Globalisation’s impact on inflation in the European Union

Raphael Auer, Andreas Fischer 05 December 2010

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It is anyone’s guess where EU inflation is headed once the effects of the financial and sovereign debt crises settle. What is certain, however, is that the inflationary process after the crises will be shaped by the same long-term structural developments that helped create the low-inflation environment in the years leading up to 2007. By far the most salient of these long-term developments is the increasing integration of the world economy, commonly referred to as “globalisation”.

For the EU, globalisation during the last two decades above all has meant increasing integration with the former Warsaw Pact Nations (in particular with the new EU member states) and also with Turkey. Another dimension for the EU is the rise of cheap imports from East Asia, in particular from China.

To what extent has increasing integration with East Asia and the former Warsaw Pact nations affected the EU’s inflationary environment during the last decade? Several studies have investigated this question including Glatzer et al. (2006), Pain et al. (2006), Borio and Filardo (2007), Wheeler (2008), and Bugamelli et al. (2010). In a recent working paper co-authored with Kathrin Degen (Auer et al. 2010) we present new evidence in this area and try to explore the likely effects of future integration.

Establishing causality

We argue that much of the existing literature fails to establish the causal effect of competition from lower-wage-country imports since trade flows are endogenous to local demand conditions. For example, when an industrial sector in Europe experiences a positive demand shock, prices increase, thereby inducing an increase in low-wage country imports. The presence of this endogeneity biases the estimated relative price effect of trade towards zeroi.

The approach we adopt to deal with this endogeneity issue is related to work studying the effect of trade integration and competition by Chen et al. (2009) and our earlier work establishing the effect of low-wage-country exporters on US inflationary pressure (see Auer and Fischer 2010 and our 2008 Vox Column).

To establish a causal effect of trade on inflation in Europe, we extend the instrumentation strategy of Auer and Fischer (2010) for the case of both heterogeneous exporter markets (with a focus on emerging Europe versus China) and heterogeneous import markets (Germany, France, Italy, Sweden, and the UK). As in Auer and Fischer (2010), the IV strategy is based on the simple observation that when low-wage-country manufacturing output grows, low-wage-country exports to Western Europe increase in labour intensive sectors relative to capital intensive sectors. Imports from the low wage countries are heavily concentrated in labour intensive industries. We show that this specialisation also holds at the margin. For example, when China's manufacturing output rises, low-wage-country exports increase much more in labour-intensive sectors than in capital intensive sectors.

To investigate the impact of trade integration with emerging Europe, we then refine the instrumentation strategy to incorporate the fact that Easter European exporters may be more or less important in certain Western European markets for certain types of goods. For example, owing to geographic proximity, Eastern European exporters could be more important in Germany than in France, and this difference, in turn, could be more pronounced for goods with high transportations costs.

Importing lower inflation

We study the combined effects of exports from China, India, Malaysia, Mexico, Philippines, Poland, Romania, Slovak Republic, Thailand, and Turkey on producer prices in Germany, France, Italy, Sweden, and the UK.

In a panel covering 110 industries from 1995 to 2008, our estimates suggest that import competition from lower-wage countries is associated with strong price effects. European producer prices fall between 3.2% and 4.8% when lower-wage-country growth in manufacturing rises by 1% above trend.

We also investigate whether the response is heterogeneous across the five Western European import markets. The coefficient estimates are significant for Germany, France, Sweden, and the UK in the regressions using import volume. Further, the coefficient estimates for import values and import volumes show that the penetration effect for prices is strongest for the UK and Sweden, followed by Germany and France. When imports from lower-wage countries capture 1% of the British market, producer prices decrease by -3.8% in the regression using import volumes. In the same regression for Sweden the price effect is -2.6%, whereas for Germany it is only -1.2%. In contrast, the estimates for Italy suffer from the problem that the first stage of our specifications is often weakly identified since Italy does not tend to systematically import labour intensive goods (Bugamelli et al. 2010 do find a small but significant effect on prices in their approach using prices at the goods level).

Is it China or Romania? Decomposing the trade effects

Beyond the main empirical findings that trade with emerging economies had a profound impact on European producer prices, we show that this result is largely driven by Chinese exports. More specifically, when Chinese exporters capture 1% of the European market, producer prices decrease about 5%.

In contrast, we find relatively scarce evidence that exports from emerging Europe (i.e., Poland, Romania, Slovak Republic, and Turkey) have significantly lowered inflation in the five European import markets. This may be because this group of low-wage countries, with the exception of Romania, is only barely “low-wage”. Wages and productivity in this region have risen rapidly during the past decade and are thus no longer overly concentrated in producing labour-intensive goods. In response to this observation, we refined our instrumentation strategy and dropped the Slovak Republic because its export performance is not representative of low-wage import competition.

For Poland or Turkey, we show that there is no big price effect. Our specifications show only a significant result for Romania. This is in line with our theory as Romania is the only "true" low-wage country in emerging Europe. When Romanian exporters capture 1% of the European market, producer prices decrease about 1.0%.

Conclusion

Globalisation and its impact on inflation and monetary policy took centre stage at the 2006 Jackson Hole Conference. The financial crisis has overshadowed this discussion. At the current juncture, central bank officials need to re-centre the monetary policy debate on globalisation’s impact on industry structure and acknowledge the contributory forces of competition from lower-wage-country imports.

References

Auer, R. A. and A. M. Fischer, 2010. "The effect of low-wage import competition on US inflationary pressure," Journal of Monetary Economics 57(4), 491-503.

Auer, R. A. and A. M. Fischer (2008). The impact of low-income economies on US inflation, VoxEU.org, 13 June

Auer, RA, K Degen, and AM Fischer (2010), “Globalisation and inflation in Europe", CEPR Discussion Paper 6451

Borio, C, and A Filardo (2007), “Globalisation and inflation: new cross-country evidence on the global determinants of domestic inflation”, BIS Working Paper 227. Basel: Bank for International Settlements, May.

Bugamelli, M, S Fabiani, and E Sette (2010), “The pro-competitive effect of imports from China: an analysis of firm level price data”, Temi di discussione 737, Bank of Italy.

Chen, N, J Imbs, and A Scott (2009), “The dynamics of trade and competition”, Journal of International Economics, 77(1):50-62.

Glatzer, E, E Gnan, and MT Valderrama (2006), “Globalisation, import prices and producers in Austria, monetary policy and the economy”, Austrian National Bank, 3:24-43.

Pain, N, I Koske, and M Sollie (2008), “Globalisation and inflation in the OECD economies”, OECD.

World Economic Outlook (2006), “How has globalisation affected inflation?”, 3:97-134.

Wheeler, T (2008), “Has trade with China affected UK inflation?”, Bank of England, External MPC Unit, Discussion Paper No.22.


i  While Auer et al. (2010) do not find a significant price effect for Italy, Bugamelli et al. (2010) do find a small but significant effect in their study using data at the establishment level.

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Topics:  Europe's nations and regions International trade

Tags:  inflation, China, EU, Central and Eastern Europe, Turkey

Senior Economist, Bank for International Settlements and Research Affiliate, CEPR

Economic Adviser at the International Research Unit of the Swiss National Bank and CEPR Research Fellow

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