The debate on global imbalances dominates the international economics policy agenda. What does it mean for Europe? Most attention has focused on America’s chronically large current account deficits and the rising current account surpluses in emerging Asia (most prominently, China) and the major oil-producing nations. Although the euro area has been represented in the IMF’s multilateral consultation on global imbalances, the European dimension has been less prominent in the debate.
At one level, this is highly understandable. Europe is not a primary contributor to global imbalances; taken in the aggregate, it has a close-to-zero current account balance, even if there is considerable heterogeneity across individual European countries. Some run big deficits (Spain, Hungary, Portugal) while others run considerable surpluses (Germany, Sweden, Switzerland). Yet even if Europe is not a major source of imbalances, it should be concerned. Shifts in the current configuration of imbalances could have a significant impact on the European economy. After all, it is commonly understood that the globalisation of product and financial markets means that European macroeconomic performance is increasingly influenced by its interdependence with the other major regions of the world economy. Our research, to be published in Economic Policy, analyses how an unwinding of global imbalances might affect the European economy.1
Today’s situation is different from the previous episode of significant global imbalances in the mid-1980s in three main ways. First, the major advanced economies are now collectively running a substantial deficit vis-à-vis emerging Asian economies and the oil producers; the policy debate can no longer be confined to the G7 whose share of global GDP has declined in recent years. Second, the scale of financial globalisation is much larger now than in the 1980s. European asset and liability positions vis-à-vis the United States have tripled since the 1980s, so shifts in exchange rates and asset prices will have a much more powerful impact on the value of European nations’ international balance sheets than was the case during the last episode. Third, much of Europe now shares a single currency, whereas movements in the US dollar the last time around were associated with volatility in the intra-European bilateral exchange rates.
From a European perspective, one key fact that has not changed is the fact that international trade linkages remain quite limited. Most cross-border trade is within Europe. The Eurozone’s bilateral trade with the United States is only 4% of its GDP. Asia now rivals the United States in importance as a global trading partner; the Eurozone’s trade with emerging Asia alone accounts for 4% of its GDP. For this reason, adjustment scenarios that involve a redistribution of global expenditure from the United States to Asia will see a decline in European exports to the United States offset by rising sales to Asia. Such scenarios may well involve significant appreciation of the euro against the dollar - but it is important to appreciate that the trade-weighted value of the euro may not move much since the euro would undergo real depreciation against Asian currencies.
In our research we employ, as a reference point, the IMF’s Global Economic Model (GEM) to assess the quantitative impact of alternative adjustment scenarios by which shifts in current account positions may take place. We also investigated the impact of the increase in financial globalisation on adjustment dynamics. Here, a central issue is the scale of net dollar exposures. A particular contribution of our research is to show that that the exposure of Europe to the dollar, while non-negligible, is much smaller than the exposure of emerging Asia and Japan. If the dollar depreciates, it will have a negative financial impact on those countries that are net dollar creditors. Although net currency positions at a national level are not easily calculated, our research shows that Europe is relatively less exposed than Japan or China. At the end of 2005, we estimate that the euro area had a positive net dollar position of 16.8% of GDP, much smaller than the net exposure of Japan (close to 40% of GDP), with the Chinese net dollar position (relative to its GDP) also estimated to be substantially in excess of the euro area’s and growing rapidly. Accordingly, the financial impact on European investors of a dollar slide is quite contained, even if it is substantially larger than in the 1980s episode. That is, to the extent that a real effective depreciation of the dollar occurs primarily vis-à-vis the largest creditor countries and regions—emerging Asia, Japan, and oil exporters—the consequences for Europe in general, and the euro area in particular, would not be large.
For these reasons, our central projections are relatively upbeat for the European economy. However, we can point to two major risk factors. First, if a disruptive adjustment scenario led to financial distress in the United States, this may trigger correlated negative movements in European financial markets through a ‘sentiment’ channel, even if the linkages in fundamentals are limited. Second, a reversal in the US deficit that is associated with an increase in global risk aversion may lead to a reassessment of the sustainability of other large deficit positions. While deficit countries such as Spain are relatively insulated through membership of the euro area, the large-deficit countries in Central and Eastern Europe are more exposed, since a reversal in capital flows could trigger speculative attacks on their currencies.
Clearly, the risks for Europe are much more significant if creditor country currencies, many of which closely track the US dollar, fail to adjust, so that at least in the short-term a weakening of the dollar would imply a substantial real effective appreciation for Europe and the euro area. In turn, this could have strong negative repercussions on activity, underscoring the importance of policy measures that help sustain output and demand. Looking forward, a shift in international portfolio preferences may well be associated with an increase in the role of the euro as a reserve currency (see, for example, Chinn and Frankel, 2005). While we have not addressed this issue in the paper, one could envisage scenarios where net exports are negatively affected by the appreciation of the euro, but economic activity benefits from a decline in required returns on euro area assets.
Such downside risks help to motivate European interest in an orderly global adjustment process. At the policy level, the main message is that those policies that will improve the growth environment in Europe (productivity-enhancing reform of product, financial and labour markets) are also those that help to reduce the dangers of a disorderly resolution of global imbalances.