Euro Area Too Dependent On Portfolio Inflows?

by: The Wilder View

This is part two of my multi-post commentary on the euro area Balance of Payments (BoP). Yesterday, in part one, I compared the EA current account balance to its country-level cross section. Today’s post will be more instructive in nature, as I dig into the components of the EA current account (CA) and capital account (KA) balances.

My general conclusion is that the EA is highly dependent on foreign demand for EA assets in the identity of its international accounts.

As a note: remember the standard international finance identity: CA + KA + errors and omissions = 0, where CA + KA is generally referred to as the Balance of Payments. An international guide to the BoP can be found at the IMF website (pdf). Generally, the EA BoP statistics adhere to the IMF definitions.

The Current Account

The chart below illustrates the 3-month accumulated current account balance as the sum of its components: the goods balance (exports minus imports of goods), the service balance (exports minus imports of services), net foreign income, and unilateral transfers. The goods, services, and income balance is € 16.2 for the three months ending in September, which is more than offset by the unilateral transfer balance, -€ 28.1 billion.

The transfer debits are generally to and from other EU institutions and other non-EU and non G7 countries (see section 7.3, table 9-pdf), which reflects subsidies from the EA to EU budgets, remittance payments, and aid to developing economies. Given the stability in these outflows, this should be no cause for concern at this time. Of note, the goods balance shrunk spanning 2003 to current, while the service balance improved. In Q3 2011, the goods balance was just €1 billion, while the services balance was €15.

The trade and income balances balances generally fund the transfer outflows. However, recently the transfer balance has picked up (-€28.1 bn in the three months ending in September, which is up from -€19 or -€20 bn in the same month of 2004 and 2005). Given the dropoff in the trade and income balance, something is funding these unilateral outflows: the capital account.

(Click charts to expand)

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The Capital Account

The chart below illustrates the 3-month accumulated capital account balance as a sum of its components: net portfolio flows (Port Inv – Bal, generally financial assets), foreign direct investment (FDI, or stickier capital flows), financial derivatives, ‘other investments’, and official reserves (ECB asset accumulation).

Since the crisis started, there’s been an stark inflow of foreign money (positive green bars) into the euro area. It’s probably worth looking at this alongside the US TIC data to gauge interest in USD denominated assets for a proxy of global portfolio diversification – another post – I digress. The EA foreign direct investment is, and has generally been, negative. Foreign direct investment is long-term investment in other countries, including the retention of earnings for investment, equity investment, or long and short term loans. Most of the FDI is leaving the EA for the UK, ‘other EU countries (those not UK, Sweden, or Denmark, and “other countries” (likely EM countries in Asia and Latin America). You can see this information in section 7.3, Table 9 (pdf). Official reserve asset accumulation is generally very small – one can barely see it in this illustration - and picks up in times of stress (like in 2008).

One interesting aspect of this data has been the persistently negative flows in ‘other investments’. Section 7.3, Tables 5-6 (pdf) indicate this is driven by outflows in the banking sector (MFI’s). I’ll attend to this in another post; but there’s been a steady reduction to EA MFI’s via short-term loans.

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The important feature of recent developments in the capital account is the sharp dropoff of the portfolio balance in September, just €31.5 bn over the last three months from €104.5 bn in the three months through August. This could be a one-off event; but the reduced foreign demand for EA assets could be problematic if a trend forms.

I would say that the EA BoP is not the most stable of all international flows. It’s now heavily dependent on portfolio flows – the green bars in the chart above - given the persistently negative foreign direct investment flows. Better put: the EA current account deficit is now funding through international asset flows into debt, equity, and lending markets. Given the deterioration of the sovereign debt crisis, I wouldn’t be surprised if these flows slowed further in coming months/quarters without a broad policy response from within Europe. Given the persistence of the transfer outflows, waning foreign demand for EA assets would pressure the currency downward if trade remains sluggish.