Progress Towards External Adjustment in the Euro Area Periphery and the Baltics

IMF Working Papers, July 22, 2014

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The euro area periphery countries and the Baltic countries had large current account deficits in the run-up to the crisis and needed adjustment of relative prices to achieve both internal and external balances.
Tangible progress has been made through lower wages and/or higher productivity relative to trading partners (“internal devaluation”), contributing to narrowing current account deficits and shifting output towards the tradables sector.
Some early adjusters cut wages more rapidly followed by productivity improvement; others have only slowly improved productivity largely through labor shedding.
For most countries the adjustment has come along with a substantial recession as the unit labor cost improvement has largely come from falling employment and much of the current account improvement from import compression.

“Internal devaluation” via lower wages and/or higher productivity relative to trading partners.
Productivity improvement following wage cuts for some countries.
Slow productivity gains achieved largely through labor shedding for other countries.
Current account improvement achieved in large part through import compression.

Adjustment has shifted output towards the tradables sector.
The adjustment process has been associated with a substantial recession in most countries.
Going forward, countries still need to:
- generate growing tradables sector employment, and
- continue adjustment to prevent imbalances from returning as output gaps close.

Sustain measures that support productivity improvements in tandem with wage adjustments where needed.
Promote policies that foster employment growth in the tradables sector to replace labor shedding-driven gains.
Continue adjustment efforts as output gaps close to avoid re-emergence of current account imbalances.