by Franz Nauschnigg
What can be done to help the “crisis economies” of southern Europe reduce their external deficits? The debate is often presented as a conflict between the deficit-burdened PIIGS – Portugal, Italy, Ireland, Greece, and Spain – and the eurozone’s current-account-surplus countries, particularly Germany. But a new and more important imbalance has emerged in recent years: the PIIGS’ trade and services deficits with China, which suggest a possible solution to southern Europe’s economic malaise – a stronger Chinese Yuan.
Until 2004, the PIIGS’ biggest trade and services deficits were with the rest of the eurozone. But in 2005, their combined deficit with the rest of the world, at €37.2 billion ($48.6 billion), exceeded their combined deficit with other euro members by more than €4 billion. Then, in 2008, before the worst of the global financial crisis hit, the PIIGS’ global deficit reached a record-high €116.5 billion, of which €34.8 billion was with China, surpassing their deficit with Germany for the first time – by more than €2 billion.
Chinese textiles slaughtering PIIGS
Crucially, though the PIIGS’ combined deficit with Germany, the eurozone, and the world narrowed substantially over the next four years, their deficit with China remained huge – at €33 billion in 2010 and €29 billion in 2011.
Two key factors help to explain how this situation came about. The first was the euro’s rapid appreciation against the yuan in the early 2000’s. The euro rose from an average rate of ¥7.4 in 2001 to ¥10.4 in 2007, before depreciating to ¥8.18 by August 2013. This happened in part because the yuan tracks the U.S. dollar, which had fallen dramatically against the euro in 2002-2004.
As a result of the euro’s sharp nominal appreciation, the eurozone as a whole became less competitive. The impact was felt particularly strongly in the PIIGS, whose booming economies were attracting huge capital inflows that drove up inflation and wages.
The adverse effect on competitiveness was compounded by a second development. Southern European economies, heavily dependent on their textiles, clothing, and footwear sectors, began to face intense competition from cheaper Chinese imports. According to research published by the International Monetary Fund, China’s textile exports were largely responsible for huge trade deficits in Portugal, Italy, Greece, and Spain. By contrast, the current accounts of Germany, Finland, Austria, and France were far less affected, owing to their greater strength in export sectors, such as machinery, in which China was relatively weak.
Other IMF research has noted that, in addition to the rise of China, integration of Central and Eastern Europe and higher oil prices affected eurozone economies’ trading positions in different ways, with the PIIGS among the hardest hit.
The worst has been avoided, because the eurozone’s current-account-surplus countries have financed the PIIGS’ external deficits, despite their significant trade imbalances with the rest of the world. Investors from outside the eurozone simply increased their claims on Germany, France, and other surplus economies.
But what can eurozone policymakers do to help? Low interest rates, high debts, and wide deficits leave little margin for further monetary or fiscal expansion. Pressure to moderate wages can go only so far; indeed, it can be counterproductive insofar as it dampens domestic demand and thus raises the risk of recession.
Europe needs a weaker euro
The crisis economies might, however, find it easier to make the necessary external adjustments under three conditions: stronger external demand, a less onerous financing environment, and a weaker euro. So if the euro falls against the yuan this would provide southern Europe’s economies with an essential boost to external demand while leaving them room to shrink their fiscal and external deficits.
The problem for policymakers is how to make this happen. Central bank intervention is out of the question so that leaves two main factors: the on-going rise in Chinese labour costs and the USD - EUR exchange rate. Chinese labour costs are growing at over 10% in real terms, slowly reducing what is still a massive competitive advantage, and the dollar is likely to gain as increased interest rates in the US take effect and European rates stay at rock bottom. But this combination is beyond Europe’s control and how soon it could happen is unclear.
That’s something for the speculators. ¸
Franz Nauschnigg is Head of European Affairs at the Austrian National Bank. The article, © Project Syndicate, 2013, was revised for The Vienna Review by the author.