Regional Focus: External Imbalances in the Euro Area are Cause for Concern

International Monetary Fund. External Relations Dept.
Published Date:
May 2006
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Much attention has been focused on global payments imbalances involving the United States, the oil producers, and Asia, yet external imbalances of individual euro area countries have also been widening recently and are approaching similar magnitudes. With the current account balance of the euro area as a whole small and relatively stable, this is not much of a policy concern: indeed, external account positions of the members of a currency union do not involve the same risks as those of countries with independent currencies. No one worries about California’s balance of payments, for example, even though the size of its economy is similar to those of the largest euro area countries.

Still, developments inside the euro area are striking and seem to point to unsustainable dynamics. Reflecting common factors, such as the area’s business cycle, the rise in oil prices, and developments in the euro’s exchange rate, the current account balance of the four largest euro area economies—France, Germany, Italy, and Spain—together declined by 0.8 percentage point of GDP between 1997 and 2005 (see table). However, differences among the countries were stark: Germany’s current account balance rose by 5 percentage points of GDP, and those of the other three fell by between 4 and 7 percentage points of GDP.

Why this divergence?

In an economic and monetary union, without independent monetary policy for each of the members, adjustment to differences in cyclical position in demand will be associated with changes in competitiveness and the external account. For example, weak domestic demand—such as has been observed in recent years in Germany—depresses prices and wages, which improves competitiveness and boosts net exports. The inverse happens in countries with strong domestic demand—for example, France and Spain.

Consistent with this story, a recent cross-country IMF staff study finds that the evolution of cost and price competitiveness explains a sizable part of the disparity in export performances. Even though the euro area countries share a common currency, their unit labor cost-based exchange rates, driven by relative cost and productivity developments and the direction of trade, behaved differently.

Thus, the effect on Germany’s international competitiveness of the euro’s appreciation from its 2000 trough has been outweighed by favorable productivity developments, moderation in wage increases, and the containment of other costs. And France has experienced only a modest real appreciation, mainly because of productivity increases. Spain, in contrast, has seen a large deterioration in competitiveness because wage increases have exceeded productivity gains. And, in Italy, falling productivity has swamped any benefits from moderate wage developments, causing a sharp deterioration in competitiveness. In fact, Italy’s move into current account deficit occurred in spite of weak domestic demand.

Widening imbalances

The four largest euro area economies share a common currency, but their striking imbalances point to unsustainable dynamics.

(current account imbalances, percent of GDP)
Euro area 4FranceGermanyItalySpain
Data: IMF World Economic Outlook.
Data: IMF World Economic Outlook.

Structural factors have also played an important role. They stem from differences in the degree of integration in the world economy, the geographical orientation and sectoral composition of exports, and, perhaps equally important, different paces of structural reform in labor and product markets in the four countries. On this score, Germany seems to be reaping the benefits of its labor market reforms, while Italy is suffering from a lack of such reforms. Pricing behavior also plays a role, at least in the short run. Italy’s exporters seem to have been passing through to export prices a higher-than-average percentage of the increase in unit labor costs, though at the expense of losing market share.

A caveat to these findings is that a significant part of trade behavior, especially during 2001–05, cannot be attributed to traditional explanatory variables. Further research and more country-specific analysis will be needed to try to explain why estimated trade trends were favorable and trade performed better than predicted for Germany, whereas such trends were unfavorable and trade was weaker than predicted for France, Italy, and Spain. These developments, if persistent, signal a need to improve competitiveness in the last three countries.

Luc Everaert, IMF European Department

For more information, please see IMF Country Report No. 05/401, France, Germany, Italy, and Spain: Explaining Differences in External Sector Performance Among Large Euro Area Countries. Copies are available for $15.00 each from IMF Publication Services; see page 160 for ordering details. The full text is also available on the IMF’s website (

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