Using external balance sheets to identify macro-economic imbalances in the euro area

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1 Using exernal balance shees o idenify macro-economic imbalances in he euro area Evere, Mary * Cenral Bank of Ireland, Saisics Division Spencer Dock, Norhwall Quay Dublin 1, Ireland mary.evere@cenralbank.ie Absrac Over he pas decade, a number of euro area counries experienced persisen and increasing curren accoun deficis. The underlying causes of hese deficis represen disequilibria in he domesic macro-economies as manifesed hrough he excessive foreign borrowing. While foreign borrowing can enhance economic growh and relaed employmen, rapid increases in such borrowing, can conribue o imbalances in he domesic economy, if used unproducively. Unproducive invesmen has implicaions for he domesic economy s abiliy o susain foreign borrowing as he invesmen mus generae a rae of reurn ha is a leas sufficien o service foreign deb. Consequenly, he srucure of he foreign capial inflows provides insigh ino he raionale underlying foreign invesors behaviour. Early warning signals ha could have been employed o assess he susainabiliy of foreign funding would have been useful for highlighing he capabiliy of euro area counries o absorb exernal shocks arising from he inernaional financial crises and relaed spillover effecs o oher secors of heir economies. This paper explores wheher srucural shifs in he composiion of foreign financing across various secors of domesic economies could have provided a warning signal for he macro-economic imbalances now being endured across a range of euro area counries. Keywords: exernal balance shee, inernaional invesmen posiion, imbalances, exernal deb, susainabiliy JEL classificaion: F21, F34, F36 *The auhor is a Senior Economis in he Saisics Division of he Cenral Bank of Ireland. The views in his paper are he sole responsibiliy of he auhor, and should no be inerpreed as reflecing he views of he Cenral Bank of Ireland or he European Sysem of Cenral Banks. The auhor would like o hank Joe McNeill for helpful commens and suggesions. 1

2 Inroducion While foreign invesmen can enhance economic growh and consequenly employmen, rapid increases in foreign borrowing uilised unproducively can conribue o imbalances in he domesic economy. Unproducive invesmen no only has implicaions for he domesic economy, bu also for he susainabiliy of foreign borrowing, as he invesmen mus generae a rae of reurn ha is a leas sufficien o service he foreign deb. Examining he ype of financial insrumens employed, and heir uses wihin he domesic economy can, herefore, provide insighs ino he level of foreign borrowing, which can be susained. This aricle considers he requiremens for exernal funding by he euro area and a number of euro area economies in recen years by considering he underlying componens of he funding of curren accoun deficis prevalen in a number of counries since he early 2s. The composiion of capial inflows ha funded hese curren accoun deficis is hen explored. Examining he srucure of foreign invesmen provides insigh as o wheher hese imbalances were concenraed wihin specific secors of euro area economies. Wheher he developmen of hese exernal deficis should have riggered early warning signals is hen examined. In ha conex, he susainabiliy of hese imbalances is considered by uilising IIP 1 daa as an indicaor of exernal indebedness. Finally an overview of hose counries ha funded pars of hese euro area imbalances is presened, followed by some concluding remarks. Exernal borrowing requiremens Changes on he curren accoun balance reflec alernaions in savings and invesmens decisions arising from flucuaions in expendiure and income paerns wihin he economy, i.e. a smaller defici or larger surplus will reflec an increase in savings relaive o invesmens. Char 1 presens he level of average invesmen compared wih nominal GDP growh for he euro area 2 and is member saes from 23 o A counry s exernal balance shee, also known as IIP, is a financial saemen summarising he economy s exernal financial asses and liabiliies. IIP represens residen holdings of foreign asses, and he financial obligaions ha residens have o non-residens, who have invesed in heir economy. In oher words, he IIP is he ne sock (asses minus liabiliies) of he economy s inernaional invesmens. The curren accoun balance is equal o he change in IIP having conrolled for valuaion effecs in exchange raes and marke price changes. 3 The period 23 o 28 is chosen as his is when curren accoun deficis are mos prominen. 4 Improved saisical coverage also conribued o he higher exernal deb levels. 2

3 Char 1: Invesmen raios of euro area counries (average 23-28) 1 9 Luxembourg GDP growh % France Ialy Germany Greece Finland Belgium Neherlands Ausria Euro area Porugal Ireland Spain Noes: (i) Invesmen and GDP growh are calculaed using he formula: [{ X X }/ X ] 1, where p=4 quarers prior. (ii) Daa are sourced from Eurosa. Invesmen as % GDP Euro area invesmen as a proporion of GDP was on average weny one per cen beween 23 and 28. Char 1 displays he Member Saes average invesmen over his period. The majoriy of counries whose invesmen was in excess of he euro area average are mainly hose ermed as peripheral counries ha have enered he IMF/EU programme over he pas year. Spain and Ausria also invesed amouns greaer han he average euro area invesmens during his period. Significan nominal GDP growh was experienced by Greece, Ireland and Spain during his period, a levels far greaer han he average growh for he euro area of around four per cen, alhough Porugal had lower levels of growh han he euro area average. p p Counries whose domesic invesmen requiremens were no able o be financed by naional savings were required o borrow from abroad. The curren accoun deficis can, herefore, also be hough of as he value of domesic economic aciviy financed by foreign savings. I is naural o assume ha widening curren accoun deficis are accompanied by falling savings and/ or increasing invesmens. Char 2 displays he requiremens for exernal financing, for he euro area and member saes, on average beween 23 and 28. 3

4 Char 2: Euro area counries exernal financing requiremens 3 Spain Ireland Invesmen as % of GDP 25 Porugal Greece Euro area Ausria Ialy France Belgium 2 Neherlands Finland Germany Savings as % of GDP Noe: Daa are sourced from Eurosa For hose counries above he line, exernal financing was required. The requiremens for exernal financing are eviden for Ireland, Spain, Porugal, Greece and Ialy and France. While a persisen and growing curren accoun defici can be seen as an indicaor of an overheaing of he economy, he defici iself should no be he primary objec of economic analysis. Insead he focus should be on he composiion of he defici, which may represen disequilibrium in he domesic macro economy. Unsusainable capial inflows, leading o persisen curren accoun deficis creae macroeconomic imbalances and impac on he growh prospecs for he economy. This phenomenon is clearly eviden for a number of euro area economies ha developed persisen curren accoun deficis over he pas decade, see Char 3. 4

5 Char 3: Euro area defici counries curren accoun balances as a percenage of GDP Per cen of GDP Euro area Ireland Greece Spain France Ialy Porugal Noe: Daa are sourced from Eurosa. Those counries ha experienced high levels of invesmen growh generally had significan curren accoun deficis. The composiion and susainabiliy of he capial inflows funding hese curren accoun deficis is addressed in he following secions. Indicaions of imbalances While inernaional capial inflows as a means of funding an economy s invesmen are generally necessary for economic growh, a rapid increase in hese capial inflows persisenly used o fund shorfalls in domesic invesmen can, however, lead o srucural macro-economic imbalances wihin an economy. In paricular, wheher foreign borrowing is driven by cyclical or srucural facors can have imporan implicaions for he susainabiliy of domesic invesmen. Consideraion of he composiion of invesmen can, herefore, serve as a useful indicaor boh of he performance of he exernal economy, and he ineracion beween he domesic and exernal economy. Analysing he componens of inernaional capial flows and relaed servicing coss provides insigh ino wheher foreign borrowing is being employed producively, and is, herefore, susainable over ime. Unproducive invesmen has implicaions for an economy s abiliy o mainain foreign borrowing as he invesmen mus generae a rae of reurn ha is a leas sufficien o service he foreign funding. In his conex, an assessmen of wheher he volume of exernally generaed deb can be susained also needs o be conduced. 5

6 Composiion of foreign invesmen Despie he broad neuraliy of Euro area curren accoun balances, as eviden in Char 4, he ne exernal posiion on he euro area exernal balance shee deerioraed a an increasing rae from 25 onwards, peaking a end-28. Revaluaion effecs due o exchange rae changes, including he appreciaion of he euro in 27, as well as asse price changes and oher adjusmens all conribued significanly o he higher exernal ne liabiliy posiion for he euro area 4. While ne ransacions in euro area exernal asses and liabiliies were relaively small over he period, hese oher changes were primarily responsible for he increasing ne liabiliy exernal posiion. Char 4: Euro area Ne IIP Millions NIIP Financial accoun, Porfolio invesmen Curren accoun balance Financial accoun, Direc invesmen Financial accoun, Oher invesmen Noe: Daa are sourced from he ECB s Saisical Daa Warehouse. The composion of euro area ne IIP by funcional caegory is also presened in Char 4. The euro area s ne IIP liabiliy declined from 23 onwards, largely driven by porfolio invesmen ransacions and oher changes in securiies issued by euro area residens. The ne asse sock of direc invesmen, however, parially offses he ne liabiliy posiion of he euro area. As saed above, i is imporan o assess he componens underlying an increase in exernal liabiliies. Direc invesmen inflows usually reflec a lasing ineres in an economy and have a direc posiive impac on economic aciviies, in erms of produciviy and employmen. Inernaional capial flows in 4 Improved saisical coverage also conribued o he higher exernal deb levels. 6

7 he form of direc invesmen and equiy are advanageous as hey end o represen long-erm invesmens, and are hus likely o be less volaile. Increasing exernal liabiliies arising from his ype of invesmen are no usually problemaic. Conversely, where he increased liabiliies are driven by porfolio invesmen and banking flows, as was he case in he euro area, hese end o be more mobile and volaile via exchange raes and financial marke price flucuaions. Furhermore, hese ypes of invesmen are more easily reraced o he home marke of he invesor in imes of financial crisis. The secoral composiion of he euro areas exernal balance shee for porfolio and oher invesmen is presened in Char 5. In he period prior o he inernaional financial crisis, foreign capial inflows were largely driven by he banking and Governmen secors. Since ha ime, Governmen ne exernal liabiliies have coninued o increase seadily, reflecing he worsening fiscal siuaion for a number of euro area economies, paricularly hose peripheral counries. Char 5: Secoral composiion of he euro areas exernal balance shee MFIs Non-MFIs of which Gov Millions Noe: These exernal posiions refer o porfolio and oher invesmen only. Developmens in he curren accoun and he ne exernal indebedness of a number of euro-area counries are now examined in Char 6. As would be expeced he accumulaion of curren accoun deficis over a number of years resuled in ne liabiliy posiions for he exernal balance shees of he defici counries, namely France, Greece, Ialy, Ireland, Porugal and Spain. 7

8 Char 6: Euro area counries ne exernal liabiliies Per cen of GDP France Greece Ireland Ialy Porugal Spain Noe: Daa are sourced from Eurosa The ne exernal liabiliy posiion for hese defici counries is furher analysed by funcional caegory 5 in Chars 7-9. Char 7: Euro area defici counries sock of ne direc invesmen Millions France Spain Greece Ialy Ireland Porugal Noe: Daa are sourced from he ECB s Saisical Daa Warehouse 5 Derivaives and reserves are no included owing o lack of comprehensive daa and irrelevance, respecively. 8

9 Char 8: Euro area defici counries sock of ne porfolio invesmen Millions France Spain Greece Ialy Porugal Ireland Char 9: Euro area defici counries sock of ne oher invesmen Millions France Spain Greece Ialy Ireland Porugal The increase in foreign obligaions of euro area counries ha experienced curren accoun deficis over he las decade largely comprises deb and equiy securiies as well as foreign loans. The dependence of counries on foreign financing hrough relaively liquid insrumens and deb 9

10 insrumens may indicae vulnerabiliies, as i shows he suscepibiliy o changing foreign senimen on he domesic economy. The secors driving he growh in he exernal imbalances for hose defici counries are presened in Chars below. Char 1: Secoral composiion-governmen 2 Char 11: Secoral composiion- MFIs Millions -4 Millions France Governmen Spain Governmen -5 Greece Governmen Ialy Governmen Porugal Governmen Ireland Governmen -6 France MFIs Greece MFIs Porugal MFIs Spain MFIs Ialy MFIs Ireland MFIs Char 12: Secoral composiion Moneary auhoriies 15 1 Char 13: Secoral composiion Oher secors 8 6 Millions France Moneary Auhoriies Spain Moneary Auhoriies Greece Moneary Auhoriies Ialy Moneary Auhoriies Porugal Moneary Auhoriies Ireland Moneary Auhoriies Millions France Oher secors Spain Oher secors Greece Oher secors Ialy Oher secors Porugal Oher secors Ireland Oher secors Growh in he exernal imbalances was driven by he banking and Governmen secors for all defici counries, excep Greece who has had a small exernal ne asse posiion for he banking secor since 6 Daa are sourced from he ECB s Saisical Daa Warehouse. Daa refer o porfolio and oher invesmen posiions only. 1

11 27. All defici counries, wih he excepion of Spain, and more recenly Ireland, have had exernal ne asse posiions for heir privae and non-banking secors over ime. Susainabiliy Persisen curren accoun deficis and increasing exernal liabiliies have mean ha he susainabiliy of exernal deb in peripheral counries has become a significan consideraion for inernaional financial marke paricipans in recen imes. The quesion of wheher exernally funded deb is susainable for secors of he euro area peripheral economies is a curren issue of concern. Naurally, from boh debors and crediors perspecives, he susainabiliy of inernaional invesmen is of key imporance. From a debors perspecive coninued finance from inernaional markes is imporan in order o address shorfalls in domesic savings and hereby fund domesic invesmen. The abiliy of he debor naion o service heir exernally raised finance - in erms of boh principal and income - is of concern from he crediors perspecive. Unsusainable levels of foreign invesmen can have an impac on domesic borrowers and heir economies, as well as foreign crediors. In addiion, projecions of he responsiveness of invesmen o exernal or domesic shocks are crucial for mainaining producive invesmen in an economy. The susainabiliy of capial inflows o counries depends on he abiliy of domesic borrowers o mee he paymen obligaions of exernal deb on an ongoing basis. To susain a curren accoun defici and increasing sock of ne exernal liabiliies, herefore depends on he level of income earned from producive aciviies, exceeding paymens due on foreign deb. Persisen curren accoun deficis, leading o accumulaing financial obligaions canno coninue indefiniely, as he paymens required o service he deb would evenually ouweigh he curren income arising from GDP growh. Adoping he mehod employed by Berau e al (28) 7, he burden of a debor naion in servicing is exernal deb can be measured using he raio of ne IIP o GDP (susainabiliy raio). Box 1 below provides deailed informaion on he susainabiliy raio. 7 Berau, C., B. Kamin, and C. Thomas (28), How Long Can he Unsusainable U.S. Curren Accoun Defici Be Susained? Board of Governors of he Federal Reserve Sysem, Inernaional Finance Discussion Papers, Number

12 Box 1: Susainabiliy raio For he susainabiliy raio o mainain sabiliy over ime, increases in he curren accoun defici mus be offse by increase of a similar magniude in GDP, i.e., increasing NIIP mus no exceed GDP growh. Increasing raios allowed o coninue wihou any aemps o correc he underlying imbalances may lead invesors o worry abou he servicing of heir foreign asses. For ne exernal liabiliies o remain susainable, he proporionae growh in GDP mus equal he proporionae accumulaion of exernal deb. The change in NIIP is NIIP NIIP NIIP, and he change in GDP is GDP GDP GDP. / 1 1 / 1 1 Following he assumpion ha he rae of reurn payable on a ne liabiliy IIP posiion canno exceed growh in GDP, accordingly he growh rae of GDP equals he growh rae of NIIP, NIIP NIIP NIIP GDP GDP / 1 1 GDP / 1 1 (1). Assuming negligible valuaion effecs as in he long run i is assumed ha he asse and liabiliy effecs would be similar an increase in NIIP liabiliies is he curren accoun defici, NIIP NIIP 1 CA (2). Subsiuing equaion (2) ino equaion (1) produces: CA / NIIP 1 = GDP GDP GDP. / 1 1 The rae of reurn, or ne ransfer paymens, for he ne liabiliy IIP is equal o he rae of GDP growh, given he assumpion ha meeing paymen obligaions on exernal deb requires a leas he similar growh in income as per GDP. For he raio of (change) NIIP/GDP o remain sable, he proporionae rise in GDP growh/ne ransfer paymens CA/GDP raio divided by he NIIP/GDP raio, NIIP CA/ GDP GDP NIIP / GDP GDP NIIP (3). GDP 1 1 mus equal he Numerical example using Irish daa: In 27, a curren accoun defici of 1.1 billion, and GDP of billion implies a defici on he curren accoun of 5.3% of GDP. NIIP was billion, which is a NIIP/GDP raio of %. Applying equaion (3) o he 27 daa reveals a susainabiliy raio of -27.4% which is far greaer han GDP growh of 7.3% during ha year. Consequenly, an increase in a NIIP liabiliy of 27% is no susainable as a GDP growh rae of 7.3% is no sufficien o service he ne ineres paymens on his level of exernal deb obligaions. This example refers o only one year, whereas susainabiliy raios need o be calculaed over a longer period of ime o analyse rends. 12

13 Chars A1 o A6 in Annex A conain he growh in GDP compared wih NIIP growh for each defici counry. Given he volume of increases in NIIP in over he pas decade in excess of GDP growh, for Spain, Greece, Ireland and Porugal i is clear ha he accumulaion of exernal deb for hese euro area counries was on an unsusainable pah since hese counries joined EMU. The susainabiliy raios, compared wih GDP growh since 1999 are presened in Annex B. An increase in ne IIP for he euro area of 8.7 per cen for example, compared wih GDP growh of 2.7 per cen implies ha ne exernal deb growh is several muliplies of GDP growh. Rapid increases of ne IIP in excess of GDP growh should pose as a warning signal for hose policy makers monioring hese developmens. These chars clearly show ha he growh in exernal indebedness was ou of line wih GDP growh and should have served as a warning signal. Unsusainabiliy was paricularly pronounced from 24 onwards for mos defici counries. Who funded whom? The credior counries funding he euro area defici counries are presened in Annex C. These daa relae o deb and equiy foreign borrowings and invesmens a beween 23 and 28. A common hread is eviden in he geographic profile of invesing counries, hose euro area counries wih curren accoun surpluses are significan invesors in heir moneary union colleagues experiencing funding gaps. In addiion, Ireland is a significan invesor arising from is role as a hos of an inernaional invesmen services cenre 8. The mos significan non-euro area invesors are he UK and he US. This is no surprising given he rade and financial link beween hese wo economies and he euro area. Moneary auhoriies, via heir reserve asse porfolios, and inernaional organisaions are also significan invesors. Conclusions While he euro area Member Saes have experienced and benefied from capial inflows from abroad, he volumes have increased since he esablishmen of he European Economic and Moneary union. Increased invesmens by Member Saes were unable o be me by domesic savings over he pas decade, and recourse o foreign borrowing was sough. The consiuens of hese inflows predominanly comprised deb and equiy and foreign loans as opposed o direc invesmen inflows which conribue o more sable economic growh and employmen. This effec was mos apparen for peripheral counries ha are now receiving loans from he EU/IMF Programme. 8 Furhermore, he daa show ha Ireland is a dominae holder of Poruguese equiy securiies, since 26 in fac i holds 75% of all porfolio invesmen equiy issued by Porugal as of end-28. However, hese volumes are skewed by securiisaion aciviies, whereby a significan volume of Irish securiisaion vehicles inves in SPVs in Porugal in order o faciliae invesors demands for deb securiies which are issued by he Irish SPV. 13

14 An analysis of he susainabiliy of he ne exernal deb of hese defici counries since 1999 reveals ha hese exernally driven imbalances were on unsusainable growh pahs, paricularly since he mid 2s. Early indicaions of he developmen of imbalances were eviden, alhough perhaps no seen as relevan owing he inegraed srucure ha moneary union offers. An examinaion of he counries ha bough he equiy and deb securiies sold by defici counries o mee heir funding gaps, suggess ha heir crediors mainly consis of oher euro area counries. Capial inflows from ouside of he euro area mainly comprise of he US and he UK, as well as moneary auhoriies and inernaional organisaions. 14

15 Annex A: Growh in NIIP liabiliies compared wih GDP growh Char A1 Char A2 6 5 Growh in NIIP GDP growh Spain 1-4 Growh in NIIP GDP growh France Per cen Per cen Char A3 Char A4 5 4 Growh in NIIP GDP growh Greece 5 4 Ireland Growh in NIIP GDP growh 3 3 Per cen 2 1 Per cen

16 Char A5 Char A6 Ialy Porugal Per cen Growh in NIIP GDP growh Per cen Growh in NIIP GDP growh Annex B: Susainabiliy raios Char B1 Char B2 1 5 Susainabiliy raio GDP growh Spain France Susainabiliy raio GDP growh Per cen Per cen

17 Per cen Char B3 Susainabiliy raio Greece GDP growh Char B4 Per cen Ireland Susainabiliy raio GDP growh Char B5 Char B6 2 1 Susainabiliy raio GDP growh Ialy 1 5 Porugal Susainabiliy raio GDP growh Per cen Per cen

18 Annex C All daa refer o end-28 and are sourced from he IMF s Coordinaed Survey of Porfolio Invesmen. Table C.1: Foreign invesors in French securiies Per cen Ausria Belgium Germany Ireland Ialy Japan Luxembourg Neherlands Norway Spain Swizerland Unied Kingdom Unied Saes SEFER+SSIO (**) Toal value of invesmen Table C.2: Foreign invesors in Greek securiies Per cen Ausria Belgium France Germany Ireland Ialy Japan Luxembourg Neherlands Norway Porugal Unied Kingdom Unied Saes SEFER+SSIO (**) Toal value of invesmen

19 Table C.3: Foreign invesors in Irish securiies Per cen Ausria Belgium France Germany Ialy Japan Luxembourg Neherlands Porugal Spain Swizerland Unied Kingdom Unied Saes SEFER+SSIO (**) Toal value of invesmen Table C.4: Foreign invesors in Ialian securiies Per cen Ausria Belgium France Germany Ireland Japan Luxembourg Neherlands Norway Porugal Spain Unied Kingdom Unied Saes SEFER+SSIO (**) Toal value of invesmen Table C.5: Foreign invesors in Poruguese securiies Per cen Ausria Belgium France Germany Ireland Ialy Japan Luxembourg Neherlands Norway Spain Unied Kingdom

20 Unied Saes SEFER+SSIO (**) Toal value of invesmen Table C.6: Foreign invesors in Spanish securiies Per cen Ausria Belgium France Germany Ireland Ialy Japan Luxembourg Neherlands Norway Porugal Unied Kingdom Unied Saes SEFER+SSIO (**) Toal value of invesmen