Are Balance of Payments Crises Looming for Certain Euro Area Members?

EU Commission and ECB officials and many so-called financial experts label financial crises in the euro area as sovereign debt crises. Furthermore, policy-makers seem to see the prospect of future crises in the euro area primarily through the lens of government debt and appear to take little account of destabilizing balance of payments and private capital flows. However, several economists are of the view that the root cause of eurozone financial crises can be found in large current account deficits in the balance of payments and their financing.

Particularly in view of the substantial impact of the Russian/Ukraine war and related sanctions on the value of trade flows of euro area countries with non-eurozone countries this piece examines the balance of payments crisis hypothesis and whether it is pertinent to the ongoing developments with respect to relations between euro area members and their trading partners.

Background

Euro area countries such as Spain, Portugal, Ireland and Cyprus that experienced financial crises this century recorded very large deficits in the current accounts of their balance of payments in the years leading up to their financial crises, with such deficits considerably exceeding the size of their government deficits. In fact, over the five years 2008 to 2012 prior to its financial crisis the external current account deficit for Cyprus averaged 10.5% of GDP, whereas the government deficit averaged 4.5% of GDP. And the large current account deficits of Spain, Ireland and Cyprus were financed through use of the TARGET2 payments system of the Eurosystem[1] as well as by very large external inflows of funds into the banks of these countries.

But even though crises in certain euro area members may have coincided with the incurring of large balance of payments deficits such crises should not be labelled as “balance of payments crises” as large external deficits may not have been the most important cause of such crises. Balance of payments crises occur when external deficits cannot be adequately financed or funded resulting in an inability of a country to service its external payments obligations. But as indicated above funding of the current account deficits of Southern European countries did not appear to be a problem in past years with the running up of debit balances in the TARGET2 system being an important “back-up” source of financing.

Financial problems arose in Spain, Cyprus and Ireland because of a large amount of the loanable funds derived from external sources by banks were not used productively and squandered. Indeed, articles by Manison and Savvides[2] highlight the reckless and collateral-only lending of Cyprus banks mainly in speculative property ventures and unaffordable housing as being the root cause of the Cyprus financial crisis of 2013. And the situation was aggravated by the inability of the Government to provide funding to bail out the two most important systemic banks, which were essentially insolvent and being drained of liquidity with massive deposit withdrawals. This explanation is consistent with the conclusion of the Italian economist, Sergio Cesaratto who states[3] that “the origin of the eurozone crisis lies in a deregulated and badly supervised financial sector that ended up being too big, with its evolution usually related to real-estate activities, and that in its fall, it dragged down the respective national governments (of Spain, Portugal, Greece and Ireland)”.

Looming Balance of Payments Problems

Unfortunately, despite difficulties and differences in assessing causes of euro area financial crises EU policy-makers and commentators in their analysis of most recent economic and financial developments in the euro area continue to see the risk of a another crisis through the lens of a new sovereign debt crisis, giving particular focus to the Italian government debt situation. In this respect, the creation of the new Transmission Protection Instrument (TPI) by the ECB is aimed at mitigating the spread of government bond yields in the euro area so as to try to prevent a perceived sovereign debt crisis.

However, data on recent economic developments in euro area countries indicate that mainly because of the recent huge increases in fuel and other commodity prices, euro area countries are incurring sharply rising trade deficits with countries outside the euro area. Reflecting soaring prices, particularly of energy imports from Russia and Norway, the trade deficit of the euro area with the rest of the world has skyrocketed over the last year with the deficit for the January-June period of 2022 amounting to 140 billion euro compared with a surplus of 101 billion euro in the same months of 2021. In fact, imports by the euro area from outside the euro area rose by 43.0 % in the first six months of 2022 compared with the same period of 2021.

Further detailed information on extra EU trade shows that the trade balances of most euro area members with countries outside the EU deteriorated sharply in the first 6 months of 2022. For example, even though it is not reliant on the import of natural gas the trade deficit of Cyprus with non-EU countries increased by more than 92% to over one billion euro in the first 6 months of 2022. Most strikingly imports of Cyprus from non-EU countries rose by 172.7% in the January to June period of 2022 compared with the same months of 2021 as the value of imports of crude oil surged and imports of intermediate inputs such as iron rods for the construction industry rose strongly as well.

It is encouraging that export receipts in Southern European countries including Italy are being boosted by substantial increases in revenues from foreign tourists. In fact, in the first 7 months of 2022 tourist arrivals in Cyprus increased by 162.5 % compared with the same period of 2021. While the improved performances of services exports should help to contain increases in the current account deficits of vulnerable euro area countries a key issue will be the extent to which trade deficits with non-EU members continue to rise and cause financing problems. In this connection with energy and other commodity prices remaining at very high levels in July and most of August it is likely that the trade balances of euro area countries will continue to deteriorate.

Thus, there could be more pressure on euro area countries in financing deficits with non-EU countries? Surely, there are limitations on use of the TARGET2 system for this external financing. For example, new arrangements for cross border payments in certain non-euro currencies such as for the financing of energy imports from Russia will have to be made. Furthermore, large foreign capital inflows into countries such as Spain, Ireland and Cyprus to take advantage of low taxes and perceived attractive property deals as happened prior to previous crises are not being repeated.

Hence, policy-makers in the euro area will need to be very vigilant in monitoring developments in the balances of the external current accounts of euro area countries and assessing whether deficits are being supported by sufficient funding and the productive use of such funds. While huge increases in the prices of energy and other commodities will undoubtedly depress economic activity and living standards in the euro area, it is possible as well that certain members of the euro area may experience balance of payments crises requiring outside financial support even, embarrassingly, from the IMF.