External Asymmetries in the Euro Area and the Role of Foreign Direct Investment

• DOI: http://doi.org/10.1111/twec.12406
• Author: Vassilis Sarantides,Nicos Christodoulakis
• Published date: 01 February 2017
• Date: 01 February 2017

External Asymmetries in the Euro Area

and the Role of Foreign Direct Investment

Nicos Christodoulakis

1

and Vassilis Sarantides

2

1

Department of International and European Economic Studies, Athens University of Economics and

Business, Athens, Greece and

2

Department of Economics, University of Sheffield, Sheffield, UK

1. INTRODUCTION

ALTHOUGH overshadowed by the ongoing debt crisis, a deeply worrying development in

the Euro area since the establishment of the common currency was the continuing diver-

gence of trade balances and current accounts among Member States. The issue was never for-

mally considered as an explicit target in the treaties for setting up the EMU, perhaps because

it was difficult to imagine that external imbalances would diverge so dramatically afterwards.

The EMU project was in fact based on the optimistic assumption that –as a result of the

monetary unification –increased factor mobility would foster growth and competitiveness

across countries, enough to redress any serious imbalances emerging in their current accounts.

The problem was addressed in an alarming tone by the European Commission (2009) only

after the global crisis in 2008 demonstrated that countries with sizeable current account

deficits are more vulnerable to credit and liquidity pressures.

Other studies went further to show that external imbalances may well have been among the

reasons that Euro area countries were entangled in their current malaise. In this context, Shel-

burne (2008) warned that the tightening of global credit may turn a problem of illiquidity into

one of insolvency. Krugman (2011) suggested that the crisis in the Southern European countries

had little to do with fiscal imbalances but mainly with the sudden stoppage of capital inflows

required to finance their huge external deficits. Other studies clearly established that EMU coun-

tries with large external deficits experienced the highest sovereign spreads (Attinasi et al. 2009;

Barrios et al. 2009). Das et al. (2010) examined in detail the discrepancies between core and

peripheral countries in the Euro area and found that structural differences had led to such pro-

ductivity gaps that made the integration process questionable in the medium run. In a similar

tone, Sinn (2012) found that the current account imbalances in the Euro area are so enormous

that pose a threat similar to that experienced during the late phase of the Bretton Woods system.

Therefore, a crucial issue is what exactly has caused so large divergences in the external

balances of the Member States. In the first years of the EMU, the dominant view was that the

external deficits have been a demand-driven phenomenon which was expected to dissipate as

soon as integration advances (Gruber and Kamin 2009). Blanchard and Giavazzi (2002)

argued that increased mobility in capital markets was likely to result in large current account

deficits in the short run. However, they disregarded any explosive pattern in the medium run

and argued that countries such as Portugal and Greece need not take any measures to reduce

their deficits. It was only after external imbalances were aggravated that alternative and more

convincing explanations were sought. In this vein, Arghyrou and Chortareas (2008, p. 755)

suggested that ‘other factors beyond income growth may explain the current account positions

of Greece, Italy, Portugal and Spain’. and provided evidence that the deviation in competitive-

ness among the Member States was a decisive factor.

©2016 The Authors The World Economy Published by John Wiley & Sons Ltd. 393

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The World Economy (2017)

doi: 10.1111/twec.12406

The World Economy

The present paper seeks to examine –in theory and empirically –the implications of

another factor that has not thus far attracted much attention, namely the different patterns of

FDI inflows across Euro area countries. Although relatively small in size if compared to othe r

macroeconomic effects, FDI inflows play a crucial role in shaping the technology advantage

and overall capital productivity in the destination country.

1

Hence, if the size and/or the

composition of FDI inflows is found to differ across Euro area countries, this might have been

be a crucial factor in reinforcing productivity gaps and causing further divergence in the

external accounts.

All countries but Greece have received higher FDI inflows in the post-EMU era, confirm-

ing the expectation that capital flows would be encouraged under EMU (Barrell and Pain

1997, 1998). However, country patterns seem to have been sharp different in both the size

and composition of FDI inflows. As described in the next section, two groups can be distin-

guished among the early members of the Euro area, according to whether their external

balances have been improved or deteriorated after EMU relative to their pre-EMU levels. As

they happen to be geographically grouped as well, these two inner groups are loosely classi-

fied as ‘North’ and ‘South’, respectively. Using this convenient taxonomy, it seems that after

the introduction of the Euro the North has attracted more FDI inflows in comparison with the

South, whereas both before and after this transition it also attracted a higher amount of manu-

facturing (traded sector) FDI. In stark contrast, the increased FDI inflows in the South in the

post-EMU era were dominated by investments in the non-traded sector. This divergence in

the pattern of FDI inflows can be of particular importance, since externalities associated with

FDI inflows might differ markedly between the manufacturing and the non-manufacturing

sectors (UNCTAD 2001).

2

Despite the recent literature on the rising asymmetries within the Euro area, this is the

first time to our best knowledge that the effect of aggregate and industry-level FDI

inflows is quantified as a critical factor for the observed external imbalances. The theoreti-

cal analysis is based on a two-sector dynamic model with traded and non-traded goods as

developed by Engel and Kletzer (1989), Brock and Turnovsky (1994), and Turnovsky

(1996). Two types of economies are considered, according to whether they are relatively

capital-intensive in the traded or non-traded sector, respectively. We prove that if a country

is FDI-intensive in the traded (non-traded) sector, an increase in FDI inflows will increase

traded (non-traded) output and improve (deteriorate) the trade balance. Thus, if the econ-

omy is relatively capital-intensive in the production of traded (non-traded) output, FDI will

be channelled in greater proportions to the traded (non-traded) sector expanding relatively

more traded (non-traded) output and, thus, improving the trade balance. Although our

model draws on the existing literature, it employs an alternative formulation on capital

installation costs that leads to unique equilibrium and avoids the indeterminacy of other

sectoral models.

To test the theoretical predictions of the model, we focus our attention on the two

groups of the Euro area over the period 1980 to 2009. Our results indicate a positive long-

run effect of FDI inflows on the trade balance in the North, while the opposite effect is

observed in the South. Consistent with our theory, in the North, the positive effect stems

1

For a survey on the effect of FDI on the host county’s activities, see Lipsey (2002) and G€

org and

Greenaway (2004).

2

We discuss the literature of sectoral FDI inflows in the next section where we present evidence for the

pattern of FDI inflows within the Euro area.

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394 N. CHRISTODOULAKIS AND V. SARANTIDES