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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.

BdE published the balance of payments for September 2012 (and 2012Q3). Developments are quite positive. Regarding the current account:

Spain current account sep 2012


The goods balance is now firmly below the -€3bn/month threshold. Compared to -€31bn in the Jan – Sep 2011 period, the balance was -€22,13bn. It’s quite positive that most of the improvement is attributed to larger goods exports (+€5.7bn to €170.52bn) than lower imports (-€3.2bn to €192.65bn). The balance in services was also improved by €3.45bn. Total goods and services balance is now +8.17bn compared to -4.15bn a year ago.

A very large improvement came from the income balance which registered at -€16.61bn, down €2.7bn from last year. After growing to more than -€3.1bn during July, the balance dropped below -€1bn during August and September most probably driven by the ‘ECB effect’.

Current transfers were -€8.07bn compared to -€6.84bn in J-S 2011 and the capital account was €3.92bn after €4.17bn a year ago. Overall, the current+capital account deficit is now mainly driven by the income deficit.

Spain financial account sep 2012


The financial account was also quite positive during September. Portfolio investment turned strongly positive during September (+€9.75bn after a +€2.34bn in August and -€10.82bn in July), a strong display of ECB ‘powers of persuasion’. Large inflows were registered in the general government category while ‘other sectors’ also had a positive balance after a long time (+€3.34bn after -€2.78bn in August) and MFI outflows continued dropping with September reading below -€2bn.

The largest change was in the other investment balance where investment on MFIs went from -€21.52bn during August to €4.93bn in September, marking the return of Spanish banks in the Euro interbank market.

External adjustment is definitely making progress in the case of Spain (with exports showing healthy increase) while ECB actions allowed for a complete U-turn on capital outflows. How long the ECB effect will last is an open question.

One meme often repeated about the Greek ‘tragedy’ is that the large current account deficits during the Euro area were fuelled by equally large government deficits. The profligate state was the source of the increase in foreign claims and made the equilibrium unstable since, given the large share of foreign ownership of government securities, a loss of financing would impact on both the current account (and the ability of the Greek economy to import goods) and the government budget (and the ability of the Greek government to finance deficit spending). In my view, the actual data paint a different picture.

The current account was mainly financed through private sector credit flows. These, very large annual flows, were originated by the domestic banking sector and allowed the private sector to finance an expanding trade deficit. The table below shows data for the period between 1999 and 2007 (when private credit expansion was at its height):

It is quite clear that private credit flow was usually at least twice as large as general government net lending. A simple scatter plot leads to an R² of 0.67:

It’s impressive how low the error term of the computed equation is, meaning that credit flows explain almost all of the current account movement. A similar exercise using government net lending leads to an R² of only 0.17 while the error term is quite large and equal to 3.41.

What seems to have actually happened is that domestic private credit flows financed imports. On a second phase, The Rest of the World (RoW) invested these flows in government securities instead of claims on the private sector. As a result, one can maintain that the expansion of net interest payments to the RoW, mainly in the form of government securities coupon payments, were the direct result of the private credit expansion. In any other case, the relevant securities would have been acquired by the domestic sector and consisted net income, rather than a net outflow.

This is quite evident in the RoW asset flows available in BoG financial accounts:

Although the cumulative current account deficit between 2000 and 2008 was almost €193bn (and another €31bn in 2009), most of it was ‘invested’ by the RoW on government securities, with the residual being only €62bn (and even a negative €2bn in 2009). While in the case of countries such as the USA, the RoW ended up acquiring claims on the private sector (in the form of various ABS paper), in the Greek case the foreign sector kept its ‘investment position’ as claims on the government sector, claims for which a large, liquid market existed and which were the main monetary instruments of the central bank.

In my view, such an ‘equilibrium’ was inherently more stable than an alternative one were the RoW held mainly claims on the private sector. As long as the central bank was determined to maintain stability in the government securities market, an adverse external financing shock could be avoided, something which would not be possible in the case of claims on the private sector, since in that case their underlying credit risk would be elevated due to the economic recession, lower real-estate prices and other factors.

On a related note, summing current account deficits since 1995 up to 2011 leads to a figure of -€276.4bn which should roughly correspond to the NIIP at historical costs. On the other hand, the NIIP in 2011Q4 according to BoG data was -€179.6bn, almost 100bn (48% GDP) lower. Based on historical financial accounts flows, at the end of 2011 the RoW should have held around €113bn of government securities, while the NIIP shows a figure of €71.6bn. The ‘internal devaluation’ has also had an ‘external’ effect on RoW claims.

Keeping on the subject of previous posts I ‘ll make a smaller post on the services balance during the Euro area.

The Ameco database does not provide services trade broken down between Intra and Extra-EU so only aggregate data are reported. The above chart makes it clear that the services surplus was quite stable moving from an average of 4% GDP before the Euro to a 6% surplus after the Euro introduction. Services imports were also very stable at 6% GDP making services exports the only source of volatility.

Going through scatter plots of the exchange rates and the services surplus leads to interesting results. REER of either EU-15 or the 35 industrial countries do not produce any significant relationship which probably suggests that labour costs had only marginal impact on the services sector. On the other hand, the NEER and the surplus show a strong upwards slopping trendline:

Normally a currency appreciation should lead to lower external demand. One assumption is that services exports are not actually related to the NEER but to other (global) trends. Nevertheless, no clear relationship emerges between global GDP or trade growth rates (using WEO data) and the services exports or surplus. The best fit comes from Euro area GDP growth data and services exports.

Interestingly, a strong relationship emerges if one examines the Brent US$ price and services exports which also suggests that exports are not driven by local factors:

In general, services seem to be relatively inelastic to labour costs and local developments, probably due to their global perspective. The following chart from the Levy Institute paper is helpful to determine exactly what role each services sector played in the examined period:

After going through various aspects of the Greek economy since the mid-90’s in the previous post (based on a Levy Institute paper), I ‘ll try and look into other factors of the post-Euro period, mainly of the goods foreign trade. First, using AMECO information for the Real Effective Exchange Rate (based on ULC), here’s the relevant REER for Greece and other major Euro economies since 2000:

What is clear is that the Greek REER (relative to the rest of 35 industrial countries) was actually lower than the Euro area aggregate figure and was quite close to the France numbers. Furthermore, Germany embarked on a significant ‘deflationary’ route and managed to keep its 2008 REER 5% lower than 2000. This is even more visible in the case of the REER relative to the rest of the former EU-15:

Greece followed the Euro area figure while Germany managed a 13% devaluation in this case. Looking into the Euro nominal effective exchange rate (again relative to the rest of 35 industrial countries), the evidence suggests that Greek exchange rate appreciation happened only because of nominal factors and was actually much lower than the Euro area, the same as Germany and other major Euro countries:

Given the strong Euro 2% inflation target (which should make the Euro REER the ‘equilibrium’ rate) and the fact that Greece outperformed the Euro REER for extra-Euro trade and was in line with the relevant intra-Euro REER, any loss of competitiveness was mainly due to nominal exchange rate fluctuations and not because of large wage appreciation. This is also evident in OECD minimum wage data which show that, relative to the productivity increase and the 2% inflation target, minimum wage setting was not inflationary, except for 2005 and 2008:

Before turning to actual trade data, it is interesting to take a look at the terms of trade. Any large appreciation will allow a country to improve its trade balance without actually increasing its export volume, while the opposite will require higher volumes (relative to imports) just to stand still:

Greek terms of trade were actually 2.5% worse than 2000, a pattern which emerged since 2003. With the exception of Italy, most countries show small changes which means that any improvement in their trade balances should have come from actual volume (and probably composition) changes.

Since the AMECO database provides goods imports and exports categorized into intra and extra-EU trade it is interesting to examine the relative growth figures. One should keep in mind that during the 2000-2008 period, EU GDP grew by 35.5% while Greek GDP by 72.5% in nominal terms.

Intra-EU Goods Imports and Exports:

Greek Intra-EU imports rose 46% while exports 48%. Greece managed to follow the aggregate EU figure for exports, a number much higher than EU GDP growth, while import growth lagged GDP growth by more than 25%. Just for comparison, both France and Italy achieved much lower growth figures and only countries such as Germany and the Netherlands managed to grow over 50%. Overall, arguing that Greek goods lost ground in the EU seems rather hard.

Extra-EU Goods Imports and Exports:

In the case of Extra-EU trade the patterns are quite different and show that core and periphery countries did not follow the same path. Both Greece and Spain (as well as Italy and Portugal to a lower extent) dramatically increased their imports without managing to compensate through higher exports. France was a low growth outlier while both Germany and the Netherlands recorded much higher export than import growth.

These trends also show up in the following tables from an excellent IMF Euro Area Imbalances study:

Imports from commodity exporters grew strongly (in a large part due to higher oil and other commodity prices) without a corresponding increase in exports. Emerging Asia exports also gained market share but periphery products (except for Portugal) were not in high demand and did not cover the expanded deficits. The strength of Germany is explained by the different goods export composition (an emphasis on capital goods and high quality/strong brand name machinery and pharmaceuticals). In the case of Greece, Emerging Asia and commodity Exporters account for 3.5% GDP higher goods deficit in 2008.

So it seems that the goods balance deficit for Greece was mostly the outcome of Extra-EU trade. Intra-EU deficit went from €15.6bn to €22.6bn while Extra-EU from €7.9bn to €22.5bn or in terms of GDP from 11.6% to 9.7% and from 5.9% to 9.7%. In any country without strong inflows (from services exports and income) to service a goods deficit of 10% GDP the exchange rate would have highly depreciated. In the Greek case, it actually appreciated. Strong inflows from other sources were also not available since the services surplus went from €8.1bn to €14.9bn while net primary income from €0.4 to -€7.6bn thus worsening the overall balance.

The above are more clear in the following graphs of Intra and Extra-EU trade and REER:

The Intra-EU trade deficit (as %GDP) is actually quite stable during the Euro period despite the REER appreciating. On the other hand, the Extra-EU trade deficit more than doubles and basically follows the REER appreciation after 2001. Other factors (probably private credit) seem to play an important role since the deficit growth does not seem to be influenced by the drop in the REER in 1999-2001.

A scatter plot of the REER to EU-15 and the Intra-EU deficit does not produce any meaningful relationship (something which is evident in the Intra-EU trade chart). On the other hand, scatter plots on the REER and NEER with other 35 industrial countries and the Extra-EU deficit display a clear upward slopping relationship:

One could probably blame the Greek authorities and private sector for not targeting the extra-EU tradable sector better. But the clear conclusion is that the Greek goods deficit problem was mainly one of an appreciating currency and large deficits towards the Extra-EU world, not one of loss of competitiveness inside the Euro area. Pushing for demand destruction through internal devaluation while having an overvalued exchange rate sounds like bad advice.

Using BoG data to look at the trade balance excluding fuel and ships leads to an impressive result. The trade deficit was declining between 2000 and 2004 and only increased by 2% GDP between 2004 and 2008, probably driven by the very large credit expansion during that period:

BoG released data on the Greek balance of payments for July 2012:


What i always keep an eye on is the balance of goods and services excluding oil. This has now turned positive to the order of €1.4bn. This is mainly driven by shrinking goods imports (-10.9%) although expanding exports (+8%) also play a role. The services balance has also been expanding modestly although that is due to lower payments than an expansion of receipts, which have actually dropped from €15.8bn in 2010 (Jan-Jul) to €15.1bn.

The other very positive development is the large reduction in interest payments (mostly as a result of the PSI) which were a bit less than €4bn, compared with €6.8bn during 2011, a reduction of almost €3bn. Any further OSI will lower interest payments even further. By now, the income negative balance is covered by net receipts in the current and capital transfers accounts. As a result, the current account will be mainly driven by the oil balance from now on. During Jan – Jul the latter was -€6.6bn while the current account -€6.46bn. The increase on the special tax on heating oil that will take place in October will definitely lead to an even lower balance compared to last year.

On a yearly basis it is very likely that the current account will settle around -6-6.5% of GDP, more than half compared to the recent past. Still, from a sectoral balances point of view the targeted fiscal primary surplus of 4.5% of GDP will lead to further economic contraction as it will translate to a private sector deficit of 8-10% during 2013-2014. In my view what is needed is a further lowering of interest payments to the official sector (by a drop on the interest rate on the Greek Loan Facility and an exchange of ECB Greek bonds with the new English-law post-PSI bonds) as well as a target of a balanced fiscal primary balance, thus allowing growth to slowly return to the Greek economy. I believe that the currently targeted primary balance will never be reached due to a deepening of the recession.

Bank of Greece released data for the Greek balance of payments of June (as well as the January – June period). Main observations:

  • The current account has dropped significantly to -€7.1bn (Jan-Jun), compared with -€13.6bn for the same period during 2010. In other words it’s now almost half of what is was two years ago.
  • The most important part of the adjustment happened in the goods balance. This went from -€15.27bn in 2010 to -€11.08bn this year, while the balance excluding oil is even more impressive, from -€10.82bn to -€5.41bn (exactly 50% of the 2010 deficit). Exports of goods (excluding oil and ships) increased by 27% from €5.2bn to €6.61bn, while imports fell 19%, from €14.09bn to €11.37bn.
  • The services balance is roughly steady, increasing from €4.53bn in 2010 to €4.97bn this year. Subtracting the services surplus from the trade balance (excluding oil) results in only a €0.44bn deficit which suggests that (given the ongoing recessionary adjustment) the total balance of goods and services excluding oil will be roughly balanced in 2012.
  • The income deficit was much lower at -€2.2bn (vs -€3.89bn in 2010 and -€4.29bn in 2011) mainly due to lower interest payments abroad. Given how the PSI accured interest was accounted for (as 6-month EFSF Bills) these figures might change in the later course of the year.
  • Current transfers were steady while capital transfers were €1.07bn instead of €0.31bn in 2011 due to much larger transfers from EU. This development should obviously be considered temporary.

In the financial account, direct investment was positive, although that was mainly due to much lower investment abroad than a surge in FDI in Greece. Portfolio and Other investment figures were huge at -€71bn and €78.7bn with €75.3bn accounted by loans by general government.

My rough projection is that by the end of 2012 the balance of goods and services will only account for the oil balance, which will be close to -5% of GDP. I do not believe that such a figure can be considered as unsustainable. What will be important is to keep the rest of the current account figures (sum of income, current and capital transfer balances) balanced which depends on the interest paid on government debt. The latter is now almost totally controlled by the official sector since most of government lending is now in the form of Greek Loan Facility loans, EFSF lending and ECB SMP holdings.

Taking the sectoral balances into account a strong government budget primary surplus requires a private deficit much higher than 5% of GDP, something which i think is clearly not manageable especially since even Eurostat is projecting that gross saving in Greece during 2012 will be double that of 2011. In my view, a primary deficit lower than 1% of GDP will be strongly recessionary.

Any more positive developments in the trade balance will be capped by the European recession, which is already showing its effects on Greek industrial production. Turnover Index in Industry for the non-domestic market rose by 6.5% in June 2012 although this was due to non-Eurozone countries increasing 10.4% while Eurozone countries actually fell 0.3%.

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Kostas Kalevras

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