## 19. The Unwinding of Imbalances from the Global Crisis

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---

### I. Introduction
- Since the mid-1990s, Southern Euro Area (SEA) countries saw current accounts deteriorate from a balance to large deficits of about 10 percent of GDP, while Northern Euro Area (NEA) countries accumulated surpluses.
- Three core questions addressed:
  - (1) Causes of large current account deficits in SEA and links to EMU/euro.
  - (2) Whether deficits exceed “norms” (equilibrium levels determined by fundamentals).
  - (3) Whether deficits matter in a currency union and which policy choices exist absent an exchange rate instrument.
- Key findings:
  - Decline in current accounts coincided with a large decrease in private saving rates and a much more moderate increase in investment rates.
  - Declines in private saving were spurred by financial liberalization in early and mid-1990s, and increasing dependency ratios.
  - Creation of EMU and introduction of the euro contributed to declines in current accounts by allowing countries to maintain investment above what could be financed from domestic saving; economic integration improved access to the international pool of saving.
  - Evidence for several countries that investment went to less productive nontradable sectors, such as construction.
  - Public sector saving increased somewhat in SEA but less than in NEA and not enough to offset sharply lower private saving.
  - Evidence indicates 2008 current account deficits of most SEA countries exceed norms, with substantial cross-country variation.
  - The global financial crisis forces some reduction in current account deficits and deleveraging as domestic demand and imports contract, again with substantial variation across countries.
  - Current account deficits are expected to remain high in the medium-run due to low productivity and weak competitiveness.
  - Policy menu explored: (1) fiscal consolidation to increase government saving; (2) “internal devaluation” lowering unit labor costs; (3) structural policies to increase productivity and growth, including in the nontradable sector; (4) tightening financial policies to curb credit growth and improve loan quality.
  - Labor productivity and minimum wages have a large effect on current account balances.
- Paper organization: stylized facts, regression analysis (CGER setting) to identify determinants and contributions, CGER-type equilibrium current account calculations, rationale for why deficits matter in a currency union, policy options, conclusion.

### II. Stylized facts and determinants of SEA current account deterioration
- SEA aggregate movements:
  - SEA current accounts: average from surplus of 0.1 percent in 1994 to deficit of 10 percent in 2008.
  - Timing: deterioration started later for Cyprus, Malta, Slovenia (later EMU/euro entry) than for Greece, Italy, Portugal, Spain.
  - NEA accumulated current account surpluses of the order of 2‒3 percent of GDP after 1994.
- Saving and investment dynamics (SEA averages, 1994→2008):
  - Private saving rates declined by 10 percentage points.
  - Investment rates increased by 2 percentage points.
  - Public saving rates improved by about 2 percentage points.
- Country patterns:
  - Greece, Italy, Portugal, Cyprus, Malta: declines in private saving were predominant factor.
  - Spain: investment boom (especially construction) and falling private saving contributed equally.
  - Slovenia: investment boomed while private saving improved.
  - Cyprus and Malta: investment boom after EU accession in 2004, but investment remained below mid-1990s peak.
- Investment composition:
  - Much of investment increases went into construction (nontradable); machinery and equipment investment increased moderately or declined.
- Financing composition:
  - Current account deficits heavily financed with debt instead of FDI.
  - Cyprus and Malta exceptions: net FDI inflows of the order of 5 and 10 percent of GDP respectively on average over 2000‒2008.
  - Cyprus relied on non-resident deposits; Malta used very large non-resident deposit inflows to invest in non-resident assets (neutral effect on financial account).
- Components contribution to average 10 percentage point decline (1994→2008):
  - Trade balance: 2.8 percentage points.
  - Net income: 3.6 percentage points.
  - Net transfers: 3.6 percentage points.
  - Excluding oil, trade balance improves slightly, but deterioration remains sizeable at some 6½ percentage points on average.
  - Excluding net interest payments, deterioration in the primary current account balance is still 7½ percentage points.
- Net foreign asset positions:
  - Greece, Portugal, Spain: among worst net foreign asset positions among advanced countries, exerting strong negative debt dynamics via rapidly declining net portfolio and other investment income.
  - Cyprus, Malta, Slovenia, Italy: positive or only slightly negative net foreign asset positions.
  - Accounting note: decline in net investment income in Cyprus and Malta partly reflects recording of reinvested FDI income as outflow of investment income and inflow of capital.

### III. The role of EMU, euro adoption, and financial liberalization
- Timeline and correlation:
  - Financial liberalization broadly between 1990 and 1993.
  - SEA-4 (Greece, Italy, Portugal, Spain) joined EMU in 1994 and euro area in 1999 (Greece in 2001).
  - SEA-3 (Cyprus, Malta, Slovenia) joined EMU around 2004 and euro area in 2007-2008.
  - Dates correspond broadly to start (EMU) and acceleration (euro area) of current account deterioration.
- Financial liberalization effects:
  - Relaxation of capital controls, entry barriers, quantitative credit controls, improved financial supervision; privatization slower.
  - Financial liberalization removed barriers to capital inflows and reduced need for domestic saving as credit availability rose.
  - Capital account openness indicator shows SEA-3 similar picture to SEA-4 with liberalization largely in early EMU stage.
- Macroeconomic convergence and interest rate effects:
  - Fiscal deficits brought down at or below 3 percent of GDP during EMU Stage 2 for most SEA countries (except Greece).
  - Inflation in SEA declined from double-digit early 1990s to a low of 2 percent in 2007; inflation differential with NEA narrowed from 5.5 percent in 1994 to less than 1 percent in 2008.
  - Nominal interest rates on 10-year government bonds declined by 8 percentage points in SEA-4 during stage two of EMU.
  - Interest rate differential with NEA fell from 5.5 percentage points to about zero.
  - Real interest rates declined by 5‒6 percentage points and fell below NEA between 2000‒2008.
- Quantitative econometric summary (preferred specification, coefficients reported as percent of GDP):
  - Initial net foreign assets: 0.042 [t=5.88]*** (positive).
  - General government balance: 0.204 [t=4.00]*** (positive).
  - Growth of GDP per capita: -0.057 (negative on CA).
  - Relative income per capita: 0.031 [t=2.44]** (positive).
  - Population growth: -0.716 [t=2.01]** (negative).
  - Current old-age dependency ratio: -0.158 [t=2.67]*** (negative).
  - Future old-age dependency ratio: 0.057 [t=1.25] (insignificant on CA).
  - Oil balance: 0.238 [t=6.61]*** (positive).
  - Financial center dummy: 0.022 [t=2.75]*** (positive).
  - Financial liberalization index: -0.04 [t=3.58]*** (negative on CA) and -0.088 [t=4.62]*** (negative on saving rate).
  - Northern EMU dummy: 0.031 [t=2.10]** (positive).
  - Northern euro dummy: -0.04 [t=2.12]** (negative on CA but raises investment).
  - Southern EMU dummy: -0.015 [t=1.19] (insignificant).
  - Southern euro dummy: -0.042 [t=2.71]*** (negative on CA and raises investment).
- Three main EMU-related empirical results:
  - (i) Financial liberalization weakened current account balances, mostly by depressing saving rates.
  - (ii) EMU impact: positive for NEA and negative but insignificant for SEA.
  - (iii) Euro adoption lowered current accounts substantially in both subregions by raising investment.

### IV. Decomposition and cross-sectional contributions
- Decomposition (1989‒1992 → 2005‒2008):
  - Majority of decline in SEA current accounts explained by SEA-specific EMU/euro effects.
  - Financial liberalization contributed about 1 percentage point to decline in current accounts.
  - Demographic developments (growing dependency ratios) major role in drop in saving rates, with a limited effect on current account due to downward investment adjustment.
  - EMU/euro process and financial liberalization effects on NEA were more moderate, yielding a decline of about 1‒2 percentage points; NEA current account increases largely attributed to global time effects (counterpart to U.S. deficits).
  - Cross-sectional difference (2005-2008 levels) between SEA and NEA: EMU/euro factors explain about 40‒50 percent of lower SEA current account.

### V. Current account norms, competitiveness and CGER analysis
- REER and competitiveness:
  - Price-based REER of SEA appreciated by 10‒16 percent since late 1990s; NEA appreciated less.
  - REER from unit labor cost in manufacturing: SEA experienced real appreciation around 25 percent between late 1990s and 2008; NEA recorded real depreciation around 8 percent.
  - SEA average across REER measures (percent change to 2008 from 1990s average): HICP 10.6 / GDP deflator 13.8 / export price deflator 15.7 / nominal ULC total economy 12.6 / nominal ULC manufacturing 24.9 / average of all measures 15.5. NEA average of all measures: -0.4.
- Growth performance:
  - Poor growth performance in SEA after EMU entry when current account deficits accumulated.
  - Growth per capita improved after EMU only in Greece, Slovenia, and Cyprus; declined in other SEA countries.
  - Growth in SEA since 1994 was on average somewhat lower than in NEA.
- CGER methodologies applied:
  - MB approach: equilibrium current account (“norm”) predicted from current account regression including fundamentals (uses regression model from Table 3); norms calculated for 2008.
  - ES approach: current account that stabilizes net foreign assets at reference level (latest observed), requiring assumptions on medium-term real GDP growth rate (g) and medium-term inflation (π).
  - Relationship used: CANFA ≈ ES (g / (g + π)).
- Comparisons of norms and 2008 outcomes (SEA unweighted arithmetic means, percent of GDP):
  - Current Accounts in 2008: -9.0
  - Underlying Current Account (adjusted for output gaps in 2008): -8.4
  - Estimated MB Norm with EMU/Euro Dummies: -6.4
  - Estimated MB Norm without EMU/Euro Dummies: -0.7
  - ES Norm (stabilizes NFA-to-GDP ratio at its average level in 2007-2008): -1.5
- Interpretation:
  - MB norms that include EMU and euro dummies imply larger (in absolute value) deficit norms than MB norms without those dummies.
  - ES approach yields norms closer to MB without EMU/euro dummies and questions normative value of EMU/euro dummies because they imply ever deteriorating international investment positions.
- Contributions to SEA current account norms (Table 6; percent of GDP):
  - Initial net foreign assets: -1.6
  - Fiscal balance: -0.1
  - Growth opportunities: -1.3
  - Demographics: -0.2
  - Financial factors: -3.4
  - Other variables: -1.3
  - Time dummy and constant: 7.3
  - Current account norms without EMU/Euro dummies: -0.7
  - EMU and euro factors: -5.7
  - Current account norms with EMU/Euro dummies: -6.4
- Key normative findings:
  - Both MB and ES norms indicate a substantial competitiveness gap for the region: 2008 current account deficits are substantially larger than norms, with largest gaps for Cyprus, Greece and Portugal; smallest gaps for Italy, Slovenia and Spain.
  - ES norms stabilize NFA at existing (often very low) levels, so they are not particularly demanding.
  - Main contributors to negative current account norms: high degree of financial liberalization, weak net foreign asset positions, and higher growth opportunities.

### VI. Impact of the global financial crisis since July 2007
- Domestic demand contracted sharply in SEA countries; net exports cushioned growth as imports collapsed.
- Average improvement in underlying current accounts: 3 percentage points of GDP (largest improvement observed in Spain).
- Result: estimated competitiveness gaps for the region are significantly lower than those calculated for 2008.
- Despite adjustment, external positions remain vulnerable: expected adjustments in outer years are gradual; current account deficits will stay relatively high in the medium-run and continue to require sizeable international financing.

### VII. Why large current account deficits matter in a currency union
- Three reasons:
  1. They may reflect domestic distortions (examples: low net savings from transitory asset-price booms, overly rosy growth expectations).
  2. Gradual adjustment is painful: reestablishing competitiveness in a currency union requires prolonged containment of wage costs and productivity gains amid limited labor mobility and limited fiscal transfers.
  3. Adjustment may be abrupt: sudden stop or expensive financing forces intense deleveraging, sharp domestic demand contraction, higher nonperforming loans, and banking-sector vulnerability.

### VIII. Policy options in a currency union and quantitative simulations
- Fiscal policy:
  - Fiscal consolidation appropriate when public saving is too low or monetary policy too lax.
  - Reverse fiscal stimuli and automatic stabilizers used during the crisis; lower public debt to reduce domestic demand pressure.
  - Eliminate policies distorting private saving/investment (examples: mortgage interest relief, favorable tax treatment of debt).
  - Example estimate: For Spain, a reduction in real government spending by 1.5 percentage point of GDP would improve the current account by 1 percentage point of GDP.
- Structural policies to improve productivity (including nontradable sector):
  - Key drivers: capital investment, education, innovation, product market regulation, labor market flexibility, business environment.
  - Product market reforms can permit temporarily lower inflation and are crucial to regain competitiveness.
- Internal devaluation (reduce labor costs relative to trading partners):
  - Instruments: lower social security contributions financed by increasing VAT (example: Germany in 2006), reduce indexation of wages to inflation, peg wage growth to average union inflation, moderate minimum wage growth and public wage growth, reassess unemployment benefits.
  - Caveat: pegging wages to the lowest-inflation country may be politically difficult and may still be insufficient depending on productivity differentials.
- Regulatory financial policies:
  - Improve financial supervision and make provisioning more stringent in booms to limit private credit growth and bad-quality loans.
  - Example: Bank of Spain’s countercyclical loan-loss provisioning helped build provisioning cushions.
  - But financial regulation alone is not a panacea.
- Quantitative simulations (Table 7 and Table 10 highlights):
  - If Italy, Portugal and Spain bring labor productivity growth to the highest levels observed in NEA (Finland and Netherlands), current accounts could improve by 2‒2.5 percentage points of GDP (Italy: 1.9 to 2.6 depending on avg vs max NEA productivity).
  - If Greece and Portugal moderate minimum wage increases to lower their ratio of minimum to mean wage to the lowest level in NEA (Austria, Germany, Finland), current accounts could improve by a further 2‒2.5 percentage points of GDP.
  - Table 7 specific (percent of GDP) examples:
    - Italy: avg/max NEA productivity effect 1.9; 2.6
    - Greece: mixed values reported (examples include 2.1; -1.1; -0.4 in table format).
    - Portugal: 2.5; 0.8; 1.6 depending on scenario.
    - Spain: 1.1; 1.7; 2.4 depending on scenario.
  - Econometric estimates of structural policies (Table 10):
    - Ratio of minimum to mean wage: coefficient 0.035 [t-stat 3.86]*** (higher minimum wages lower CA).
    - Labor productivity growth (instrumented): coefficient 0.284 [t-stat 2.32]**.
    - Financial liberalization index: negative and significant (e.g., -0.04 [3.58]***).
    - Northern EMU dummy: positive and significant (e.g., 0.031 [2.10]**).
    - Northern euro and Southern euro dummies: negative and significant in many specifications (e.g., Northern euro -0.04 [2.12]**; Southern euro -0.042 [2.71]***).

### IX. Econometric robustness and channels via saving and investment
- Robustness:
  - Results robust to country fixed effects, lagged current account inclusion, clustering standard errors, outlier tests, IV estimation, and sensitivity checks (dropping countries/periods/variables).
- Channels:
  - Financial liberalization strongly lowers the savings rate and has no significant effect on investment once lagged saving is controlled for.
  - EMU-euro effects on Southern Europe primarily raised investment rates (not saving).
  - In Northern Europe, EMU reduced both saving and investment, but euro adoption led to a rebound of investment.

### X. Conclusions
- Most of the decline in SEA current accounts since mid-1990s reflected a decline in private saving rates, driven by financial liberalization and increasing dependency ratios.
- The euro and EMU helped SEA countries maintain investment despite lower saving by improving access to international saving — facilitating borrowing but not implying optimal or sustainable borrowing.
- SEA current account deficits in 2008 exceeded long-run fundamental norms; the global financial crisis began unwinding imbalances but further corrections are needed.
- Policy response instruments: fiscal consolidation, internal devaluation, structural policies to boost productivity, and tighter regulatory/financial policies.
- Quantitative estimates indicate raising labor productivity and moderating unit labor costs (notably minimum wages) could substantially improve current positions.

*Source: _wp10139 — IMF staff calculations and analysis as presented in the chapter "19. The Unwinding of Imbalances from the Global Crisis".*

### 1. Contributions to Current Account Deficits of SEA in 1994 and 1998 .......................7

### 1. Contributions to Current Account Deficits of SEA in 1994 and 1998 .......................7

### Major sections in the content unit
- 1. Contributions to Current Account Deficits of SEA in 1994 and 1998 .......................7
- 2. Stages to the Euro Adoption .......................................................................................9
- 3. Determinants of the Current Accounts and Saving and Investment Rates ...............12
- 4. Real Exchange Rate Developments ..........................................................................14
- 5. Current Account Norms ............................................................................................16
- 6. Contributions of Current Account Norms .................................................................17
- 7. The Improvement in Current Accounts from Policy Changes ..................................20
- 8. Determinants of the Current Account Balance .........................................................28
- 9. Robustness Tests of Current Account Regression ....................................................29
- 10. Impact of Structural Policies on the Current Account ..............................................30

### Figures included in the content unit
- 1. Euro Area: Current Account Balance .......................................................................32
- 2. Southern Euro Area Countries: Current Account Balances 1970‒2008 ...................33
- 3. Southern Euro Area: Savings and Investment ..........................................................34
- 4. Southern Euro Area: Private and Public Saving .......................................................35
- 5. Southern Euro Area: Private and Public Investment ................................................36
- 6. Southern Euro Area: Financing of Current Account Balances ..............................37
- 7. Euro Area: Components of Current Account Balances ............................................38
- 8. Net International Investment Position ...........................................................38
- 9. Euro Area: EMU and Current Accounts .................................................................39
- 10. Southern Euro Area: EMU and Financial Liberalization .........................................40
- 11. Macroeconomic Policy Developments .....................................................................41
- 12. Euro Area: EMU and Interest Rates .........................................................................41
- 13. Euro Area: Contributions to Changes in Current Accounts, Savings and Investments Rates, 2005‒2008 versus 1989‒1992 .......................................................................42
- 14. Old Age Dependency Ratio ......................................................................................43
- 15. Southern Euro Area: Contributions to Difference in Current Accounts, Savings Rates and Investment Rates from Northern Euro Area, 2005‒2008 ..................................44
- 16. Real Effective Exchange Rate ..................................................................................45
- 17. Euro Area: EMU, Economic Growth, and Output Gaps ..........................................47
- 18. Current Account Norms ............................................................................................48

*Source: _wp10139 - 1. Contributions to Current Account Deficits of SEA in 1994 and 1998 .......................7*

### 19.    The Unwinding of Imbalances from the Global Crisis .............................................49

### 19.    The Unwinding of Imbalances from the Global Crisis .............................................49

### I. INTRODUCTION
- Since the mid-1990s, Southern Euro Area (SEA) countries saw current accounts deteriorate from a balance to large deficits of about 10 percent of GDP, while Northern Euro Area (NEA) countries accumulated surpluses.
- Three core questions addressed:
  - (1) Causes of large current account deficits in SEA and links to EMU/euro.
  - (2) Whether deficits exceed “norms” (equilibrium levels determined by fundamentals).
  - (3) Whether deficits matter in a currency union and which policy choices exist absent an exchange rate instrument.
- Key findings:
  - Decline in current accounts coincided with a large decrease in private saving rates and a much more moderate increase in investment rates.
  - Declines in private saving were spurred by financial liberalization in early and mid-1990s, and increasing dependency ratios.
  - Creation of EMU and introduction of the euro contributed to declines in current accounts by allowing countries to maintain investment above what could be financed from domestic saving; economic integration improved access to the international pool of saving.
  - Evidence for several countries that investment went to less productive nontradable sectors, such as construction.
  - Public sector saving increased somewhat in SEA but less than in NEA and not enough to offset sharply lower private saving.
  - Evidence indicates 2008 current account deficits of most SEA countries exceed norms, with substantial cross-country variation.
  - The global financial crisis forces some reduction in current account deficits and deleveraging as domestic demand and imports contract, again with substantial variation across countries.
  - Current account deficits are expected to remain high in the medium-run due to low productivity and weak competitiveness.
  - Policy menu explored: (1) fiscal consolidation to increase government saving; (2) “internal devaluation” lowering unit labor costs; (3) structural policies to increase productivity and growth, including in the nontradable sector; (4) tightening financial policies to curb credit growth and improve loan quality.
  - Labor productivity and minimum wages have a large effect on current account balances.
- Paper organization: stylized facts, regression analysis (CGER setting) to identify determinants and contributions, CGER-type equilibrium current account calculations, rationale for why deficits matter in a currency union, policy options, conclusion.

### II. WHAT EXPLAINS THE RISE IN CURRENT ACCOUNT DEFICITS IN SOUTHERN EURO AREA COUNTRIES?
- Stylized facts:
  - SEA current accounts: average from surplus of 0.1 percent in 1994 to deficit of 10 percent in 2008.
  - Timing: deterioration started later for Cyprus, Malta, Slovenia (later EMU/euro entry) than for Greece, Italy, Portugal, Spain.
  - NEA accumulated current account surpluses of the order of 2‒3 percent of GDP after 1994.
  - Within-group variation noted: Malta, Slovenia, and especially Italy had more moderate deficits (Italy ~3 percent of GDP); some NEA (e.g., Ireland) ran large deficits pre-crisis.
- Saving and investment dynamics:
  - On average across SEA, private saving rates declined by 10 percentage points between 1994 and 2008.
  - Investment rates increased by 2 percentage points on average over the same period.
  - Public saving rates improved by about 2 percentage points on average.
  - Country examples:
    - Greece, Italy, Portugal, Cyprus, Malta: declines in private saving were predominant factor.
    - Spain: investment boom (especially construction) and falling private saving contributed equally.
    - Slovenia: investment boomed while private saving improved.
    - Cyprus and Malta: investment boom after EU accession in 2004, but investment remained below mid-1990s peak.
  - Much of investment increases went into construction (nontradable) while machinery and equipment investment increased moderately or declined.
- Divergence with NEA:
  - By 2008, SEA saving rates were substantially below NEA due to lower private and public saving.
  - Investment rates broadly in line with NEA except Spain and Slovenia (much higher).
  - Public saving improved in SEA but less so than NEA, compounding private-sector buoyancy.
- Financing composition:
  - Current account deficits heavily financed with debt instead of FDI.
  - Larger countries (Spain, Greece, to lesser extent Italy): large importers of bond-related inflows.
  - Portugal and Slovenia: large foreign loans.
  - Cyprus and Malta exceptions: substantial net FDI inflows of the order of 5 and 10 percent of GDP respectively on average over 2000‒2008.
  - Cyprus relied on non-resident deposits; Malta used very large non-resident deposit inflows to invest in non-resident assets (neutral effect on financial account).
- Components contribution to 10 percentage point average decline in current account (1994→2008):
  - Trade balance contributed 2.8 percentage points.
  - Net income contributed 3.6 percentage points.
  - Net transfers contributed 3.6 percentage points.
  - Excluding oil, trade balance improves slightly, but current account deterioration remains sizeable at some 6½ percentage points on average.
  - Excluding net interest payments, deterioration in the primary current account balance is still 7½ percentage points.
- Net foreign asset positions:
  - Greece, Portugal, Spain: among worst net foreign asset positions among advanced countries, exerting strong negative debt dynamics via rapidly declining net portfolio and other investment income.
  - Cyprus, Malta, Slovenia, Italy: positive or only slightly negative net foreign asset positions.
  - Note: strong decline in net investment income in Cyprus and Malta reflects accounting practice where reinvested FDI income is recorded as outflow of investment income and inflow of capital.

### The role of EMU
- Timeline and correlation:
  - Financial liberalization broadly between 1990 and 1993.
  - SEA-4 (Greece, Italy, Portugal, Spain) joined EMU in 1994 and euro area in 1999 (Greece in 2001).
  - SEA-3 (Cyprus, Malta, Slovenia) joined EMU around 2004 and euro area in 2007-2008.
  - Dates correspond broadly to start (EMU) and acceleration (euro area) of current account deterioration.
- Financial liberalization:
  - SEA converged towards NEA levels in financial liberalization.
  - Liberalization involved relaxation of capital controls, entry barriers, quantitative credit controls, improved financial supervision; privatization slower.
  - Financial liberalization removed barriers to capital inflows and reduced need for domestic saving as credit availability rose.
  - Capital account openness indicator shows SEA-3 similar picture to SEA-4 with liberalization largely in early EMU stage.
- Macroeconomic convergence:
  - SEA fiscal deficits brought down at or below 3 percent of GDP benchmark during EMU Stage 2, except Greece.
  - Inflation in SEA declined from double-digit early 1990s to a low of 2 percent in 2007; inflation differential with NEA narrowed from 5.5 percent in 1994 to less than 1 percent in 2008.
  - Lower fiscal deficits and inflation help improve current account; but sounder policies reduced country risk premium and interest costs on foreign borrowing.
- Interest rate convergence:
  - SEA nominal and real interest rates fell rapidly and converged to NEA low levels.
  - Nominal interest rates on 10-year government bonds declined by 8 percentage points in SEA-4 during stage two of EMU.
  - Interest rate differential with NEA fell from 5.5 percentage points to about zero.
  - Real interest rates declined by 5‒6 percentage points and fell below NEA between 2000‒2008.
  - Short-term interest rates showed a similar picture for SEA-3 in later years.

### A quantitative analysis
- Methodology:
  - Standard current account regressions controlling for broad determinants; introduce financial liberalization measures and dummy variables for EMU participation and euro adoption.
  - Allow EMU and euro adoption to have different impacts on NEA and SEA.
  - Model also estimated replacing current account with saving and investment rates to shed light on channels.
  - Data averaged over four-year periods; panel of 49 advanced and emerging economies during 1973‒2008 (unbalanced panel).
- Caveats:
  - Differentiated dummies address heterogeneity only partially; estimated effects are averages.
  - Difficult to disentangle EMU from euro adoption effects; euro existed just over 10 years at time of study.
  - Crisis and earlier 1992‒93 events complicate comparisons across periods.
- Empirical determinants (preferred specification summarized in Table 3; coefficients reported as percent of GDP):
  - Initial net foreign assets: positive effect on current account (0.042) [t=5.88]***.
  - General government balance (percent of GDP): positive effect (0.204) [t=4.00]***.
  - Growth of GDP per capita: negative on current account (-0.057) but positive and significant on saving/investment regressions.
  - Relative income per capita: positive effects (0.031 on current account) [t=2.44]**.
  - Population growth: negative effect (-0.716) [t=2.01]**.
  - Current old-age dependency ratio: negative (-0.158) [t=2.67]***.
  - Future old-age dependency ratio: positive (0.057) [t=1.25] (insignificant on current account).
  - Oil balance: positive (0.238) [t=6.61]***.
  - Financial center dummy: positive (0.022) [t=2.75]***.
  - Financial liberalization index: negative on current account (-0.04) [t=3.58]*** and negative on saving rate (-0.088) [t=4.62]***.
  - Northern EMU dummy variable: positive on current account (0.031) [t=2.10]**; Northern euro dummy variable: negative on current account (-0.04) [t=2.12]** but positive effects on investment rates.
  - Southern EMU dummy variable: insignificant on current account (-0.015) [t=1.19].
  - Southern euro dummy variable: negative on current account (-0.042) [t=2.71]*** and raises investment.
- Three main results regarding EMU-related variables:
  - (i) Financial liberalization weakened the current account balance, mostly by depressing saving rates.
  - (ii) EMU impact: positive for NEA and negative but insignificant for SEA.
  - (iii) Euro adoption lowered current accounts substantially in both subregions by raising investment.
- Interpretation:
  - EMU had offsetting effects: improved macro policies could improve current accounts, but sharp decline in interest rates could worsen them; net balance differed between SEA and NEA.
  - EMU opened door to surge in capital flows from NEA to SEA, which had larger investment needs, affecting current accounts oppositely across regions.
  - Euro adoption depressed current accounts in both regions via higher investment—factors include perceived higher growth prospects and portfolio diversification into the euro.

- Decomposition (1989‒1992 → 2005‒2008):
  - Most of the decline in SEA current accounts explained by SEA-specific EMU/euro effects.
  - Euro adoption allowed investment to be maintained at much higher levels than domestic saving would have financed with broadly unchanged domestic saving rate—improved access to international saving pool.
  - Financial liberalization contributed about 1 percentage point to decline in current accounts.
  - Demographic developments (growing dependency ratios) major role in drop in saving rates, with negative but limited effect on current account due to downward adjustment of investment.
  - EMU/euro process and financial liberalization effects on NEA were more moderate, yielding a decline of about 1‒2 percentage points; NEA current account increases largely attributed to global time effects (counterpart to U.S. deficits).
  - Cross-sectional difference (2005-2008 levels) between SEA and NEA: EMU/euro factors explain about 40‒50 percent of lower SEA current account.

### III. DO THE CURRENT ACCOUNT DEFICITS EXCEED NORMS?
- Approach:
  - Examine real effective exchange rates (REER) and growth performance since EMU entry.
  - Use IMF CGER methodologies: Macro-Balance (MB) and External Sustainability (ES) to determine equilibrium current account and assess disequilibrium.
- REER and competitiveness:
  - Price-based REER of SEA appreciated by 10‒16 percent since late 1990s; NEA appreciated less.
  - REER from unit labor cost in manufacturing shows SEA experienced real appreciation around 25 percent between late 1990s and 2008, whereas NEA recorded real depreciation around 8 percent.
  - Table 4 reported percentage changes in various REER measures (1999=100) to 2008 from 1990s average; SEA average across measures: 10.6 (HICP) / 13.8 (GDP deflator) / 15.7 (export price deflator) / 12.6 (nominal ULC total economy) / 24.9 (nominal ULC manufacturing) / average of all measures 15.5. NEA average of all measures: -0.4.
- Growth performance:
  - Poor growth performance in SEA after EMU entry when current account deficits accumulated.
  - Growth per capita improved after EMU only in Greece, Slovenia, and Cyprus; declined in other SEA countries.
  - Growth in SEA since 1994 was on average somewhat lower than in NEA; mixed evidence of catching-up to NEA per capita income levels despite lower initial income levels.
  - Positive output gaps in SEA correlated with current account balance deterioration; NEA had similar output gaps without current account deterioration.
- Competitiveness and exports:
  - Some evidence of improvements in nonprice external competitiveness (e.g., export market shares), but exports alone may be too narrow to judge competitiveness.
  - Thought experiment: reducing domestic demand (and raising unemployment) to correct current account deficits without relative price adjustment might require deep recession—suggesting demand management alone may be infeasible or suboptimal.
- Formal CGER measures:
  - MB approach: equilibrium current account (“norm”) predicted from current account regression including fundamentals (uses regression model from Table 3); norms calculated for 2008.
  - ES approach: calculates current account that stabilizes net foreign assets at reference level (usually latest observed value), requiring assumptions on medium-term real GDP growth rate (g) and medium-term inflation (π).
  - Relationship expressed: CANFA ≈ ES (g / (g + π)). (Equation presented as 1 ES g CANFA g π π + ≈ + + in source formatting.)
  - MB and ES norms compared to actual 2008 current account deficit corrected for the cycle (“underlying current account”).
- Additional notes:
  - Robustness checks: “steady state” current account norms also calculated from regression including current account dynamics; steady state norms excluding EMU and euro dummies broadly in line with MB and ES norms (details in Appendix/Table 9 referenced).

*Source: IMF staff calculations and analysis as presented in the chapter "19. The Unwinding of Imbalances from the Global Crisis" (excerpts supplied).*

### 5. However, the steady state current account norms including EMU and euro dummies are even higher (in

### _wp10139 - 5. However, the steady state current account norms including EMU and euro dummies are even higher (in

### Current account norms and adjustments (2008)
- SEA Average (unweighted arithmetic means):  
  - Current Accounts in 2008: -9.0 (percent of GDP)  
  - Underlying Current Account (current account adjusted for output gaps in 2008): -8.4 (percent of GDP)  
  - Estimated MB Norm with EMU/Euro Dummies: -6.4 (percent of GDP)  
  - Estimated MB Norm without EMU/Euro Dummies: -0.7 (percent of GDP)  
  - ES Norm (stabilizes NFA-to-GDP ratio at its average level in 2007-2008): -1.5 (percent of GDP)
- Interpretation: MB norms that include EMU and euro dummies imply larger (in absolute value) deficit norms than MB norms without those dummies; the ES approach yields norms closer to MB without EMU/euro dummies and calls into question the normative value of EMU/euro dummies because they lead to ever deteriorating international investment positions.
- Note on output-gap correction for comparisons with norms: the paper adjusts actual current accounts for domestic and partner output gaps; the formal correction expression and variable definitions are provided in the source (variables include CA/Y, ppCAY, GAP, *GAP, export/import elasticities Xξ, Mξ).

### Contributions to SEA current account norms (Table 6; percent of GDP)
- SEA average contributions:  
  - Initial net foreign assets: -1.6  
  - Fiscal balance: -0.1  
  - Growth opportunities: -1.3  
  - Demographics: -0.2  
  - Financial factors: -3.4  
  - Other variables: -1.3  
  - Time dummy and constant: 7.3  
  - Current account norms without EMU/Euro dummies: -0.7  
  - EMU and euro factors: -5.7  
  - Current account norms with EMU/Euro dummies: -6.4

### Key findings on norms, competitiveness gaps, and vulnerabilities
- Both MB and ES norms indicate a substantial competitiveness gap for the region: 2008 current account deficits are substantially larger than norms, with largest gaps for Cyprus, Greece and Portugal; smallest gaps for Italy, Slovenia and Spain.
- ES norms stabilize NFA at existing (often very low) levels, so they are not particularly demanding.
- For the region as a whole, main contributors to negative current account norms are: high degree of financial liberalization, weak net foreign asset positions, and higher growth opportunities.

### Impact of the global financial crisis (since July 2007)
- Domestic demand contracted sharply in SEA countries; net exports cushioned growth as imports collapsed.  
- Average improvement in underlying current accounts: 3 percentage points of GDP (largest improvement observed in Spain).  
- Result: estimated competitiveness gaps for the region are significantly lower than those calculated for 2008.  
- Despite adjustment, external positions remain vulnerable: expected adjustments in outer years are gradual; current account deficits will stay relatively high in the medium-run and continue to require sizeable international financing.

### Why large current account deficits matter in a currency union
- Three reasons:  
  1. They may reflect domestic distortions (examples: low net savings from transitory asset-price booms, overly rosy growth expectations).  
  2. Gradual adjustment is painful: reestablishing competitiveness in a currency union requires prolonged containment of wage costs and productivity gains amid limited labor mobility and limited fiscal transfers.  
  3. Adjustment may be abrupt: sudden stop or expensive financing forces intense deleveraging, sharp domestic demand contraction, higher nonperforming loans, and banking-sector vulnerability.

### Policy options in a currency union (major categories and specifics)
- Fiscal policy:  
  - Fiscal consolidation appropriate when public saving is too low or monetary policy too lax.  
  - Reverse fiscal stimuli and automatic stabilizers used during the crisis; lower public debt to reduce domestic demand pressure.  
  - Eliminate policies distorting private saving/investment (examples cited: mortgage interest relief, favorable tax treatment of debt).  
  - Example estimate: For Spain, Catalán and Lama (2006) estimate a reduction in real government spending by 1.5 percentage point of GDP would improve the current account by 1 percentage point of GDP.
- Structural policies to improve productivity (including nontradable sector):  
  - Key drivers: capital investment, education, innovation, product market regulation, labor market flexibility, business environment.  
  - Product market reforms can permit temporarily lower inflation and are crucial to regain competitiveness.
- Internal devaluation (reduce labor costs relative to trading partners):  
  - Instruments: lower social security contributions financed by increasing VAT (example: Germany in 2006), reduce indexation of wages to inflation, peg wage growth to average union inflation, moderate minimum wage growth and public wage growth, reassess unemployment benefits.  
  - Caveat: pegging wages to the lowest-inflation country may be politically difficult and may still be insufficient depending on productivity differentials.
- Regulatory financial policies:  
  - Improve financial supervision and make provisioning more stringent in booms to limit private credit growth and bad-quality loans.  
  - Example: Bank of Spain’s countercyclical loan-loss provisioning helped build provisioning cushions.  
  - But financial regulation alone is not a panacea (Spain example).

### Quantitative simulations of policy impacts (Table 7 and Table 10)
- Table 7 indicative calculations for Italy, Portugal, Spain, Greece:  
  - If Italy, Portugal and Spain bring labor productivity growth to the highest levels observed in NEA (Finland and Netherlands), current accounts could improve by 2‒2.5 percentage points of GDP (Italy: 1.9 to 2.6 depending on avg vs max NEA productivity).  
  - If Greece and Portugal moderate minimum wage increases to lower their ratio of minimum to mean wage to the lowest level in NEA (Austria, Germany, Finland), current accounts could improve by a further 2‒2.5 percentage points of GDP.  
  - Table 7 specific values (percent of GDP, columns ratio of min to mean wage and labor productivity growth):  
    - Italy: ratio change -1.1; min/avg NEA labor productivity change 0.0; avg NEA to max NEA: 1.9; 2.6  
    - Greece: ratio change 1.0; 2.1; -1.1; -0.4  
    - Portugal: ratio change 1.4; 2.5; 0.8; 1.6  
    - Spain: ratio change 0.0; 1.1; 1.7; 2.4
- Table 10—Econometric estimates of structural policies on current account (selected preserved coefficients and significance):  
  - Ratio of minimum to mean wage: coefficient 0.035 (t-stat [3.86]***); higher minimum wages lower the current account (interpreted as raising wage costs and reducing competitiveness).  
  - Labor productivity growth (instrumented): coefficient 0.284 (t-stat [2.32]**) in the instrumented specification; lagged labor productivity growth: coefficient 0.054 ([1.66]*).  
  - Financial liberalization index: negative and significant across specifications (e.g., -0.04, [3.58]***).  
  - Northern EMU dummy variable: positive and significant in many specifications (e.g., 0.031, [2.10]**).  
  - Northern euro dummy variable and Southern euro dummy variable: negative and significant in many specifications (e.g., Northern euro dummy -0.04, [2.12]**; Southern euro dummy -0.042, [2.71]***).

### Econometric findings on determinants (Tables 8–9 summary)
- Standard determinants with expected signs and significance:  
  - Initial net foreign assets: positive and significant (e.g., 0.046, [6.99]***).  
  - General government balance: positive and significant (e.g., 0.179‒0.204, significant).  
  - Relative income per capita: positive and significant (e.g., 0.022‒0.039, significant).  
  - Population growth and current old-age dependency ratio: negative and significant.  
  - Future old-age dependency ratio: positive (evidence that expected higher old-age dependency prompts saving).  
  - Oil balance: positive and significant (e.g., 0.262, [7.12]***).  
  - Financial center dummy: positive and significant.
- Financial liberalization and capital account openness: negative effect on current accounts; the broader financial liberalization index is robustly significant.  
- EMU and euro dummy variables:  
  - EMU appears to have improved current accounts in Northern countries by about 3 percentage points (Northern EMU dummy positive).  
  - Euro adoption tended to lower current accounts in both Northern and Southern subregions (e.g., euro dummies negative, additional ~4 percentage points relative to EMU effect).  
- Robustness: results robust to country fixed effects, lagged current account inclusion, clustering standard errors, outlier tests, IV estimation, and sensitivity checks (dropping countries/periods/variables).

### Channels via saving and investment
- Financial liberalization strongly lowers the savings rate and has no significant effect on investment once the lagged saving rate is controlled for.  
- EMU-euro effects on Southern Europe primarily raised investment rates (not saving).  
- In Northern Europe, EMU reduced both saving and investment, but euro adoption led to a rebound of investment.

### Conclusions (summary)
- Most of the decline in SEA current accounts since mid-1990s reflected a decline in private saving rates, driven by financial liberalization and increasing dependency ratios.  
- The euro and EMU helped SEA countries maintain investment despite lower saving by improving access to international saving — facilitating borrowing but not implying optimal or sustainable borrowing.  
- SEA current account deficits in 2008 exceeded long-run fundamental norms. Adjusting deficits is costly and can be abrupt; the global financial crisis began unwinding imbalances but further corrections are needed.  
- Policy response instruments: fiscal consolidation, internal devaluation, structural policies to boost productivity, and tighter regulatory/financial policies. Quantitative estimates indicate raising labor productivity and moderating unit labor costs (notably minimum wages) could substantially improve current positions.

*Source: IMF Staff Calculations and analyses as presented in the supplied content unit.*

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