Markets & Finance

The Eurozone's Homegrown Deficit Woes


Officials in the eurozone -- the 12 countries that use the euro as a common currency -- continue to voice concern about global economic imbalances. One particular target: The so-called twin deficits in the U.S. -- in foreign trade and the federal budget. Economic leaders have called on the U.S. to correct these gaps, amid fears that should they spiral out of control, it could lead to a big, sudden correction in the U.S. dollar. A freefall in the greenback could push up the euro and undermine eurozone growth prospects.

But the eurozone may wish to keep a sharp eye on its own house. To wit: The eurozone current account -- measuring trade in goods and services with the rest of the world, as well as certain financial transfers -- moved into deficit territory in 2005 for the first time since 2001. And the eurozone is also running a significant public-sector deficit as well. It seems the eurozone now has its own twin deficits to worry about.

TRADE IMPACT. The latest eurozone balance of payments data for December, 2005 showed a seasonally adjusted current-account deficit -- measuring trade in goods and services with the rest of the world, as well as certain financial transfers -- of €5.3 billion, the sixth consecutive month in the red. Data for the full year show a deficit of €29 billion, or around 0.4% of GDP. This compares to a surplus of €45 billion, or 0.6% of GDP in 2004. For all of 2005, the eurozone reported a deficit in the current account -- the first year since 2001.

Much of this development was due to a deterioration in the eurozone's trade balance, which posted a surplus of just €58.1 billion, down from a surplus of €104.5 billion in the previous year. Export growth has picked up in 2005, but import growth was even stronger, mainly boosted by higher oil prices.

The services balance moved into surplus last year, but the income balance reported a deficit of €3.6 billion, compared with a surplus of €3.2 billion in 2004. The latter is mainly due to the fact that the number of eurozone equities held abroad has increased significantly in recent years. A geographical analysis suggests that the current account with the U.S. did not change much, and that much of the deficit was due to an increase in the deficit with oil-exporting countries.

GLOBAL RIPPLES. Oil prices are not expected to fall significantly any time soon, which means that the current-account deficit could remain for some time. The previous current-account surplus, especially in comparison with the U.S. deficit, has repeatedly been cited as a factor underpinning the euro's strength vs. the dollar. Trends have now changed, especially as flow data in the balance of payments also have taken a turn for the worse.

Net foreign direct-investment outflows amounted to €155.3 billion in 2005, compared with outflows of just €46.8 billion in 2004. The deterioration was mainly due to a marked increase in the investment of eurozone companies abroad, which in turn was fueled by a jump in capital investment, mostly inter-company loans.

It seems as though stronger demand in the eurozone and globally is not only fueling domestic investment, but also investment abroad. Many companies are already producing a large part of their output abroad, and this is having an impact -- especially as global demand is expected to remain strong and companies are creating production capacity closer to the points of demand.

DECLINING FOREIGN INTEREST. At the same time foreign investment in the eurozone has dropped sharply, mainly due to a decline in such investment in eurozone equity capital and reinvested earnings. The latter amounted to just €13.9 billion in 2005, compared with €76.6 billion in 2004 and €120.4 billion in 2003.

The eurozone still posted portfolio investment inflows of €142.6 billion in 2005, up from inflows of €71.2 billion in 2005, but most recent developments are less encouraging. Quarterly data showed outflows of €57.1 billion in the last quarter of 2005. This was a combination of both eurozone entities increasing their holdings of foreign equities, as well as foreign parties substantially cutting back their holdings of eurozone equities.

Meanwhile, foreign interest in eurozone bonds and notes, as well as money-market instruments, declined sharply. Indeed, nonresidents sold a large amount of euro-area money-market instruments in November and December last year, which coincided with the start of the European Central Bank tightening cycle.

VULNERABLE CURRENCY. Net outflows in foreign direct investment, coupled with lower net inflows in portfolio investment, meant the eurozone posted large net average monthly outflows in combined direct and portfolio investment during the last quarter of 2005. Crossborder trade and investment flows are representative of real money flows between countries, which in turn determine demand for currencies and exchange-rate developments.

While real currency changes are not correlated with the current account per se, they're correlated with the current account netted with investment flows. A deficit in the current account, coupled with net portfolio and direct investment outlooks, mean asset outflows are undermining the prospect for the euro. The broad basic balance, (BBB), the sum of current account and investment flows, is now posting a deficit. A BBB deficit represents a net outflow of trade and investment flows and undermines the currency's real value.

The eurozone is not only spending more on foreign trade than it is earning, it can also no longer rely on investment flows to compensate for this. And the current-account deficit is going hand in hand with a substantial public-sector deficit, which only declined marginally last year.

LITTLE RELIEF. The ECB in its latest monthly report warns that significant or severe fiscal imbalances persist in many eurozone countries. The report notes that reductions in the deficit ratio are expected to be modest this year and beyond, despite improving growth prospects.

In the long run, demographic developments and the problem of an aging population will add to fiscal pressures in the eurozone. Officials will have to press ahead, not only by cutting back public deficits, but also by implementing further structural reforms to make the area more attractive for foreign investors. As it is, all developments point to a depreciation of the euro vs. other major currencies in the medium term, rather than the appreciation that markets had feared.


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