elastically provided by the ECB).
  3. The customer pays for the capital good by transferring funds to a German bank. For the transaction to take place, the  Greek bank debits its reserve account at the Bank of Greece with the corresponding amount and BoG increases its Target2 net liability position. In case the Greek bank is short of reserves (compared to average reserve requirements) it can source funds at the BoG marginal lending facility, at the weekly MRO or at the interbank (repo) market.
  4. Since the interbank repo rate is quite favorable compared to the marginal facility rate, the Greek bank will use high quality bonds from its bond portfolio (mainly Greek government bonds) to source funds from the European interbank repo market using the bonds as collateral. It is clear at this point that the new bank loan remains on the Greek bank books and is never transferred outside its balance sheet, nor does it play any significant role in the cross-border flows.
  5. Apart from the increase in bank liabilities to RoW (described in (4)), periphery countries also saw a large increase in the amount of government bonds held by the foreign sector. As a result, instead of (4), Greek banks could just use the flow of funds from abroad (which were used to acquire Greek government bonds) to repay their (extra) liabilities towards the BoG and maintain a stable amount of interbank funding. It should be noted at this point that any inflows of funds either from the interbank market or from foreigners for the purpose of buying government bonds will lower the net liability position of BoG to the rest of the Eurosystem (a position that actually remained quite small until the start of the 2008 crisis).

What is clear from the above is that cross border flows are accommodating (in the sense that central bank financing is always available to cover them) and that the reason of incoming flows has almost nothing to do with the original loans and transactions (in our case a bank loan to pay for an investment project ends up in a cross border liability of the government or the banking system).

Financing of cross border flows was always provided by the Eurosystem. Inflows of funds to buy government bonds and interbank loans were merely used by the banking system as a cheaper source of funds instead of large liability positions towards the corresponding NCB. Capital inflows did not ‘fund investment in the periphery’ but were the result of foreign portfolio preferences and mostly changed the composition of the net liability position in the periphery away from Target2 liabilities which were replaced by higher liabilities of the government and banking sector.

BoG recently released the Greek balance of payments for July 2015 (which is actually the first release where the data are based on ELSTAT rather than bank transactions). The release is the first after the imposition of capital controls (following the announcement of the Greek referendum) and includes some quite interesting developments.

Compared to July of 2014 the balance of payments increased to €4.25bn (from €1.27bn), an increase of close to €3bn. The major movements in specific categories are as follows:

  • The fuel balance dropped from -€726mn to -€227mn mostly due to a large fall in fuel imports of €731mn (although exports also fell €241mn). A large part of the drop is probably due to much lower oil prices compared to a year ago.
  • Purchases of ships were nil compared to €114mn last year.
  • Other goods imports fell strongly by €730mn to a little more than €2bn (while the average figure during the first 7 months of 2015 was around €2.6bn).
  • Apart from travel receipts all categories of the services balance dropped significantly, especially payments abroad (-€690mn) and transport receipts (-€700mn).
  • Secondary income receipts (basically government receipts from the EU) increased substantially by €1.75bn.

The effects of capital controls were very strong on most elements of the goods and services balances. It is helpful that exports of other goods did not seem to be affected and actually increased by €50mn. It will be interesting to observe August figures (when they do get released) to determine to what extent the drop in goods and services imports was permanent or just postdated.

The improvement of the goods and services balance was €1.24bn in a single month. As long as this improvement is permanent I think it is reason enough to not expect a large fall in Greek GDP during 2015Q3. Even a nominal drop of 6% during the third quarter (which is consistent with a fall of 5% in real GDP if the VAT increases are taken into consideration) is equal to roughly €2.9bn. In other words, the improvement of the July balance of goods and services is close to 40% of that drop. As long as the August external balance figures are also positive news it is very hard for Greek internal demand to negate the positive impact of the external sector. Third quarter GDP might actually prove to be quite resilient.

UIP obviously stands for Uncovered Interest Parity. The following is a crude visualization of its explanatory strength. The graph depicts the difference between real 12-month Libor rates for Euro and USD against the change in the US/Euro exchange rate. An increase in the real spread should lead to a Euro appreciation with the two graphs moving in the same direction (data are monthly since January 2007):

real 12m-libor USD euro - exchange rate movement

It is quite evident that the two series are highly correlated (correlation coefficient of 0.65 with R² equal to 0.42). What is very interesting is the fact that the spread is driven by inflation differentials between the Eurozone and the US (as a result of current disinflationary forces in the Euro area), since nominal rates have converged in the two regions:

libor-euro minus libor-usd

Obviously the above graphs are rather crude and a better indicator of future inflation rates would be inflation swap rates. These might help explain recent exchange rate movements (which are not easy to explain in the first graph).

In any case, the relative unwillingness of the ECB to act upon the disinflationary forces in the Eurozone does have its toll on the exchange rate which might negate a large part of the improvement of the RER. How far inflation rates will remain weak is going to play a crucial role on future exchange rate movements.

Bank of Greece Balance Sheet

Bank of Greece released its balance sheet for October 2013:

Bank of Greece Balance Sheet Oct 2013

One has to acknowledge that the data point to a relative stabilization. MRO borrowing was lower €1.3bn while ‘Other claims’ dropped about €1bn. This was reflected in both the Target2 (-€2.7bn) and banknotes (-€0.3bn) liabilities. Although haircuts remained relatively stable, the €1bn fall in ELA contributed to a fall of €12bn in posted collateral.

Current Account

Bank of Greece also released data on the September current account. Looking into various categories a few clear conclusions are:

  • The trade balance is still driven mainly by fuel imports and exports with exports higher by €0.64bn in the first 9 months and imports down €1.5bn for an overall improvement of more than €2.1bn.
  • Other goods exports are showing considerable signs of weakness with the total increase in the first 3 quarters being only 3.6%. Imports actually increased in September compared to one year ago, probably due to the stronger tourist wave. It seems that other goods might end up posting only a marginal total improvement during 2013.
  • Tourist revenue has been the main sector posting healthy growth this year. They increased €1.34bn although transport revenue was lower €1.13 leaving the total services income only slightly higher (+€0.2bn or +0.9%).
  • What is quite worrying is the fact that profit/interest/dividends payments abroad are already higher than last year both for the 9-month period and September. The PSI effects are over and interest payments are again a drug on economic growth.
  • EU receipts have played a major role in improving the current account with funds being higher by €1.63bn.

In general, although a few sectors show considerable strength (mainly tourism and oil exports), other goods exports are stalling while import contraction has reached its limits and cannot provide any further relief. Given the above trends it seems that the external sector will not be able to assist during the final 2013 quarter and won’t be the growth engine for 2014.

A quick post on the topic of Greek imports/exports and their connection to domestic demand. The graph below shows the share of intra/extra-EU Greek imports to domestic demand as well as the share of intra-EU Greek exports to EU domestic demand (minus Greek demand) and Greek demand. An increasing share of imports and a declining share of exports (in terms of EU demand) would point to a loss of competitiveness. A stable share on the contrary would be in favor of the trade/income connection:

Greek Imports Exports share of domestic demand

What is clear is that:

  1. Intra-EU imports were very stable at 12-13% share during 2003 – 2008.
  2. Intra-EU exports as a share of internal demand were also very stable during the same period.
  3. Intra-EU exports as a share of EU internal demand not only kept their share but also managed to increase it from 7.4% in 2002 to 10.6% in 2008 (scaled by 100). Since they remained stable as a share of Greek domestic demand this implies that Greece was growing faster than the rest of EU. Although it managed to increase its share of exports, its high growth contributed to exports not increasing as a share of domestic demand. Actually, during 2002-2008 Greek domestic demand either in constant or current prices increased at close to double speed than the EU figure. One has to acknowledge though that domestic inflation also increased faster, making Greece less competitive in CPI terms (which mainly hurts the services/tourism sector).
  4. Extra-EU imports was the only category showing an increase, at least after 2005 (from 8.5% in 2004 to 10.9% in 2008). This category though includes imports of oil and ships and is affected by the exchange rate.

The idea of a loss in competitiveness does not appear to be supported by the data. This is also evident if one checks Greek Real ULC relative to competitor groups (series OLCDO in Ameco). Real ULC are very stable after 2002 with a declining trend:

Greece Real ULC relative to competitor groups

Continuing on the subject of the external sector I ‘d like to elaborate a bit on a simple fact: Imports are usually a function of domestic demand, not of relative prices. Greek imports did not increase during the Euro era because Greece lost competitiveness but simply because its internal demand grew faster than its trading partners. As a result, exports grew slower than imports and the latter became a much larger percentage of GDP.

The point of this observation is significant. As long as domestic demand is strongly correlated with credit growth (and credit flows were above 15% of GDP during the peak of the credit expansion and dropped to negative territory after 2009), imports (and the trade balance) will follow domestic demand with relative prices playing a secondary and limited role. Trying to adjust through wages will further reduce domestic demand, something which might improve the trade balance but at the expense of employment, debt servicing costs and long-term growth potential (due to hysterisis effects and negative net investment).

As a starting point I ‘ve calculated the ratio of imports of goods and services to domestic demand (excluding inventories) at constant prices for the 1995 – 2013 period (the last observation is based on projections from Ameco). A unit root test indicates that the process is stationary (although the test is not highly significant):

imports demand unit root testIf one tests for a simple AR(1) process the results are quite significant, with a good fit (R² = 0.52) and no problems in basic diagnostic tests. The computed long-run mean value is equal to 30.2%.

regression result

Looking into the corresponding graph (of fitted, actual and residual values), it is clear that the fit is good apart from two periods. The Euro introduction of 1999 – 2001 and the pre-crisis period of 2006 – 2008. Both can be considered special cases: In the first case, the Euro introduction came just after a large stock market bubble while during the second, net imports of fuel and ships increased by more than 3% of GDP, from 3.8% in 2005 to 7.2% in 2008. Obviously just adding a dummy variable for these years increases the fit to R²=0.80 with a relevant coefficient of 3.1.

regression graph

Right now, the relevant ratio is close to 27.5% which points to either a permanent regime change (with import substitution) or significant credit and income constraints (something also evident from the negative residuals for the last few years). A return of the ratio closer to 30% would subtract roughly the same amount from GDP, constraining growth (if the long-run variable is still around 30%).

One can argue about if the relevant long-run mean is high or not, but the reality is that any positive residuals (which might be indicators of relative price effects) have clear and plausible explanations related to outside factors and imports more or less followed the evolution of domestic demand. A relative price policy (targeting wages) seems to be just a wrong diagnosis of the problem.

As I ‘m sure is quite clear by now, I ‘m not a huge fan of the price mechanism as the main adjustment process for economic imbalances. In my view, most of the adjustment in the economy happens through quantities, especially for the (quite large) part that has high elasticity to demand (manufactured goods, services with the price mechanism working mainly in the case of commodities and housing). As a result, it is my belief that the current focus on ULC adjustments as a path for improved export performance in the periphery is wrong and will have negative results on final internal demand that will outweigh any possible positive effects on exports.

The correct way to look into this subject is to calculate export price and income elasticities. Nevertheless, since the ULC adjustment has only been happening since 2010, one can also use more ‘elementary’ tools to analyze periphery export performance for the last few years.

What I ‘ve done is the following:

  1. Use the goods exports price deflator to deflate intra-EU nominal exports of periphery countries. I am aware that this method might under/overestimate the relevant volume figures, but I ‘m not aware of any deflated series for intra-EU trade.
  2. Calculate ‘external’ intra-EU demand as EU-27 domestic demand in constant prices minus the corresponding periphery country figure.
  3. Take the ULC-based REER to EU-15. Although one should generally use a price-based index, I am using this index since the focus of internal devaluation is on wages and ULCs.
  4. Calculate correlations and R² for the 2009 – 2012 period for:
    • exports and external demand
    • exports and REER
    • export prices and REER
    • REER and internal demand

periphery exports external demand and REER

The results are not surprising:

  1. With the exception of Portugal, correlation between exports and external demand is close to 1 (with very high R²). This is in accordance with the literature that finds that, especially short-term, elasticities of demand are close to unity while price elasticities are much lower than one.
  2. Exports and REER show correlations close to -0.6 with low R². Greece is an outlier with a correlation of zero (which is a quite significant observation). In general, the relationship between ULC and export performance is weak.
  3. Correlations between export prices and REER are quite high with significant R². Yet they are of the wrong sign: A devaluation in ULC terms is accompanied by an increase in export prices. One should probably look into price effects more closely, breaking down export prices to import prices, nominal exchange rate (for import prices), profit margins and ULCs contributions, in the same manner that Ameco calculates the corresponding contributions for the final demand deflator. An interesting observation is that the correlation coefficient is quite similar for all countries.
  4. The correlation between the change in REER and internal demand is very high (close to unity for Spain and Portugal and 0.9 for the other two countries) with very high R². This means that any reduction in wages is automatically reflected on internal demand. Since the latter is far greater than exports, internal devaluation is self-defeating in real terms since it lowers a much larger part of demand. Imports are the only factor that cushions the effect somewhat.

Since periphery demand is a large part of external demand for most of the countries (22% for Greece, 16% for Spain, 12% for Italy), the combined effort to lower ULCs, along with the high correlation between REER and internal demand, actually also reduces external demand to a large extent. Given that the EU is in recession, it is only natural to observe an actual stagnation/reduction in exports, even though REERs have been reduced significantly.

Just to complement the post, I ‘d like to add the evolution of the Greek ULC-based REER towards the 35 main trading partners as well as of the NEER (a comparison I ran across on this paper). If the ‘loss of competitiveness’ of Greece was driven by ULCs, the ΔREER – ΔNEER should be large. A close inspection of the actual data shows that the contribution of ULC (in a trade-weighted analysis) actually trended around zero, with the NEER driving any changes in the REER (which appreciated around 17% between 2000 and 2009). It is quite strange to ask from workers to bear the cost of a nominal exchange rate appreciation through reduced wages and unemployment.

Greek NEER REER-35

After outlining a fairly simple analytical framework for the examination of Greek imports in the previous post, the next logical step is to use that to look into exports and imports developments in the periphery and Germany. Calculating the corresponding imports/exports penetration and price changes yields the following results (imports and exports are for the goods category):

Periphery Germany Import Export Penetration and Prices

Since the penetration change is derived by comparing the volume change of trade (exports or imports) with GDP, it can be considered a measure of relative incomes. If GDP increases faster than exports then, if the exports and GDP deflator change by the same amount, the exports share will decrease. A few key observations by country:

  • Germany: Germany was clearly able to increase its export penetration significantly compared to imports in the Euro period. This happened although its terms of trade worsened considerable, especially compared to the pre-Euro period. This pattern points to different growth rates of relative incomes between Germany and its trading partners, something evident in its stagnant internal demand.
  • Greece: Greek terms of trade were roughly steady during the whole of 1992 – 2008 period, an observation quite contrary to the fall in competitiveness story (although it is the only country where export prices did not fall). The trade deterioration can be explained completely by exports – imports penetration, due most probably to higher income growth in Greece. That would suggest that any correction would be ‘automatic’ as long as the income growth fell closer to European levels.
  • Spain: Spain shows a picture similar to Greece. Its terms of trade were rather constant while its exports – imports penetration figures basically reversed sign betwen 1992 – 1999 and 2000 – 2008. The credit/housing boom probably accounts for that.
  • Italy does not really show any clear pattern. It did not lose in volume during the Euro period while it gained considerably in prices (the largest improvement in the sample equal to -13.9%).
  • Portugal: Portugal is a peculiar case. Patterns between 1992 – 1999 and 2000 – 2008 are roughly the opposite. It improved its terms of trade (and lost volume) in the first period while the reverse happened in the Euro era.

Overall, each country has its own story to tell and no common explanation is relevant for all cases.

Ι ‘ve focused on inflation in recent posts so I would like to make a few points on export price inflation dynamics in the periphery. Since the idea of reduction in unit labor costs rests on the assumption that lower costs will be reflected on export prices and through price elasticitiy (which is usually below 1) to export growth, it is reasonable to check certain metrics:

  1. The magnitude of export price inflation in periphery countries compared to Germany and
  2. How export prices move compared to import prices. A reduction of ULC (other things equal) will allow for higher firm profit margins and lower export prices, even if import prices increase (depending on value added). If on the other hand other firm costs increase (taxes on production/income, access and cost of credit, energy costs), the margin will be lower and export prices will follow import prices closely.

I ‘ve used the Ameco database goods imports and exports deflator series for Germany and the periphery. The latter excludes Ireland which is a rather special case since it is an export hub for large multinational corporations:

Germany Periphery Export Import prices inflation

It is clear that Greece is an outlier, with export prices increasing over 21% in the 2010-2012 period. while it is also the only country where net export price inflation was positive which is probably a result of other costs on production. The rest of the periphery (with the exception of Portugal) displays a rather normal increase in export prices (the Euro area increase in the 2010-2012 period was 9.4%) with Germany still managing to keep its export inflation at very low levels.

Net changes are highly negative for the rest of the periphery which means that any reductions in labor and other costs are passed through to prices, despite any increase in import prices (the analysis would be more clear if value added of exports was easily available).

A simple linear trend shows that there is strong positive correlation (coefficient of 1.07) between net export prices and the final export price inflation. The fact that Greece, despite having the largest fall in ULC, is the only country with a positive net increase in export prices suggests that other factors (my guess is access to credit) play a major role in firm costs and do not allow them to not pass through any import price increases. In terms of export price inflation, Greek internal devaluation seems to be quite far from success so far.

export prices - net export import prices trendWhat is even more alarming is the fact that during the same period (2010-2012), the private consumption expenditure deflator for Greece increased 8.6% and the domestic demand excluding stocks 3.4%. It seems that exports had price dynamics of their own.

Probably most of the most persistent and wide spread views of the general public is that a large currency devaluation results in more or less equivalent losses in purchasing power. Thus an exit of a periphery country from the Euro (which would probably be accompanied by a large devaluation of between 20-50%) is not considered a viable alternative to the current real income losses due to austerity and recession.

Unfortunately, the reality is quite different. Large devaluations are accompanied with significant changes in the CPI-based Real Exchange Rate (while if the loss of purchasing power was equal to the devaluation, the RER would not move). This is due to the fact that a devaluation only changes the import/export prices of tradable goods, not the general price level.

A very interesting study on the subject suggests a simple accounting model of calculating the effects of a devaluation on the CPI. It starts with a simple index where all goods are considered tradable and changes it to reflect reality:

Table 1 shows that there is substantial comovement between the price of imports and exports and the nominal exchange rate. In Argentina, Brazil, and Mexico this comovement is present at all the horizons we consider. For Korea and Thailand, the comovement is stronger in the first few months after the devaluation

Table 1 indicates that the retail price of tradable goods moves by much less than the price of imports and exports (see also Figure 1).Table 1 also shows that the price of nontradable goods and services moves by much less than the rate of devaluation. Although the retail prices of tradable goods move more than prices of nontradable goods and services, the differences are small relative to overall movements in the nominal exchange rate.

According to Table 3 on average, nontradable goods account for roughly 50 percent of the CPI basket. In our view, this decomposition substantially understates the percentage of the CPI basket that is composed of nontradables because it ignores distribution costs for tradable goods and local goods.
Recall that we compute the CPI using retail prices. These prices are necessarily different from producer prices, because they reflect distribution costs associated with wholesale and retail services, marketing and advertising, and local transportation services. Burstein, Neves, and Rebelo (2003) show that these costs are large. According to their estimates, the average distribution margin for consumption goods, is roughly 50 percent.

Distribution services are nontradable in nature, since they are intensive in local land and labor. So Burstein, Neves, and Rebelo’s findings imply that half of the retail price of a tradable good reflects nontradable goods and services. Consequently, distribution costs account for approximately 25 percent of the CPI bundle raising the total share of nontradables in the CPI to 75 percent.

Consider the remaining 25 percent of the CPI basket classfified as tradable goods. Many of these goods are actually local goods that are produced solely for domestic consumption. For example, yogurt is traditionally classiffied as a tradable good. However, almost all the yogurt produced in Argentina is sold locally (see Table 8, which provides additional examples). It is difficult to precisely estimate the share of local goods in the CPI. However, the calculations below suggest that local goods could represent as much as 22 percent of tradable goods or 11 percent of consumption. In this case, taking distribution costs and local goods into account reduces the share of pure-traded goods in the CPI basket to 14 percent.

price accounting for large devaluationsIt is clear that although initial devaluations are significant (128% in the case of Argentina), the final result on the CPI is much lower (34%):

annual prices deflators in large devaluations

Another, more detailed approach, is the one taken by another paper, which uses Input-Output tables to compute the results of a 50% drachma devaluation (after a switch from the Euro to national currency) on the CPI, under various model assumptions (such as whether workers try to avoid losses in purchasing power by demanding higher wages). The conclusion is that, under the most ‘inflation-prone’ model, the first year inflation will be 9.3%, a rather small cost for the return of sovereignty.

per-period cost inflation ratesAnother way to gain more perspective on the subject is to look into the recent high inflation history of Greece during the 80’s, early 90’s. The Ameco database provides a very useful statistical series with the contributions of various factors to the final demand deflator. The factors are import prices (corrected for the exchange rate), the exchange rate, nominal ULC, gross-operating surplus (firm profit margins) and net indirect taxes. The series can be used as a close proxy for the CPI and allows one to breakdown inflation into the contributions of the domestic sector and the exchange rate:

Greece - Contributions of Domestic and Exchange rate sector to final demand deflator

During the 80’s the mean contributions of the exchange rate and the domestic sector were 3.3% and 15.4% while in the 90’s 1% and 8.9%. Neither the inflation of the 80’s, nor the disinflation of the 90’s was a result of the external sector (constant depreciation in the first period, ‘strong drachma policy’ in the second) but of large (monetary) claims of the domestic sector on production. Inflation dropped because the domestic sector contribution went from 15% in 1990-1991 to 5% in 1997 and 2.5% in 2000 (the same values for the exchange rate were 2%, and -0.5%). One can attribute the persistent high inflation to mismanagement and loose monetary policy rather than to currency depreciation.