surveillance of intra-euro-area competitiveness and imbalances

ISSN 0379-0991

Surveillance ofIntra-Euro-AreaCompetitiveness

and ImbalancesEUROPEAN ECONOMY 1|2010

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ISBN 978-92-79-14686-2

DOI 10.2765/35373

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European CommissionDirectorate-General for Economic and Financial Affairs

Surveillance of Intra-Euro-AreaCompetitiveness and Imbalances

EUROPEAN ECONOMY 1/2010

ACKNOWLEDGEMENTS

This report was prepared in the Directorate-General for Economic and Financial Affairs under thedirection of Marco Buti, Director-General, and Servaas Deroose, Director of the Directorate for theMacroeconomy of the euro area and the EU and Acting Deputy Director-General.

The main contributors were Narcissa Balta, Uwe Böwer, Reinhard Felke, Christian Gayer, MaryMcCarthy, Aurora Mordonu, Eric Ruscher, Alessandro Turrini, Guntram Wolff and Marcin Żogała.

The country chapters in Part III were prepared in the Directorates for the Economies of the MemberStates under the responsibility of Director Jürgen Kröger and Acting Director Matthias Mors. Thecontributors were Jean-Luc Annaert, Paolo Battaglia, Josef Baumgartner, Mateo Capó Servera, PedroCardoso, Ivan Ebejer, Pierre Ecochard, Polyvios Eliofotou, Carsten Eppendorfer, Renata Hruzova, JavierJareño Morago, Mitja Košmrl, Bettina Kromen, Pim Lescrauwaet, Mart Maivali, Petr Malecek, JanisMalzubris, Maarten Masselink, Marco Montanari, George Moschovis, Manuel Palazuelos Martińez,Carmine Pappalardo, Elena Pavlova, Vito Ernesto Reitano, Vladimir Solanic and Jonathan van derHeijden.

Comments and suggestions by colleagues in the Directorate-General for Economic and Financial Affairsas well as by other services of the Commission are gratefully acknowledged.

Statistical assistance was provided by Yves Bouquiaux, George-Marian Isbasoiu, Fabrizio Melcarne,Alberto Noriega Guerra, Ewa Sdrakas, Jacek Szelozynski and Christos Zavos.

Secretarial support was provided by Françoise Briard and Elzbieta Kropp.

Comments on the report would be gratefully received and should be sent by mail to the following address:

Servaas DerooseDirector –Macroeconomy of the euro area and the EU / Acting Deputy Director-GeneralDirectorate-General for Economic and Financial AffairsEconomy of the euro area and EMUEuropean CommissionB-1049 Brussels

or by e-mail to [email protected]

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CONTENTS

Executive Summary 1

Introduction 5

Part I: Horizontal analysis - Trends in competitiveness and impactof the crisis 71. Competitiveness in the euro area: pre-crisis trends (1998-2007) 82. Developments in competitiveness and external performance

during the crisis 123. Explaining recent developments: a look at the underlying drivers 184. Underlying domestic macroeconomic imbalances 235. Competitiveness adjustment within the euro area 27

Part II: Overall Assessment and Policy Implications 351. Overall competitiveness assessement 362. Policy implications 38

Part III: Competitiveness Developments In Euro-Area Countries 471. Belgium 492. Germany 543. Ireland 604. Greece 665. Spain 726. France 787. Italy 838. Cyprus 899. Luxembourg 9510. Malta 10011. Netherlands 10512. Austria 11013. Portugal 11614. Slovenia 12215. Slovakia 12716. Finland 131

Annexes 137A. Statistical Appendix 138

v

LIST OF TABLESI.2.1. Current account composition (in % of GDP) 14I.3.1. Net lending and borrowing by sector, euro-area Member States (change 2007-

09, percentage points of GDP) 20I.5.1. Selected structural indicators, euro area countries 34II.2.1. Synopsis of country-specific competitiveness developments and challenges (I) 45II.2.2. Synopsis of country-specific competitiveness developments and challenges (II) 46III.3.1. Geographical distribution of Ireland's external trade 63III.9.1. Luxembourg and neighbours: wages, productivity and unit labour costs (2001 -

2008) 97III.12.1. Austria's outward FDI position in CESEE in 2007 113III.12.2. Sector structure of Austrian outward FDI - all countries in 2007 114A.1. BELGIUM - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 138A.2. GERMANY - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 139A.3. IRELAND - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 140A.4. GREECE - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 141A.5. SPAIN - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 142A.6. FRANCE - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 143A.7. ITALY - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 144A.8. CYPRUS - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 145A.9. LUXEMBOURG - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 146A.10. MALTA - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 147A.11. NETHERLANDS - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 148A.12. AUSTRIA - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 149A.13. PORTUGAL - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 150A.14. SLOVENIA - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 151A.15. SLOVAKIA - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 152A.16. FINLAND - Indicators related to competitiveness (% of GDP unless otherwise

indicated) 153

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LIST OF GRAPHSI.1.1. Intra-area real effective exchange rate developments, based on GDP deflator,

euro-area countries (1998-2007, 1998=100) 8I.1.2. Intra-area real effective exchange rates developments, based on export prices,

euro-area countries (1998-2007, 1998=100) 9I.1.3. Export growth, euro-area countries (annual average growth rate in %, 1998-

2007) 9I.1.4. Current account position in 1998 and changes between 1998 and 2007, euro-

area countries (% of GDP) 10I.1.5. Net foreign asset position, euro-area countries (in percent of GDP) 10I.2.1. Intra-area real effective exchange rate developments, euro-area countries

(change 2007-09, in %) 12I.2.2. Exports, export markets and market shares, euro-area countries (change 2007-

2009, in %) 13I.2.3. Market share changes, euro-area countries (annual average growth rate in %) 13I.2.4. Changes in current accounts, euro-area countries (% of GDP) 14I.2.5. Change in the current account between 2007 and 2009 and its position in 2007,

euro-area countries (% of GDP) 14I.2.6. Net foreign asset positions, euro-area countries (% of GDP) 15I.3.1. Changes in domestic demand and in the trade balance, euro-area countries

(change between 2007-09) 18I.3.2. Changes in exports and in the trade balance, euro-area countries (change

between 2007-09) 18I.3.3. Share of capital and consumption goods in total exports of goods, euro-area

countries (2007, in %) 19I.3.4. Changes in ULC and its components relative to pre-crisis trends, euro-area

countries (percentage points) 20I.3.5. Shocks to GDP and employment during the crisis, euro-area countries

(percentage points) 21I.3.6. Growth in hours worked per person employed, euro-area countries (average

annual change in %, 2008-09) 21I.4.1. Real house prices, euro-area countries (annual growth in %) 23I.4.2. Credit growth, euro-area countries (change in y-o-y growth Jan. 2008-Jan. 2010) 24I.4.3. Corporate leverage, euro-area countries (2008, in %) 25I.4.4. Potential growth, euro-area countries (average annual growth in %) 25I.4.5. Changes in corporate profitability, euro-area countries (2004-07, in percentage

points) 26I.4.6. Changes in current account and unemployment, euro-area countries 26I.5.1. Asymmetries in the response of competitiveness to the business cycle, euro-area

countries 29I.5.2. Micro evidence on nominal and real wage rigidities, euro-area countries 30I.5.3. Employment growth in the non-tradable sector relative to the tradable sector,

euro-area countries (2001-07 in %) 31III.1.1. Evolution of the current account balance (% of GDP) 49III.1.2. Real effective exchange rate using different deflators (2000 = 100) 50III.1.3. Nominal unit labour costs (2000=100) 51III.1.4. Compensation/employee (2000=100) 52III.2.1. Growth of exports and REER 54III.2.2. Degree of openness (% of GDP) 54III.2.3. Direction of trade (% of total exports) 55III.2.4. Structure of trade (RCA for all exports (vs. world)) 55III.2.5. REER vs. rest of euro area 56

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III.2.6. Corporate profitability (Gross operating surplus/Gross value added (%)) 56III.2.7. Financial account (% of GDP) 57III.2.8. Net lending (+) / borrowing (-) (% of GDP) 57III.3.1. Nominal and real (based on ULC) effective exchange rates (1995=100) 61III.3.2. USD/EUR, GBP/EUR and Ireland's nominal effective exchange rate (1995=100) 64III.4.1. Current account balance (% of GDP) 69III.4.2. Net lending (+) / Net borrowing (-): Sectoral breakdown (% of GDP) 69III.5.1. REER based on ULC (total economy, 1999=100) 73III.5.2. Current account balance in Spain (% of GDP) 74III.5.3. Net lending (+) / Net borrowing (-). Sectoral breakdown (% of GDP) 75III.5.4. Net financial transactions with the rest of the world. Sectoral breakdown (% of

GDP) 75III.6.1. Openness of EU economies, 2008 (exports and imports as a % of GDP) 78III.6.2. Evolution of the current account balance and its main components 78III.6.3. REER (vs. 35 IC) based on export price deflator (2000=100) 80III.6.4. REER (vs. 35 IC) based on ULC (2000=100) 80III.7.1. Terms of trade and current account balances 83III.7.2. Export performance 84III.7.3. REER based on ULC and the gross operating surplus in the corporate sector 85III.8.1. REER - Cyprus vs. euro area,NEER - Cyprus vs. 40 industrial countries (2000=100) 90III.8.2. Wages – Productivity, Cyprus vs. euro area (2000=100) 90III.8.3. Current account balance (% of GDP) 92III.8.4. Net lending (+) /net borrowing (-) broad sectoral breakdown (% of GDP) 92III.9.1. Luxembourg's share in total euro-area exports (in %) 95III.9.2. Luxembourg: real effective exchange rate indicators (2000 = 100) (IC36) 96III.9.3. Luxembourg and euro-area yearly % increase in wages and productivity (in %) 97III.10.1. Developments in Malta's external account, 1995-2011 100III.10.2. Change in Malta's exports market share, 1995-2007 102III.11.1. Relative export performance of the Netherlands (net exports of goods and

services as a percentage of GDP) 105III.11.2. Real effective exchange rates versus IC 35 (2000=100) 106III.11.3. Relative unit labour costs and wage developments in the Netherlands 107III.12.1. Total exports by region (billion €) 110III.12.2. Total imports by region (billion €) 110III.12.3. Nominal compensation per employee in manufacturing (annual % change-

until 1995 West Germany) 112III.12.4. Current account in % of GDP 112III.12.5. Real effective exchange rates compared with rest of euro area 112III.12.6. : Real effective exchange rates compared with 35 trading partners 112III.13.1. Trade performances in Portugal, euro area and EU averages (2000=100) 116III.13.2. Export performances: goods versus services (2000=100) 117III.13.3. Real effective exchange rates vs. the euro area and IC35 (2000=100) 118III.13.4. A long-term view of Portugal's external account (% of GDP) 119III.14.1. Evolution of the current account balance (% of GDP) 122III.14.2. Real effective exchange rate (based on ULC in the total economy) 123III.14.3. Wage and productivity developments 125III.15.1. Regional composition of exports in 1997 127III.15.2. Regional composition of exports in 2008 127III.15.3. Effective exchange rates (2000=100) 128III.15.4. Current account balance (% of GDP) 128III.15.5. Monthly REER vs. IC35 (HICP,1999=100) 129III.16.1. Trade balance and current account balance (% of GDP) 131III.16.2. Change in export structure (% share of total) 132

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ix

III.16.3. Real effective exchange rates (2000 = 100) 132III.16.4. Nominal unit labour costs, industry breakdown 134

LIST OF BOXESI.2.1. The external financing of current account deficits during the financial crisis 16I.5.1. Assessing competitiveness adjustment needs on the basis of equilibrium

exchange rate estimates 28

EXECUTIVE SUMMARY

Persistent competitiveness divergences andmacroeconomic imbalances within the euro areaare a cause of concern both for individual MemberStates and for the functioning of EMU. Theyincrease the economic and financial vulnerabilityof individual Member States. Large losses incompetitiveness combined with persistentaccumulation of large current account deficitscannot be sustained forever and can be reversedonly at the cost of protracted periods of painfuladjustment. Because of trade and financialspillovers across Member States, largemacroeconomic imbalances may also hinder thefunctioning of EMU and weigh on confidence inthe euro.

The Eurogroup has discussed the issue ofcompetitiveness divergences repeatedly in recentyears and agreed in July 2008 to initiate a regularreview of competitiveness developments withinthe euro area. The present report is part of theEuropean Commission's input to the review carriedout by the Eurogroup in 2010. It provides an in-depth assessment of competitiveness and currentaccount developments in euro-area Member States.The report is composed of two parts. The first onepresents a horizontal assessment ofcompetitiveness divergences and macroeconomicimbalances, focusing on the impact of the crisis,and discusses possible policy responses. Thesecond part provides an in-depth assessment of thecompetitiveness situation in each individualMember State.

Competitiveness divergences and currentaccount imbalances increased steadily in pre-crisis years

During the ten years preceding the crisis, the euroarea experienced a steady divergence in thecompetitive position and the current accounts of itsMember States. Some Member States sawpersistent gains in price/cost competitivenessrelative to the rest of the euro area while othersregistered substantial losses. External divergencealso took the form of a steady widening ofdifferences in current account positions. SomeMember States built up significant surpluses whileothers accumulated very large deficits. In thoseMember States for which data is available, theaccumulation of large current account deficits wasassociated with a sharp deterioration of externalliabilities, with net foreign asset positions reaching

between 80 % and 100 % of GDP in 2008depending on the countries considered. Thedeterioration in external liabilities was aggravatedby persistent valuation effects. Finally, a numberof Member States showed signs of seriousstructural weaknesses in their export performancealthough their current account deficits remainedmoderate (BE, FR, IT).

The divergence trend observed in the early years ofthe euro reflects the build-up of a range ofdomestic imbalances in some Member States.Changes in competitiveness and current accountsare not necessarily bad in a monetary union. Forinstance, catching-up countries have stronginvestment requirements that call for inflows offoreign capital and therefore current accountdeficits. Nevertheless, the divergence incompetitiveness and current accounts in the euroarea over the past decade was in part fuelled byvarious domestic economic imbalances, includinginappropriate responses of wages to a slowdown inproductivity, excessive credit growth in the privatesector and housing bubbles. In current accountdeficit countries, large capital inflows led to anunsustainable accumulation of household andcorporate debt, in some countries aggravated by aninappropriate response of fiscal policy. In someMember States, the accumulation of large currentaccount surpluses reflected structural weaknessesin domestic demand.

The crisis has exacerbated the problemsposed by intra-euro-area imbalances

Competitiveness divergence within the euro areahas persisted throughout the crisis. Most indicatorsof price and cost competitiveness point to a furtherdivergence in competitiveness within the euroarea, both during the crisis and in the early stage ofthe recovery. Modest signs of convergence havecome from labour costs although this seems toreflect mostly cyclical factors. The only clearevidence of competitiveness rebalancing comesfrom Ireland which registered significant gains incompetitiveness in 2008 and 2009.

In contrast, the crisis has prompted a significantreduction in current account differences acrossMember States. Most Member States whichentered the crisis with large current accountdeficits have experienced significantimprovements in their current account positions

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European CommissionSurveillance of Intra-Euro-Area Competitiveness and Imbalances

over the past two years. Meanwhile, most MemberStates with large current account surpluses haveseen substantial falls in their balances. Largeimprovements in current account deficits were alsoregistered in Ireland and in some of the new euro-area Member States. This convergence reflects anumber of factors. Member States which enteredthe recession with large current account deficitshave experienced both a sharper drop in private-sector demand and a less dramatic fall in exportsthan the rest of the euro area. The deficit-reducingeffect of these forces has been amplified bychanges in the composition of domestic demandwith, in particular, a substitution of imports withdomestic products. Conversely, Member Stateswhich entered the recession with large currentaccount surpluses have experienced more resilientprivate-sector demand and a bigger exposure to theslump in world trade due to their exportspecialisation and greater trade openness.

The recent convergence in current accountpositions may be partly temporary and not backedby the necessary changes in relative prices. Keydrivers of the convergence, such as the collapse inglobal demand in surplus countries, thesubstitution of imports in some deficit countries,are cyclical, and the pre-crisis divergence trend islikely to partly resume once the recovery gainsstrength. In the absence of progress in recoveringcompetitiveness, the rebalancing in current accountdeficit countries will be associated with aconsiderable rise in unemployment. Indeed, for thecorrection in current account deficits to besustainable, production needs to be re-directedfrom weaker domestic demand to the export sector.This process must be underpinned by gains incompetitiveness. By the same token, surpluscountries need to address underlying structuralweaknesses in domestic demand.

Part of the correction of current accountdifferences may be of more structural nature. Thecrisis has triggered a partial unwinding of some ofthe underlying domestic imbalances such as assetand real estate booms. However, further correctionwill be necessary and new imbalances haveemerged. Some of the countries with externalimbalances or competitiveness problems haveregistered a cooling-off of the housing market andearly signs of improvements in private-sectorbalance sheets. Further unwinding of these

imbalances appears however necessary. Moreover,recent improvements in domestic imbalances havebeen associated with large rises in unemployment.Part of the rise in slack in labour markets iscyclical and will be absorbed when the economypicks up, but part of it reflects a process ofstructural downsizing in some sectors.Unemployment therefore risks becoming of a morestructural nature. In current account surpluscountries, evidence of a structural strengthening ofprivate sector demand remains elusive.

The need for a rebalancing of competitivenessacross euro-area Member States remains. Mosteuro-area Member States have a relatively lowadjustment capacity that could be further hamperedby the crisis. The correction of competitivenessand external imbalances requires significantchanges in relative prices and a reallocation ofdemand and supply between the non-tradablesector and the export sector. The economy of manyeuro-area Member States is characterised by arelatively high level of labour and product marketrigidities which, in the absence of appropriatereforms, are likely to lengthen periods ofadjustment and to make them more costly in termsof unemployment. There is a risk that the crisiscould render the necessary adjustment even morechallenging:

• In the period of very low inflation brought bythe crisis, nominal rigidities are more likely tohamper downward adjustments in relativelabour costs and prices. Nominal rigidities arehigh in most of the Member States facingcompetitiveness problems.

• Second, unless appropriate policies are put inplace, the crisis risks weighing significantly onmedium-term prospects for potential outputgrowth. Possible losses in growth potential aregenerally projected to be stronger in MemberStates with large competitiveness problems. Inthese countries, wage bargaining systems facethe double challenge of having to adjust to pastlosses in competitiveness as well as to reducedproductivity growth and deteriorated labourmarkets.

• Third, pre-crisis balance-sheet stress has beenseverely compounded by the crisis-induceddrop in asset prices and changes to risk

2

Executive Summary

attitudes. The ongoing phase of balance sheetcorrection is likely to persist for some time.Member States which face considerableadjustment needs in terms of both pricecompetitiveness and corporate balance sheetswill have to strike a delicate balance betweenraising corporate cash flow to fix balancesheets and lowering prices to restorecompetitiveness.

• Finally, the crisis has negatively affectedfinancial intermediation, thereby hampering thenecessary reallocation of capital and,consequently, labour across sectors.

Competitiveness divergences call for anambitious and comprehensive policy response

All euro area Member States are facing formidablepolicy challenges to address the economic,budgetary and financial implications of the crisisand to pave the way to sustainable growth.Mitigating the impact of the crisis on potentialoutput and employment, boosting productivitygrowth and strengthening the euro area's externalcompetitiveness position in the global economy areobjectives that are shared by all. However, asmooth adjustment of intra-euro areacompetitiveness divergences and macroeconomicimbalances is key for the recovery and, moregenerally, for the successful and sustainablefunctioning of EMU in the long term. It istherefore essential that Member States put in placean ambitious and comprehensive policy responsegeared at speeding up and improving intra-areaadjustment mechanisms.

Tackling competitiveness divergence and currentaccount imbalances will require action in a broadrange of Member States, including both those withcurrent account deficits and surpluses.Nevertheless, the policy response will have todiffer significantly across Member States, and willhave to be carefully designed to address thespecific vulnerabilities and needs of the countryconcerned. At the current juncture, givenheightened financial market discipline and themagnitude of deleveraging needed, the situationappears particularly challenging and the need forpolicy action particularly pressing in Member

States showing a combination of high public debt,large current account deficits and largecompetitiveness losses.

The policy response should be comprehensive. Itshould cover measures in four key areas: fiscalpolicies, credit markets, labour markets, andproduct and service markets. While measurestargeted at boosting labour productivity orimproving the functioning of the financial sectorwould be beneficial in all Member States, the mixof policies – including both macro- andmicroeconomic - should be targeted to the country-specific needs and challenges. In particular, largeprice and cost adjustments will be needed inMember States which have accumulated largelosses in competitiveness and large current accountdeficits in pre-crisis years. This calls for policyaction to foster gains in labour productivity andenhance wage flexibility. In most Member States,wages are formed in a collective bargainingprocess without formal involvement ofgovernments. Nevertheless, policy-makers canaffect wage setting processes via a number ofways, including the provision of information orwage rules, changes to wage-indexation rules andthe signalling role played by public sector wages.In addition, reforms of labour markets should alsocontribute to make wage setting processes moreefficient. Finally, also non-price competitivenessfactors, such as technology-intensity, quality ofservices and the dynamics of export destinations,have a role to play in adjustment processes in thesecountries. In Member States which accumulatedlarge current account surpluses in pre-crisis years,there is a need to identify and tackle the sources ofpersistent weakness in some parts of private sectordemand, including the possible role of a lack ofcompetition in the service sector, of the tax systemand credit constraints.

Co-ordinated efforts involving both countries withcurrent account deficits and surpluses wouldfacilitate competitiveness adjustment. While theadjustment effort remains the responsibility ofeach individual Member State, coordinated effortsto rebalance demand and competitiveness couldproduce a smoother adjustment path with smalleradjustment costs for the euro area as a whole.Coordination would, however, not mean anidentical policy response in all Member States. Itcould take various forms, including agreement on a

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common diagnosis and on the nature of the policyresponse needed, regular exchanges of informationabout policy measures with competitivenessimplications for the euro area, etc.. The Eurogroupcan play a key role in the coordination process byidentifying adjustment needs and fostering acommon diagnosis.

The policy response should be seen in the contextof the design of exit strategies. Some measurestaken in the context of the European EconomicRecovery Plan, such as the use of temporarysubsidies for employment, may hindercompetitiveness adjustment processes, e.g. bypreventing the necessary reallocation of labour. Itis therefore important that these measures do notbecome entrenched. More generally, thecomprehensive and coordinated exit strategies ineuro-area Member States need to take into accounttheir impact on relative competitiveness andcurrent account imbalances. In particular, fiscalconsolidation requirements must give due weightto the impact of competitiveness adjustment onrevenues and debt while the role of fiscal policy inspeeding up competitiveness adjustment should betaken into account when designing exit strategies.In line with recent EDP decisions, there is someroom for gradualism in surplus countries but swiftand determined consolidation is imperative torestore market confidence in deficit countries. Onthe supply side, measures taken in the context ofexit strategies should contribute to rebalancingcompetitiveness within the euro area and tofacilitating necessary labour and capitalreallocation.

Looking further ahead, i.e. beyond pressingcompetitiveness adjustment needs, it is alsoimportant to reflect on possible avenues forimproving the surveillance of external anddomestic imbalances. The crisis has clearlydemonstrated the need for closer policycoordination and deeper and broader policysurveillance to facilitate such coordination. Therecent experiences validate the analysis made inthe Commission's 2008 EMU@10 Report. Thereport made the case for deeper and broadermacroeconomic surveillance in the euro area toaddress emerging macroeconomic imbalances atan early stage. It is now time to move to action andharness the framework of economic coordinationand surveillance in the euro area in order toprevent future imbalances or detect and tacklethem early on. In particular, given the critical roleplayed by credit cycles in the emergence of largecurrent account deficits in some parts of the euroarea, a key medium-term policy challenge is toprevent the emergence of imbalances on credit andasset markets. It is necessary to devise and put inplace mechanisms that would limit the occurrenceof credit and asset price excesses but also devisespecific instruments to cool-off credit and assetmarkets if necessary. The issue is critical in EMUwhere regional/national credit cycles cannot beaddressed by monetary policy. Given theimportance of credit developments for macro-prudential supervision, these considerations alsoraise the question of the link betweencompetitiveness surveillance and the riskassessment to be carried out by the EuropeanSystemic Risk Board.

INTRODUCTION

The first decade of EMU has witnessed steadycompetitiveness divergence between euro-areaMember States together with the emergence oflarge differences in current account positions. Insome Member States, the counterpart to risingexternal imbalances has been the build-up of arange of domestic imbalances, including housingbubbles, overstretched balance sheets and surgingexternal liabilities. In other Member States, thiscounterpart has taken the form of persistentweakness in private sector demand. Persistentcompetitiveness divergences and macroeconomicimbalances are a cause of concern for the euro areaas a whole. They increase the economic andfinancial vulnerability of individual Member Statesand pave the way for protracted periods of painfuladjustment. Because of large trade and financialspillovers across Member States, largemacroeconomic imbalances may also hinder thefunctioning of EMU and weigh on confidence inthe euro.

These problems have been acknowledged for sometime now. In its Communication on "EMU@10:successes and challenges after 10 years ofEconomic and Monetary Union" the Commissionproposed a broad policy agenda aimed atimproving the functioning of EMU. It stressed inparticular the need to broaden economicsurveillance in order to detect and addressmacroeconomic imbalances at an early stage.Enhanced surveillance efforts were seen asparticularly warranted in the area of externalcompetitiveness and current accounts wherenoticeable divergences between Member Stateshad emerged since the launch of the euro.

In order to address these challenges, the Eurogroupagreed in July 2008 to initiate a regular review ofcompetitiveness developments within the euroarea. The present report is part of the EuropeanCommission's input to the review carried out bythe Eurogroup in 2010. It assesses the externalperformance of euro-area Member States since thelaunch of the euro, focusing in particular on theimpact of the global financial and economic crisis.It also discusses possible policy responses. Thecompetitiveness assessment is broad-based,drawing on the examination of a wide range ofindicators comprising price- as well as non-pricecompetitiveness, current accounts, external assetpositions, export market shares etc. It also includesa review of the domestic imbalances that underlie

changes in competitive positions. The report iscomposed of three parts:

Part I presents a horizontal perspective with across-country review of developments in price andcost competitiveness and external performance. Itfocuses on recent developments and the impact ofthe crisis, setting them against the more medium-term trends observed since the launch of the euro.It also analyses changes in the drivers ofcompetitiveness and external performance and inthe underlying domestic imbalances. A section isdevoted to the implications of the crisis for thecompetitiveness adjustment channel in the euroarea.

Part II, provides an overall assessment ofcompetitiveness developments in the euro area anddiscusses policy implications. It proposes a set ofpolicy measures at the macro- and microeconomiclevel to improve competitiveness adjustmentwithin the euro area.

Part III presents country-specific fiches oncompetitiveness developments in the 16 individualeuro-area Member States. The country specificanalysis underpins the overall competitivenessassessment and policy analysis presented in thereport by an extensive and detailed expertise of theeconomies and institutions of the countriesconcerned.

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Part IHorizontal analysis - Trends in competitivenessand impact of the crisis

Part I of the report provides a horizontal analysis of the impact of the financial and economic crisis onexternal imbalances within the euro area. It is structured as follows. Section 1 sets the stage by recallingthe developments in competitiveness and current accounts within the euro area since the introduction ofthe euro. Section 2 surveys the impact of the financial crisis on competitiveness and current accounts inthe euro area. Section 3 discusses the main drivers of the recent developments and the extent to whichthey may be considered as a temporary or persistent legacy of the crisis. Differences in Member States'external performance can in part be related to a range of domestic imbalances that call for policy action.Section 4 therefore reviews progress made with this these underlying domestic imbalances. Finally,Section 5 discusses the implications of the financial crisis for the functioning of the competitivenessadjustment mechanism.

1. COMPETITIVENESS IN THE EURO AREA: PRE-CRISISTRENDS (1998-2007)

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In the decade preceding the global economic crisis,the euro area experienced significant and persistentdivergence in its Member States' competitivenessas measured by real effective exchange rates(REER). Some Member States saw significant fallsin their REER, while others registered sharp rises(Graph I.1.1). Most of the countries that haveintroduced the euro in the last few years alsoexperienced periods of sustained appreciation, butmost of it preceded euro adoption and wasconsistent with underlying fundamentals.

Graph I.1.1: Intra-area real effective exchange ratedevelopments, based on GDP deflator,euro-area countries (1998-2007, 1998=100)

Initial euro-area countries

80

90

100

110

120

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

IE

ES

IT

DE

AT

FIFR

ELNL

BLEU

PT

New euro-area Member States

90

100

110

120

40

70

100

130

160

190

SK

801998 1999 2000 2001 2002 2003 2004 2005 2006 2007

10

(rhs)

SI (lhs)CY (lhs)

MT(lhs)

Source: Commission services.

Although the precise country ordering depends onthe specific measure used, the broad pattern ofdivergence is visible irrespective of price deflator(i.e. GDP deflator, unit labour costs or exportprices) or reference group (i.e. intra-euro area ortotal REER).

However, narrow measures of REER (i.e.restricted to the specific segments of theeconomy), such as export price-based REER, may

in some cases show a different picture thanmeasures covering the entire economy(Graph I.1.2). These differences can in general berelated to differences in price behaviour betweenthe tradable and the non-tradable sectors.

An important feature of these REER developmentsis their persistence over time. While episodes ofstrong divergence in REER were also observed inperiods prior to the launch of the euro, particularlyin the 1970s and 1980s, the divergence wasgenerally reversed rapidly by nominal exchangerate re-alignments.

The pre-crisis divergence in price and costcompetitiveness across Member States can beascribed to a range of factors, some of which arelinked to the healthy functioning of EMU. Tosome extent, changes in relative prices reflected aprocess of cross-border convergence in the pricelevel of tradable goods fostered by the SingleMarket and the enhanced price-transparencybrought by the euro. In a few Member States, theBalassa-Samuleson effect also played a role.(1)The observed divergence in competitivenessdevelopments was, in part, a natural response tocyclical divergence as Member States in acomparatively strong cyclical position experienceda real appreciation.

Nevertheless, divergence in price competitivenessalso has much less benign causes. Cyclicaldifferences are relatively small in the euro area andcannot explain the persistence of thecompetitiveness divergence over a period of10 years. Indeed, divergence in pricecompetitiveness was also partly driven by aninappropriate response of wages to country-specific shocks in some Member States (IE, EL,ES, IT, PT). A few of them (ES, IT) experienceddifficulties in adjusting to deterioratingproductivity performance in the manufacturingsector. Others (IE, EL) suffered from excessive

(1) The Balassa-Samuelson effect states that, under someconditions, a country that experiences faster gains in theproductivity of the tradable sector relative to the non-tradable sector than the rest of the world will alsoexperience higher inflation (i.e. a real appreciation). Theeffect is frequently used to explain why catching-upeconomies tend to experience a lower price level than moreadvanced economies and an appreciating real exchangerate.

Part IHorizontal analysis - Trends in competitiveness and impact of the crisis

wage pressures in the service sector, with publicwages acting sometimes as a key driver (PT).

Graph I.1.2: Intra-area real effective exchange ratesdevelopments, based on export prices,euro-area countries (1998-2007, 1998=100)

Initial euro-area countries

80

90

100

110

120

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

IE

ES

IT

PT

DE

AT

FI

FR

EL

NL

BLEU

New euro-area Member States

80

90

100

110

120

130

1998 1999 2000 2001 2002 2003 2004 2005 2006 200740

70

100

130

160

190

SK (rhs)

SI (lhs)

CY (lhs)

MT(lhs)


Divergence in price and cost competitiveness inthe euro area went hand in hand with a divergentexport performance. Some Member Statesbenefited from a surge in exports of goods andservices, with annual growth averaging 7-8% ormore during 1999-2007 (DE, IE, LU, SI, SK)(Graph I.1.3). In contrast, other Member Statesposted a rather dismal export performance, withaverage annual growth in the 2-4% range (BE, FR,IT, CY, MT, PT). To some degree, this disparityreflects differences in geographical specialisation,with some Member States being better positionedin fast growing export destinations such as EastAsia or Eastern Europe. However, geographicalspecialisation can explain only a limited part of theexport differences and the heterogeneity is mostlyattributable to differences in market sharedevelopments. Some countries lost considerablemarket shares and posted sluggish export growthover 1999-2007 (BE, FR, IT, MT, PT) while others

were much more successful on both counts (DE,IE, SI, SK).

Graph I.1.3: Export growth, euro-area countries (annualaverage growth rate in %, 1998-2007) (1)

0

2

4

6

8

10

12

14

BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FI

(1) Export of goods and services, volumes, NationalAccounts.Source: Commission services.

Non-price competition also contributed to thedifferences in Member States' export performance.Changes in Member States' competitive positionsare not always fully captured by measures of priceor cost indicators. The differences in exportperformance of some Member States over thedecade preceding the crisis are in fact difficult toexplain solely on the basis of measurable price andcost considerations (2). Non-price competitivenessis difficult to assess as it depends on a range offactors such as product quality or technologicalcontent, after-sale services or distribution servicesand cannot be captured in a single indicator.However, structural factors such as sectoral ortechnological specialisation played a role in theobserved divergence of Member States' exportdynamics.

The diverging trend in competitiveness and exportperformance were associated with a steadywidening of the differences in Member States'current account positions. Since the introduction ofthe euro, current account differences in the euroarea have been on a clear widening trend and thedivergence reached an all-time high in 2007. To alarge extent, the current account positions reachedin 2007 were built after the launch of the euro

(2) See 'Differences in Member States’ export performance' inEuropean Commission (2010), 'The impact of the globalcrisis on competitiveness and current account divergencesin the euro area', Quarterly Report on the Euro Area No.1.

9


(Graph I.1.4), although some countries enteredStage III of EMU with an already sizeable deficit(especially PT). Most of the fluctuations andcountry differences in current accounts boil downto developments in the balance of goods andservices, which is usually the largest component ofthe current account.

Graph I.1.4: Current account position in 1998 and changesbetween 1998 and 2007, euro-area countries(% of GDP) (1)

-15

-10

-5

0

5

10

15


Position in 1998Change 1998-2007

(1) Net lending (+) or net borrowing (-), total economy; forLU balance on current transactions.Source: Commission services.

Member States which accumulated large currentaccount deficits also saw a sharp deterioration oftheir external liabilities with net foreign assetpositions reaching 80-100% of GDP (seeGraph I.1.5). Moreover, the deterioration of theirnet asset positions was larger than warranted bytheir cumulated current account deficits. This wasdue to negative valuation effects. Valuationseffects on external assets and liabilities are thecapital gains/losses on these asset and liabilitiesthat are due to fluctuations in asset prices andexchange rates. Financial globalisation has led to asharp increase in gross cross-border holdings offoreign assets and liabilities that paves the way forincreasingly large valuation effects. Such valuationeffects can play an important role as they affect thelevel of the trade balance needed to keep the NFAposition stable. (3)

(3) For an analysis of valuation effects in the euro area see'The importance of valuation effects for external assetpositions in the euro area' in European Commission (2010),'The impact of the global crisis on competitiveness andcurrent account divergences in the euro area', QuarterlyReport on the Euro Area No.1.

Between the launch of the euro and the onset of thecrisis, current account deficit countriesexperienced steady negative valuation effectswhich added significantly to the deterioration oftheir net external asset position. These effects weremostly due to the fact that price gains on equityliabilities (i.e. equity held by foreigners) exceededprice gains on external equity assets.

Graph I.1.5: Net foreign asset position, euro-area countries(in percent of GDP) (1)

-120

-100

-80

-60

-40

-20

0

20

40

60

BE DE IE EL ES FR IT NL AT PT SI SK FI

19982007

(1) Fore Ireland and Slovenia data for 2001 instead of 1998.Source: Commission services.

A large part of the cross-country divergence in thecurrent account since the late 1990s is rooted indomestic demand factors. There have beenconsiderable and persistent differences in thestrength of domestic demand across MemberStates since the launch of the euro. Strongerrelative demand pressures in a given Member Statetend to fuel import demand and depress the currentaccount. Differences in domestic demand pressuresacross Member States were related to 'traditional'medium-term determinants of the current accountsuch as fiscal policy and demographic factors, aswell as to reductions in risk premiums and easieraccess to international financing, especially incatching-up economies. Differences in exportperformance – and therefore price competitiveness– also contributed to the divergence of currentaccounts but, in most Member States, this was ofsecond order compared with domestic demandfactors.

Losses in competitiveness and the build-up oflarge current account deficits in some Member

10


11

States can be related to a range of underlyingdomestic macroeconomic imbalances. As alreadyhighlighted, labour markets did not always respondappropriately to country-specific shocks.Productivity performance was also disappointingin some indebted and converging economies.Although these catching-up Member Statesbenefited from large capital inflows, foreigncapital was often channelled to the mostproductive uses. More specifically, in someMember States the inflow of capital facilitated therise in household and corporate debt. It fuelledexcessive credit dynamics and contributed to theemergence of housing bubbles. Moreover, as acounterpart to the increasing debt, net foreign assetposition deteriorated significantly, increasingexposure to global financial shocks.

Underlying domestic imbalances were notrestricted to large current account deficit countries.Surplus countries such as Germany, theNetherlands and Austria experienced a significantincrease in their current account after thebeginning of the decade which reflects persistentweakness in private sector demand. (4) Theweakness can primarily be traced back to thecorporate sector although households also played arole in Germany. In the three countries, companiesraised gross savings and reduced physicalinvestment to acquire financial assets and reducedebt. Further work is needed to understand thedrivers of this persistent balance sheet adjustmentbut, in some cases, policies may have encouragedthe self-financing of corporations and has putretained profits at a tax advantage.(5)

(4) For a more detailed analysis of current account surpluses inthe euro area see ' Anatomy of current account surpluses inthe euro area ' in European Commission (2010), 'Theimpact of the global crisis on competitiveness and currentaccount divergences in the euro area', Quarterly Report onthe Euro Area No.1.

(5) See Bundesbank (2000), Monthly bulletin, August (p.61).

2. DEVELOPMENTS IN COMPETITIVENESS AND EXTERNALPERFORMANCE DURING THE CRISIS

12

Since the outbreak of the financial crisis in 2007the divergence in price-based measures ofcompetitiveness has continued in the euro area.Except for Ireland, the intra-euro-area REER basedon GDP deflators does not show any clear sign ofconvergence in price competitiveness in 2008 and2009 (Graph I.2.1).(6) Most of the Member Statesregistered very small changes in this measure ofcompetitiveness, usually not exceeding 2% overthe last two years, although Ireland, with adepreciation of almost 7% stands out. (7) TheREER deflated with export prices shows morevariations among countries but again without anyclear rebalancing of pre-crisis competitivepositions (Graph I.2.1). There is even somepositive correlation between the developmentsduring 1999-2007 and during 2008-2009, implyingthat the competitiveness divergence based on thismeasure rose further during the crisis.

Only measures of the REER based on unit labourcosts (ULC) show some modest movementtowards reducing the previously accumulateddivergence. Among current account deficitcountries, Spain and, to a lesser extent, Greecerecorded a depreciation of the intra-euro-areaREER based on ULC over 2008-09, but themagnitude of depreciation was rather limited. Incontrast, Portugal resumed real appreciation after afew years of moderation (Graph I.2.1). At the sametime, most of the surplus countries (NL, AT, FI)experienced real appreciation, with Germany’sREER being broadly stable. Among the rest of thecountries, developments were ratherheterogeneous. Slovenia and Slovakia recordedlarge appreciations (though mostly before euroentry in the case of Slovakia) and Italy andBelgium moderate ones. Cyprus, Malta, Irelandand France saw improvements in their costcompetitiveness. Overall, these differences inULC-based REER developments suggest thatsome moderate competitiveness adjustment tookplace through unit labour cost via the labour

(6) Data shown in this report is based on the Commission'sAMECO database (storage of early March 2010).

(7) Slovakia has recorded large real appreciation during since2007. However, it should be borne in mind that Slovakiaintroduced the euro only at the beginning of 2009 and mostof the real appreciation comes from the nominalappreciation experienced before the introduction of theeuro.

market. The absence of clear signs of convergencewith the price-based measures of the REERindicates, however, that the convergence effect ofdevelopments in ULC was largely offset byopposite movements in profit margins.

Graph I.2.1: Intra-area real effective exchange ratedevelopments, euro-area countries(change 2007-09, in %) (1)

REER based on GDP deflator

-8

-6

-4

-2

0

2

4

6

8

BE DE IE EL ES FR IT CY MT NL AT PT SI SK FI

REER based on export price deflator

-8

-6

-4

-2

0

2

4

6

8


REER based on ULC deflator

-8

-6

-4

-2

0

2

4

6

8


(1) Percent change between annual average in 2007 andin 2009. Data for 2009 based on Commission AutumnEconomic Forecast. SK is off scale, the value is 10.3% (GDPdeflator), 9.1 % (export price deflator) and 14.3% (ULCdeflator). Data for Belgium include Luxembourg.Source: Commission services.


Over the 2008-09 period exports fell in all MemberStates due to the collapse in world trade, but thesize of the fall differed significantly betweencountries. On the one hand, Italy’s export volumesof goods and services contracted by almost 12%and Finland’s by more than 10% on average peryear during those two years. On the other hand,exports of Ireland, the Netherlands and Greece fellby a more moderate average of 2-4%. At the sametime, growth rates in country-specific foreigndemand (i.e. the foreign demand addressed to eachindividual Member State and which depends onthe geographical structure of its exports) did notdiffer so much across Member States, implyingthat the differences in exports were mainly due tolarge differences in market share developments(Graph I.2.2).

Graph I.2.2: Exports, export markets and market shares,euro-area countries (change 2007-2009,in %) (1)

-12

-10

-8

-6

-4

-2

0

2

4

6


ExportsExport marketsMarket shares

(1) Exports: exports of goods and services, NationalAccounts (average annual growth). Export markets: exportweighted imports of goods and services at constant pricesfor 35 industrial markets (average annual growth). Marketshares: ratio of exports to export markets (% change).Source: Commission services.

The differences in market share developmentscannot easily be related to recent pricecompetitiveness developments. This suggests thatfactors other than price competitiveness must haveshaped export developments over the recent period(these factors will be discussed in the nextsection). Although the export performances over2008-09 differed considerably among MemberStates, there is some indication that countries withlarge current account deficits (EL, ES, PT) andcountries without large deficits but a weak export

performance prior to the crisis (BE, IE, FR, IT)fared somewhat better than the large surpluscountries (DE, LU, NL, AT, FI) and the new euro-area Member States (CY, MT, SI, SK), especiallywhen compared with past trends (Graph I.2.3).While current account deficit countries were onaverage loosing market shares before the crisis,they have generally posted some gains since 2007.The opposite holds broadly for the surpluscountries and the new Member States.Developments in the other countries were ratherheterogeneous with France and Belgium showing areversal of pre-crisis trends.

Graph I.2.3: Market share changes, euro-area countries(annual average growth rate in %) (1)

-8

-6

-4

-2

0

2

4

6


1999-20072008-2009


The crisis has triggered a significant narrowing ofcurrent account differences within the euro area.The reversal of the previous divergence trend incurrent accounts can be traced back to both surplusand deficit countries (Graph I.2.4). Most countrieswith large current account surpluses (DE, NL, FI)saw significant falls in their external balances over2008-09 with smaller changes in Luxembourg andAustria. (8) With the exception of Portugal,countries with large deficits experienced largeimprovements in their current account positions.Improvements, sometimes large (MT, SI), werealso registered in the deficits of the new MemberStates. Finally, in the rest of the countries (BE, IE,FR, IT) current accounts deteriorated somewhat,except Ireland, which registered an improvement.

(8) This data is based on the March 2010 storage of theAMECO database. More recent data suggest that thecurrent account deficit in Greece may have improved onlymarginally during the crisis.

13


Table I.2.1: Current account composition (in % of GDP) (1)

Ch. Ch. Ch. Ch. Ch. C2007-09 2007-09 2007-09 2007-09 2007-09 2007-09

BE 2.8 -1.1 0.7 -0.3 -1.4 -0.3 2.0 -1.7 -0.2 0.2 1.9 -1.5DE 4.6 -2.5 1.8 -0.2 -1.4 -0.2 5.0 -2.9 0.0 0.0 5.0 -3.0IE 15.8 5.6 -17.6 -3.2 -1.3 -0.1 -3.1 2.2 0.0 0.0 -3.1 2.2EL -4.8 6.2 -3.7 -0.8 -0.2 0.5 -8.8 5.9 1.3 -1.0 -7.5 5.0ES -2.1 4.7 -1.9 0.4 -1.2 -0.3 -5.1 4.9 0.4 -0.1 -4.7 4.8FR -1.2 0.7 0.7 -0.4 -1.7 -0.3 -2.3 0.0 0.0 -0.1 -2.3 -0.1IT -0.4 -0.2 -1.7 -1.1 -1.0 -0.1 -3.2 -1.4 0.0 -0.1 -3.1 -1.5CY -6.4 -0.1 -5.7 0.1 0.4 0.1 -11.6 0.1 0.2 0.1 -11.5 0.3LU 31.1 -2.3 -20.6 0.2 -1.2 1.8 9.4 -0.3 N/A N/A N/A N/AMT 2.6 4.5 -6.2 -2.7 1.1 2.6 -2.5 4.5 0.8 -0.1 -1.7 4.3NL 7.2 -1.5 -2.8 -4.2 -1.7 -0.2 2.7 -5.9 -0.5 -0.1 2.3 -6.0AT 4.2 -1.7 -1.1 1.0 -0.7 -0.2 2.5 -0.9 0.0 0.0 2.5 -0.9PT -7.6 -0.1 -4.1 -0.4 1.1 -0.4 -10.6 -0.8 1.2 -0.2 -9.4 -1.0SI 1.5 3.2 -1.5 0.6 -0.6 0.2 -0.5 4.0 0.0 0.1 -0.5 4.2SK -0.2 0.8 -1.2 1.4 -1.7 -0.3 -3.1 2.0 0.7 0.3 -2.4 2.3FI 2.8 -2.4 -0.1 -0.1 -1.2 -0.2 1.5 -2.8 -0.5 -0.2 1.0 -3.0

Balance of goods &services

Net primary income Net current transfers Current transactions Capital transactions Net borrowing

(1) (2) (3) (1)+(2)+(3)=(4) (5) (4)+(5)=(6)

2009 20092009 2009 2009 2009 h.

(1) Net lending/borrowing composition, which consists of the current account and capital transactions.Source: Commission services.

As a result of these changes, there is a clearnegative correlation between the current accountposition recorded in 2007 and developments in2008-09 (Graph I.2.5).

Graph I.2.4: Changes in current accounts, euro-areacountries (% of GDP) (1)

-15

-10

-5

0

5

10


1998-072007-09


The trade balance was the main driver of thechanges in the current account in 2008-09 (seeTable I.2.1). However, other components of thecurrent account also played a role in some MemberStates. Especially, in the Netherlands the largedeterioration of the primary income balance wasthe main component of the drop in the currentaccount since 2007. The deterioration stemsmainly from a fall in dividends payments onforeign investment, caused by the global crisis.

Graph I.2.5: Change in the current account between 2007and 2009 and its position in 2007, euro-areacountries (% of GDP) (1)

FI

SK

SI

PT AT

NL

MT

LU

CY

ITFR

ESEL

IE

DE

BE

R2 = 0.55

-8

-6

-4

-2

0

2

4

6

-15 -10 -5 0 5 10 15Current account position in 2007

Curre

ntac

coun

tcha

nge2

007-2

009


An important metric against which to assess thesustainability of current account deficits is theoverall net foreign asset position. Despite thereduction in the level of current account deficits,large deficit countries have so far continued toexperience a deterioration of their Net ForeignAsset position (NFA) (Graph I.2.6). In 2008, withthe exception of Greece, Member States with largenet external liabilities registered a furtherdeterioration of their NFA position as a share ofGDP. NFA position in deficit countries is expectedto deteriorate further in the years to come ascurrent account deficits continue to beaccumulated, although on a smaller scale thanbefore the crisis. The forecast sharp slowdown in

14


GDP in deficit countries will be an aggravatingfactor, which will more than offset the effects ofsmaller current account deficits on the ratio ofNFA to GDP.

Graph I.2.6: Net foreign asset positions, euro-areacountries (% of GDP)

-120

-100

-80

-60

-40

-20

0

20

40

60

BE DE IE EL ES FR IT NL AT PT SI SK FI

20072008


In current account surplus countries, the crisis hastriggered some negative valuation effects onexternal asset and liability positions reducing NFApositions by about 5 percentage points of GDP in2008 (last available data). These valuation effectscan in part be related to adjustments in the pricingof risk on bonds as well as losses due to the sub-prime crisis. Further negative valuation effects in2009 are not unlikely. Valuation effects have alsotriggered very large changes in NFA positions insome Member States that are acting as financialintermediation centres and/or serve as aninvestment base for multinational companies (e.g.BE, IE). These countries have accumulated largegross positions which may lead to large swings inNFA positions at times of crisis. In 2008, negativevaluation effects reduced the NFA position ofIreland by about 30 percentage points of GDP(which represents 6 times the current accountdeficit of that year).(9) Finally, the crisis appearsso far (again on the basis of 2008 data) to havepartly reversed the pre-crisis trend of negativevaluation effects in large current account deficitcountries. This is quite clear for Greece where

Portugal.( )

ncing of current account deficits inthe euro area.

(9) The negative valuations effects in Ireland mostly comefrom the country's net foreign asset position in securitiesother than sharesdue to Ireland's large net (positive)holdings of securities other than shares abroad, the globalfall in the price of these securities since then beginning ofthe cris has translated into large negative valuation effectsin this country.

positive valuation effects improved the ratio ofNFA to GDP by more than 20 percentage points in2008. These valuation effects, that are mostlyrelated to fluctuations in equity prices, were alsopositive although much smaller in Spain and

10

Looking at the financial side of the balance ofpayment, the analysis of capital flows indicatesthat the financial crisis has accentuated a trendtowards short-term financing of current accountdeficits within the euro area. Available, althoughpatchy, data suggest that large current accountdeficits within the euro area are primarily financedby funds from other euro-area Member States(see Box I.2.1). If anything, the financial crisisseems to have accentuated this pattern despite thefact that it has brought a sharp drop in cross-borderflows within as well as outside the euro area.Nevertheless the crisis also seems to haveaccelerated a trend towards a shortening of thematurity structure of capital inflows with a rise incentral bank funding and short-term bank funding.This raises sustainability issues concerning thepost-crisis fina

Overall, this short review of recent developmentsin Member States external performance suggestthat the economic and financial crisis has led to areduction in the current account differences in theeuro area, but has led to only modest convergencein price/cost competitiveness. In spite of smallercurrent account divergences, negative NFApositions have continued to build up in deficitcountries. Also the trend towards short-termfinancing of the deficit has further strengthenedduring the crisis. The impact of the crisis onMember States' export performance has been quiteheterogeneous, particularly in terms of exportmarket shares, but these differences cannot berelated to competitiveness developments. To someextent, Member States which posted robust exportgrowth prior to the crisis have been hit more

(10) In EL, ES and PT, domestic equity prices rose faster thanin the rest of the world during the years preceding thecrisis. As a result, foreign equity holdings in thesecountries benefited from bigger equity price gains thanthese countries' equity holdings abroad, generating negativevaluation effects on the net foreign asset position. As thesame factor has played in reverse since the beginning of thecrisis, past valuation losses have been partly reversed.

15


severely by the slump in world trade than thosewhich showed a weaker performance in the past.

16


Box I.2.1: The external financing of current account deficits during the financial crisis

The financing of current account deficits seems to have remained mainly intra euro area during thefinancial crisis. A geographical coverage of cross-border financial flows is not systematically available foreuro-area Member States, neither in the financial account statistics nor in the balance of payments statistics.However, two different statistical sources indicate that the cross-border flows of current account deficitcountries are mainly of an intra euro-area nature. Firstly, IMF data on financial stocks, available in terms ofportfolio investment for a larger number of countries, show that prior to 2008 between 70% and 80% ofportfolio investment in Spain, Portugal, Greece and over 50% in Ireland came from euro-area countries. (1)Secondly, the Bundesbank's balance of payments data on financial flows show that Germany has been a netsupplier of funds to the euro area and a net receiver of flows from outside the euro area in recent years. (2)From 2008Q3 to 2009Q2, German net outflows to the euro area increased slightly, while non euro-area netinflows to Germany increased substantially. All things considered, it is likely that euro-area current accountdeficit countries have been important beneficiaries of German capital outflows before and during thefinancial crisis.

Net financial flows – Germanys % of GDP 1

Net other investment flows in the banking sector% of GDP 1

-25

-20

-15

-10

-5

0

5

10

15

20

25

2006Q3-2007Q2 2007Q3-2008Q2 2008Q3-2009Q2

Euro areaNon euro area

-15

-10

-5

0

5

10

Mone

tary

autho

rities

Othe

rMFI

longt

ermOt

herM

FIsh

ortter

mPo

rtfoli

oinv

estm

ent

Mone

tary

autho

rities

Othe

rMFI

longt

ermOt

herM

FIsh

ortter

mPo

rtfoli

oinv

estm

ent

Mone

tary

autho

rities

Othe

rMFI

longt

ermOt

herM

FIsh

ortter

m

Portugal Spain Germany

2006Q3-2007Q22007Q3-2008Q22008Q3-2009Q2

(1) Positive number indicates net inflows, and a negativeone indicates net outflows.Source: Deutsche Bundesbank.

(1) For PT and ES, short and long-term other investmentsfor other MFIs include deposits, loans and other. For DE,they only include loans. Positive number indicates netinflows, and a negative one indicates net outflows.Source: Bank of Portugal, Bank of Spain andDeutsche Bundesbank.

The crisis has marked a generalised plunge in cross-border flows. After a period of growing financialintegration characterised by buoyant cross-border flows with the rest of the world, a reduction in theintensity of cross-border flows became visible already in the second half of 2007 in Spain, Portugal andIreland. In Ireland, the total of external assets and liabilities flows plunged from 337% of GDP in 2007 to173% of GDP in 2008. The reduction in the total of external assets and liabilities flows for both Spain andPortugal was of the order of 20 pp of GDP between 2007 and 2008, from about 37% of GDP in 2007.Consistent with these developments, German total financial inflows and outflows dropped from 45% ofGDP in 2007 to 12% of GDP in 2008.

Monetary authorities have enhanced net borrowing from abroad in order to deal with liquidityshortages and other Monetary and Financial Institutions (MFIs) have accelerated short-term

(1) Data on cross-border portfolio holdings are available from the IMF Coordinated Portfolio Investment Survey (CPIS).While the CPIS offers a geographical decomposition of investment in assets across 218 destinations, it suffers fromthe caveats that some countries might be under reporting and that the data are available only with a two year time lag:accordingly, the latest data available are from 2007.

(2) A more detailed geographical decomposition of net foreign investment flows from Germany to euro-area individualMember States gives a distorted picture, given that bilateral flows from one country to another often transit via thirdcountries

(Continued on the next page)

17


18

Box (continued)

borrowing from the rest of the world. In the fourintensify borrowing from abroad in order to overcomethe same time, other credit institutions have raised thelong-term funding. Also other MFIs' net inflows of poonset of the crisis. This indicates cre

surveyed countries, monetary authorities have had tol

ir

dit institutions' difoutside the domestic market as well as an increase in

y mar

iquidity shortages in the domestic money market. Atshort-term borrowing from abroad at the expense of

rtfolio investment have fallen dramatically since theficulties in raising funds through securities issuancethe collateral requirement which credit institutions

ket.have to supply in order to get finance on the mone

3. EXPLAINING RECENT DEVELOPMENTS: A LOOK AT THE

19

UNDERLYING DRIVERS

Developments in current account positions sincethe beginning of the financial crisis can be tracedback to a range of factors related to domesticdemand and export performance.

Graph I.3.1: Changes in domestic demand and in thetrade balance, euro-area countries(change between 2007-09)

FI

SK

SI

PT

ATNL

MT

LU

CY IT

FR

ES

ELIE

DE

BE

R2 = 0.31

-3

-2

-1

0

1

2

3

4

5

6

7

-20 -15 -10 -5 0

Ch. in domestic demand growth (in pp)

Ch.in

thetra

deba

lance

(in%

ofGD

P)


There is a relatively close cross-country correlationbetween changes in the trade balance and changesin domestic demand between 2007 and 2009(Graph I.3.1). Member States which saw animprovement in the trade balance also experienceda stronger contraction of domestic demand than therest of the euro area and vice versa. The negativerelation suggests that a large part of the recentchanges in current accounts has been driven bychanges in domestic demand via the importchannel.

To a lesser degree, recent developments inMember States' trade balances reflect alsodifferences in the exposure to the slump in worldtrade (Graph I.3.2). Changes in the trade balancesare positively correlated with the changes in thecontribution of exports to GDP growth during thecrisis. The latter can be interpreted as a measure ofthe size of the trade shock experienced during the

in their current account positions. The correlationis however considerably smaller than for domesticdemand, indicating that country differences inexposure to the trade slump have played a lessimportant role that country differences in domesticdemand.

Graph I.3.2: Changes in exports and in the trade balance,

crisis. A higher contribution indicates lower

elow some

the

exposure to the slump in world trade (eitherb cause of a lower drop in exports or because of

er trade openness). This suggests that, toextent, Member States with a lower exposure to

trade slump in 2008-09 also saw a bigger drop

euro-area countries (change between2007-09)

FI

SK

SI

PT

AT NL

MT

CYIT

FR

DE

R2

-3-2-1012345

7

-40 -35 -30 -25 -20 -15 -10 -5 0

Ch. in export contribution to GDP growth (in pp)

Ch.in

trade

balan

ce(in

%of

GD


ES

ELIE

= 0.176

P)

Summing up, this evidence suggests the followingexplanation for the recent reduction in currentaccount differences within the euro area. After a

nce, the global financialturmoil has brought some convergence in current

d a biggerexposure to the slump in world trade, which have

decade of steady diverge

account positions via its differentiated impact ondemand and trade in surplus and deficit countries.Most Member States which entered the recessionwith large current account deficits have seen acombination of very weak domestic demand and alower exposure to the slump in world trade than inthe rest of the euro area. This has allowedsignificant improvements in the trade balance viaboth lower imports and more resilient exports.Conversely, Member States which entered therecession with large current account surpluses haveexperienced more resilient demand an

worked towards reducing the surpluses.

Overall, the crisis has clearly exposed thevulnerabilities in countries with large currentaccount imbalances, both deficits and surpluses. Ofcourse, the precise nature of the vulnerabilitiesvaries between countries.


differences in domestic demand during the crisis,the strong negative demand shock triggered by thecrisis in large current account deficit countries canbe traced back to the private sector. The current-account balance of an economy reflects the savingand investment decisions of the domesticinstitutional sectors: households, corporations andthe government. Data on saving and investmentbalances show that Member States with largecurrent account deficits have experienced a sharprise in the Net Lending or Borrowing (NLB) of theprivate sector only partly offset by a deteriorationin government deficits (Table I.3.1). (11) The

en less pronounced inor Spain, is largely

nd to be less exposed to trade

, except for

Turning first to the causes of the observed country

pattern, which has bePortugal than in Greececonfined to high deficit countries. Only Ireland andSlovenia show similar developments in privateNLB in the rest of the euro area. In contrast, incountries with large current account surpluses,changes in private-sector savings and investmenthave been far more limited. In those countries,drops in current account surpluses have beenmostly driven by increasing public deficits.

Moving on with the causes of the observed countrydifferences in trade exposure during the crisis,these can be related to both differences in tradeopenness and in the product composition ofexports. Most Member States posting large currentaccount deficits teshocks than the rest of the euro area due to theirlower trade openness. In addition, the crisis hasexposed the importance of non-price factors forexport developments. In particular, thecomposition of the export basket has been animportant determinant of the exposure to the worldtrade turbulences during the crisis. (12) The crisishas hit trade flows much more severely for someproducts than others. Trade in servicestransport, has in general fared better than trade ingoods. Among goods, investment goods have seenmuch steeper drops in trade. In contrast, trade intraditional "non-cyclical" sectors such as food andbeverages or pharmaceuticals, has been moreresilient. Surplus countries in the euro area show a

(11) The NLB of a sector is calculated as the difference betweenits savings and its investment and therefore measures thesector's contribution to the overall current account.

dinvestment goods (Graph I.3.3) and have facedsharper contractions in exports during therecession. All the other Member States tend to bemore specialised in consumption goods, which hasmitigated the impact of the trade slump on exports.The geographical distribution of exports does notseem to have been a major factor of countrydifferences in trade exposure. Overall, the driversof the differentiated export developments in theeuro area during the crisis have been to a largeextent cyclical and may well turn around with therecovery.

Graph I.3.3: Share of capital and consumption goods in

high relative specialisation in capital an

total exports of goods, euro-area countries(2007, in %)

(12) See European Commission (2010) 'The impact of theglobal crisis on competitiveness and current accountdivergences in the euro area', Quarterly Report on the EuroArea No.1.

0IE EL ES FR IT CY LU MT NL AT PT SI SK

10

15

20

25

30

35

40

45 Capital goodsConsumption goods

5

BE DE FI


In some deficit countries, an additional source ofimprovement in the trade balance has been anexceptionally strong drop in imports reflectingchange in the composition of domestic demand.The change has been particularly visible in someMember Sates (notably EL, ES, CY, SI but alsoFI). A comparison of changes in imports anddomestic demand shows that the elasticity ofimports with respect to demand has increasedsubstantially during the crisis in these countries,implying a substitution of local demand away fromimports towards domestic products.

t can be related tocomposition effects and the investment cycle. WithThe substitution effec

falling wealth and lower incomes, households arelikely to shift consumption to products of lowerprice segments. To the extent that domestic andforeign goods belong to the low and high pricesegment respectively, the shift will reduce the

20


consumption of foreign goods over-proportionally. (13) A further factor possiblyexplaining the strong fall in imports could berelated to the kind of products imported. When acountry meets a large part of its needs ininvestment goods via imports – as seems to be thecase in Greece – its total import demand is very

eenhe

en by the crisis and

to developments in

sensitive to the investment cycle, which has bextremely sharp in the current crisis. Overall, tsubstitution effect is drivshould be largely temporary. The associatedimprovements in the trade balance should waneprogressively as the investment and consumptionrecoveries set in.

Turning to the drivers of competitiveness, changesin unit labour costs have shown some signs ofconvergence across Member States mainly due todevelopments in labour productivity. Unit labourcost (ULC) growth has accelerated significantlysince the beginning of the crisis in most MemberStates but more so in large-surplus countries thanin other Member States (Graph I.3.4).

This differentiated behaviour of ULC has been thecause of the moderate convergence of REER basedon ULC, reported in Section 2. The convergencehas been mainly dueproductivity (measured as output per worker),which decelerated more sharply in surplus than inlarge-deficit countries. Spain has even experienceda pick up in productivity growth compared with its

(13) For example, there is anecdotal evidence that, since thebeginning of the crisis, Spanish customers have partlyshifted their consumption from luxury imported cars todomestically produced cheaper models.

long-termStates are geneous with productivitystrongly hit by the crisis in some recent euro-areaentrants (SI, SK) but also in Ireland. In contrast,developments in compensation of employees havebeen rather dispersed among surplus and deficitcountries. In other countries, growth incompensation has fallen below past trend withparticularly sharp drops in Ireland, Slovakia andSlovenia.

Graph I.3.4: Changes in ULC and its components relative

trend. Developments in other Memberrather hetero

to pre-crisis trends, euro-area countries(percentage points) (1)

-8

-6

-4

-2

0

2

4


6

8 Unit labour costsCompensation per employeesProductivity

(1) Difference between annual average growth rate in2008-2009 and in 1999-2007. Employment in persons.Source: Commission services.

The employment response to the fall in outputgered by the crisis differed significantly acrosstrig

relsmarea Mem

M

Member (Graph I.3.5). The fall in employmentative to pre-crisis trends has been comparativelyaller in surplus countries and some new euro-

ber States, while larger elsewhere. To

Table I.3.1: Net lending and borrowing by sector, euro-area ember States (change 2007-09, percentage points of GDP)

Hh Corp Total Hh CorpBE 1.4 1.0 2.4 -5.7 -3.3 1.7 -0.6DE 0.0 -0.4 -0.4 -3.5 -4.0 0.5 -2.4IE 12.4 0.4 12.7 -12.7 0.0 5.4 -3.2EL -4.1 16.2 12.1 -8.8 3.3 -8.3 14.9ES 9.8 8.4 18.2

Net lending borrowing GrPrivate

Gov TotalPrivate

-13.1 5.1 6.0 4.6FR 1.9 3.6 5.4 -5.5 -0.1 0.9 1.5

0.2/A

LU N/A N/A N/A N/AMT N/A N/A N/A N/ANL 2.6 -3.1 -0.5 -4.9 -5.5 3.0 -5.3AT 1.9 0.0 1.9 -3.7 -1.8 2.0 -0.9PT 3.3 1.9 5.3 -5.2 0.0 2.0 -1.2SI 1.9 8.6 10.4 -6.5 4.0 1.5 -0.5SK 4.4 -0.3 4.1 -4.7 -0.6 4.8 -3.6FI 3.2 1.4 4.6 -8.1 -3.5 2.4 -4.0

o

Total Hh Corp Total1.1 -5.2 -4.1 0.2 -1.2 -1.1 -1.3 -2.4-1.9 -3.0 -4.9 0.6 -1.8 -1.2 -0.1 -1.32.2 -12.6 -10.5 -6.9 -3.6 -10.4 0.0 -10.46.6 -6.4 0.2 -4.5 -1.3 -5.8 0.0 -5.7

10.6 -12.6 -2.0 -3.6 -3.6 -7.2 1.1 -6.12.5 -5.2 -2.7 -0.9 -2.0 -2.9 0.1 -2.70.8 -3.9 -3.1 -0.6 -2.1 -2.7 -0.3 -3.0N/A -6.9 N/A N/A N/A N/A N/A -3.2N/A -5.0 N/A N/A N/A N/A N/A -2.5N/A -2.6 N/A N/A N/A N/A N/A -10.2-2.3 -4.2 -6.5 0.8 -2.3 -1.5 0.1 -1.41.1 -3.6 -2.6 0.2 -1.0 -0.8 -0.7 -1.60.8 -5.2 -4.4 -1.0 -3.4 -4.4 1.3 -3.11.1 -5.8 -4.7 -0.3 -8.5 -8.7 0.5 -8.21.2 -3.9 -2.7 0.3 -1.7 -1.4 -5.8 -7.2-1.6 -7.6 -9.2 -0.7 -5.4 -6.1 0.4 -5.7

Gov Total

ss savings Gross capital

Gov TotalPrivate

IT 1.5 1.6 3.1 -3.8 -0.6 0.9 -CY N/A N/A N/A -6.8 N/A N/A N

N/A N/A -5.9N/A N/A -2.3


21


some extent, the opposite pattern is visible whenlooking at the average number of hours worked perperson (Graph I.3.6). In countries where averagehours per worker fell significantly in 2008-09 (DE,LU, AT but also BE) employment growthremained relatively close to trend, a sign ofstronger labour hoarding.

Graph I.3.5: Shocks to GDP and employment during thecrisis, euro-area countries(percentage points) (1)

-12BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FI

-10

-8

-6

-4

-2

0

2

EmploymentGDP

(1) Difference between annual average growth rate in2008-2009 and during 1999-2007. Employment in persons.Source: Commission services.

low-skilled and self-employed. (14) The weight ofthese groups in total workforce has influenced themagnitude of labour hoarding/shedding acrossMember States. Spain is a noticeable example inthis regard, where fixed-term contracts representclose to ⅓ of total employment. Self-employedhave also experienced relatively larger losses inemployment. This can be explained by thedependency of the self-employed on bank capital,which has become scarcer in the crisis and by theuse of self-employment contracts as a form offlexible employment in some companies. Self-employment is much more prevalent in Southerneuro-area countries than in Northern countries suchas those with current account surpluses. (15)

Graph I.3.6: Growth in hours worked per person employed,euro-area countries (average annual changein %, 2008-09)

-0.5

0.0

0.5

1.0

-2.0

-1.5

-1.0



Differences in employment and productivity partlyreflect the sectoral distribution of the shocksinflicted by the crisis. Countries that haveexperienced comparatively large shocks to theconstruction sector have also recorded significantlabour shedding (particularly ES and IE), asemployment in this sector is to relatively largerextent based on temporary and flexible contractsand the labour force is relatively low-skilled.Productivity in construction is also relatively low,so the reduction of employment in this sector hasalso worked towards increasing the productivity inthe whole economy. In contrast, the employmentresponse to the crisis has tended to be weaker andlabour hoarding larger in countries where themanufacturing sector has been the epicentre of thecrisis (e.g. DE, SI, SK).

Differences in employment and productivity canalso be related to the structure of the labourmarket. Labour market data suggest that the crisishas affected mainly the workers with relativelyunstable work status, such as temporary workers,

Differences in employment response are alsoaccounted for by differences in employmentpolicy. Governments have taken a range ofmeasures to address the weakening labour market,which have had an impact on employment andlabour costs. Government-sponsored schemes tosupplement wages of workers working at reducedhours have encouraged labour hoarding in severalcountries. These measures have been mostpronounced in countries as Austria, Germany,Luxembourg, Italy or France, but broadly absent inSpain, Greece or Portugal. Governments' action in

(14) For a thorough review and discussion see EuropeanCommission (2008), 'Labour market and wagedevelopments in 2008', European Economy No. 8/2009.

(15) The share of the self-employed in the euro area is 9.5%,while the (un-weighted) average in Greece, Spain,Portugal, Cyprus and Italy is 15% and the (un-weighted)average in Germany, Austria, Luxembourg and France is5.8%.

22


23

the labour market has also aimed at alleviatingnon-wages costs in overall labour costs. These

Looking forward, the analysis presented in this

and surpluses have narrowed significantly in 2008and 2009, this adjustment has not been followed

stly cyclicaland is likely to be at least partly reversed with the

ities will return to pre-crisis levels once the severe shock of the crisis

p d, inthe absen gains, largercurrent account deficits could re-emerge. In thecurrent account surplus countries, there is evidencethat the contraction in exports was particularlystrong due to the collapse in world trade. With therecovery in other parts of the world taking hold,exports are likely to bounce back. This wouldwiden current account surpluses again. However, itis worth stressing that the dividing line betweenpermanent and temporary/cyclical effects isparticularly difficult to draw in the currentsituation.

measures have usually taken the form of reductionin social security contributions (BE, FR, DE),especially for low earners (FI, MT). These rebateswere usually conditional on job creation andhelped to support employment.

Overall, the recorded convergence in labour costgrowth within the euro area may prove to belargely temporary. The convergence in ULCgrowth mostly reflects different Member Stateresponses to the crisis in terms of productivity andemployment policies rather than wage adjustmentto pre-crisis competitiveness divergence. Theproductivity responses are largely cyclical and arelikely to be progressively reversed when therecovery sets in and emergency labour marketmeasures are unwound. Accordingly, most of theobserved convergence in ULC during 2008 and2009 is forecast to reverse up to 2011.

section suggests that the reduction in currentaccount differences observed since the beginningof the crisis is likely to be partly reversed as therecovery takes hold. While current account deficits

by significant price adjustments. The moderateadjustment of ULC seems to be mo

recovery. The reduction of large current accountdeficits in 2008 and 2009 has been driven bystrong falls in imports than rather by gains inexport market shares. The fall in imports can betraced back to falling domestic demand andchanged elasticities of imports relative to income.It is likely that the elastic

abates. Im orts could then increase again ance of competitiveness

4. UNDERLYING DOMESTIC MACROECONOMIC

24

to distinguishingbetween 'harmful' and 'benign' changes in

e developments before the crisis,competitiveness divergence was driven by both

IMBALANCES

Changes in competitiveness and current accountsare not bad per se in a monetary union. Given thatthe nominal exchange rate can no longer play therole of an adjustment tool, response to shockstakes place via competitiveness changes. A keyissue for economic policy is

competitiveness, with the former requiring someform of policy intervention while adjustment to thelatter can be left to market forces. Economictheory suggests that the distinction largely dependson the extent to which changes in externalperformance are driven by market dysfunction orpolicy mistakes. It is therefore crucial from apolicy perspective to assess the extent to whichdevelopments in competitiveness and externalperformance within the euro area can be related topolicy mistakes, market failures or any form ofdomestic macroeconomic imbalance at MemberState level. (16)

Looking at th

'harmful' and 'benign' factors. Factors such asBalassa-Samuelson effects, price convergence orcyclical differences in unit labour costs could beconsidered to be largely neutral for externalperformance. In the same vein, current accountdispersion within the euro area was partly a sign ofincreased financial market integration, with theeuro acting as a catalyst. At the same time,differences in cost competitiveness could in part beascribed to inappropriate responses of wages toproductivity shocks. Furthermore, losses incompetitiveness and the accumulation of largecurrent account deficits could, in a number ofMember States, be related to a range of domesticmacroeconomic imbalances that warrant closesurveillance. These include sluggish productivityperformance, the accumulation of high privatesector debt and the emergence of housing bubbles.In surplus countries, the improvement in externalbalances in pre-crisis years can in part be ascribedto persistent weakness in private sector demand,

(16) For a discussion see European Commission (2009),

with balance sheet adjustment in the corporatesector playing an important role. (17)

The present section discusses the extent to whichrecent developments in competitiveness andcurrent accounts since the onset of the crisis areunderpinned by changes in underlying domesticimbalances. It looks successively at recentdevelopments in housing markets, private sectorcredit and balance sheets.

Graph I.4.1: Real house prices, euro-area countries

'Competitiveness developments within the euro area',Quarterly Report on the Euro Area, No 1.

(annual growth in %) (1)

-14

-10

-6

-2

2

6

10

14

18

22


Average 2004-200620072008

(1) House pri es deflated by the HICP.cSource: ECB, Commission services.

The progressive cooling off of housing markets inthe euro area is helping to reduce current-accountimbalances. Housing markets have played apivotal role in the divergence of external positionsacross euro-area Member States over the pastdecade. They have amplified the effects ofdifferences in real interest rates and in the speed offinancial deepening on domestic demand acrossMember States. In some Member States, the rapidexpansion of the construction sector has alsocontributed to divert resources away from theexport sector. These trends have been all the more

lopments have beenworrying as house price devein some cases clearly unsustainable. The ongoing

(17) See e.g. European Commission (2006), The EU Economy2006 Review: Adjustment dynamics in the euro area –Experiences and challenges;

European Commission (2008), EMU@10 – Successes andchallenges after 10 years of Economic and MonetaryUnion, European Economy No. 2/2008, EuropeanCommission, DG Economic and Financial Affairs.


pricebooms were greatest before the onset of the crisis

headjustment is translating into a large increase in

alances which underlie competitivenessproblems in the euro area.

In contrast, signs of balance sheet adjustment in

cooling off of housing markets is affecting alleuro-area Member States except Germany andPortugal, where house prices have remained fairlyflat of negative (Graph I.4.1). It tends, however, tobe more pronounced in countries withcompetitiveness problems and where house

(BE, EL, ES, IE, FR, MT, SI).

The rebalancing of the construction sector isvisible in terms of prices but also quantities. Inmost euro-area countries that underwent or stillundergo a catching-up process, as well as Ireland,(although to a lesser degree), the crisis has entaileda dramatic downshift in construction activityrelative to pre-crisis trends. In contrast, thedownshift has been more muted in currentaccount-surplus countries, with the exception ofFinland. Overall, the reduction of housingimbalances is helping to reduce externalimbalances within the euro area. At this juncture, itremains difficult to say, however, to what extentthe reduction is durable or will be reversed withthe recovery.

In a number of Member States, households haveembarked on a balance sheet adjustment processcombining an increase in savings and a reductionin residential investment. This is particularly thecase of some current account deficit countries (ESand IE and to a lesser degree PT and SK). (18) T

households’ net lending/borrowing (NLB) which isreducing current account deficits. The extent towhich the ongoing adjustment is durable or just atemporary by-product of the crisis is difficult toassess. The crisis has probably led to a lastingchange in risk attitudes, particularly in the bankingsector, suggesting that at least part of theadjustment will persist. In contrast, althoughhouseholds have raised NLB everywhere acrossthe euro area but in Germany, the increase hasgenerally remained limited in Member States thatdo not feature high current-account deficits (withthe exception of FI). The balance sheet adjustmentprocess therefore goes in the direction of reducingthe imb

the corporate sector remain so far limited except in

No data available for EL, CY, LU and MT.(18)

andpossibly in airly reliable indication ofbalance sheet repair in the corporate sector isgenerally provided by a simultaneous decline incorporate investment and a rise in corporatesavings. While in a world of perfect capitalmarkets, adjustment to debt overshooting andexcessive leverage can be obtained by the issuanceof new equity, in reality the issuance of new equityis often constrained by many factors such as fixedcosts of equity issuance, temporarily high riskaversion, the cost of external funding, issuesrelated to corporate control, etc. These capitalmarket imperfections force corporations to rely, atleast partly, on internal funding to adjust their

ss.

ch concurrentand savings have been

d essentially in Spain, Greece and to asser degree in France. Slovenia is borderline,

in theeuro area a n savings. Inother Member States, investment has generallydropped due to various cyclical factors (a lack ofdemand, increased uncertainty, restricted access toexternal funds) but savings have also decreasedsignificantly due to deteriorating profitability.

Graph I.4.2: Credit growth, euro-area countries (change

Spain, Greece and, to some degree, in FranceSlovenia. A f

balance sheet structure. To achieve this, firmsimultaneously cut investment and raise savingSince the onset of the crisis, sumovements in investmentregisterelewith the largest drop in capital formation

nd only a marginal fall i

in y-o-y growth Jan. 2008-Jan. 2010)

-15

-5

0

5

-40

-35

-30

-25

-20


-10

Non-financial corporationsHouseholds

Source: ECB, Commission services.

Recent credit data provide further evidence ofbalance sheet adjustment. Credit to households andcorporations fell dramatically over the 2008-09period in most Member States with large currentaccount deficits, in some of the new euro-area

25


luses.

tadjustment nhighly indebted Member States. But in any event,further balance sheet adjustment is likely in thecorporate sectors of a range of Member States,particularly in large-deficit countries. Adjustmentsto asset price falls, debt overshooting, highleverage and lower growth prospects can triggerprotracted phases of balance sheet adjustmentcharacterised by substantial reductions in the netborrowing of the corporate sector. Recent researchsuggests that euro-area corporations entered therecession with debt overhang of about 15%. (19) Inaddition, the crisis has triggered sharp falls in assetprices which have led to a strong increase in

In

his would raise the debtburden relative to expected earnings and might

ro area (with theexception of PT, see Graph I.4.4). Moreover, these

growth prospects (IE and most new MemberStates).

Member States (CY, SI and SK) and of thecountries where deficits are not very large butexport performance was weak prior to the crisis(mostly BE and IE) (Graph I.4.2). In contrast, thedrop in credit has been less strong in MemberStates with large current-account surp

It is difficult to say how far balance sheein the household sector still has to go i

leverage ratios across euro-area Member States.addition the crisis is also projected to reduce euro-area growth potential. T

force companies to reduce debt further. Due tothese factors combined with changes in riskattitudes and risk premia, the financial turmoil islikely to be followed by a drawn-out period ofcorporate balance sheet repair in the euro area.

Needs in terms of corporate balance sheetadjustment appear particularly large in MemberStates with large external deficits. Leverage isindeed high in their corporate sector (Graph I.4.3),potential growth is expected to decelerate morestrongly than in the rest of the eu

countries also faced persistent pressures onprofitability in the years preceding the crisis(Graph I.4.5). Some of these factors are also atplay in other country groups and could entail somebalance sheet adjustments to respond to pastpressures on profits (CY, IT) or a sharp slowdownin

Graph I.4.3: Corporate leverage, euro-area countries(2008, in %) (1)

200

300

0

100

BE DE EL ES FR IT NL AT PT SI SK FI

(1) Ratio of debt to value added in the non-financialcorporate sector. Debt is the sum of securities other thanshares and loans. Data for IT are for 2007.Source: Commission services.

Graph I.4.4: Potential growth, euro-area countries(average annual growth in %)

(19) Sorensen C.K., D. Marques Ibanez and C. Rossi (2009),'Modelling loans to non-financial corporations in the euroarea', ECB working paper, No. 989 (January).

0

1

2

3


5

62004-20072008-2011

4


While some progress has been made (and more isto come) in terms of underlying domesticimbalances in current account deficit countries,imbalances related to domestic demand seem topersist in surplus countries. During the crisis,domestic demand remained relatively resilient insurplus countries due to significant fiscalexpansion and compa atir vely stable private sector

et lending. As a result, imports have been fallinguch less than exports and current account

nmsurpluses have contracted. This constituted asizeable positive growth contribution to the rest ofthe world. At this juncture, it is however difficult

discernto any substantial structural strengthening

26


27

of private-sector demand in these Member States.The changes in risk attitudes and in bank lendingtriggered by the crisis could prolong the period ofcorporate balance sheet correction whichcontributed to the accumulation of surpluses insome of them in the pre-crisis years.

Graph I.4.5: Changes in corporate profitability, euro-areacountries (2004-07, in percentage points) (1)

-4

-2

0

2

4

6


nge in the ratio of gross operatin(1) Cha g surplus to grossvalue added in the non-financial corporate sector. 2004-06for EL and LU.Source: Commission services.

Whereas some underlying macroeconomicimbalances have been reduced, new imbalanceshave started to build-up. Some of the countrieswith external imbalances or competitiveness

art of it is of a more persistent or structuralnature. Further evidence of the persistence of therise in unemployment comes from the steep rise in

ciated

crisis has triggered a process of structuraldownsizing in some industrial sectors, notablyconstruction (EL, ES and IE). The requiredreallocation of the labour force to expandingsectors, mostly the export sector, will take time –involving workers' retraining but also new capitalinvestment – and therefore risks being assowith a lasting rise in unemployment.

Graph I.4.6: Changes in current account andunemployment, euro-area countries

FI SKSIPT

ATNL MT

LUCYIT

FR

ES

EL

IE

DE BE

R2 = 0.20

-2

0

2

4

6

8

10

12

-8 -6 -4 -2 0 2 4 6Ch. in current account (2007-09) (2)

Ch.in

unem

plyme

ntra

te(20

07-09

)(1)

(1) In pp of labour force. (2) Change in Net lending (+) ornet borrowing (-), total economy (in pp of GDP); balance ofcurrent transactions for LU.Source: Commission services.

Further evidence of persistent underlyingimbalances comes from a lack of price andcompetitiveness adjustment. The rebalancing ofcurrent accounts among euro-area Member States,has so far been associated with some rebalancingof house prices but, as documented in Section I.2little changes in other underlying relative prices.To be sustainable, a correction in current accountsmust be supported by changes in competitivenessand relative prices in order to redirect demand and

problems have registered a cooling off of thehousing market, early signs of improvements inhousehold balance sheets and very preliminaryevidence of an adjustment in corporate debt. Theseimprovements in underlying domestic imbalanceshave, however, been associated with large rises inunemployment. This is particularly the case forSpain and Ireland (Graph I.4.6).

Part of the rise in slack is cyclical and will beabsorbed when the economy picks up. However,p

supply between the export sector and the rest ofthe economy. (20) This has so far not been the case.The lack of competitiveness adjustment does notseem to be due to the slow response of prices andwages to changes in the cyclical conditions as thecompetitiveness divergence is projected to persistin the medium term. (21)the estimated NAIRU in Spain and Ireland. The

(20) See discussion on adjustment in Section I.5 for moredetails.Commission (2009), European Economic Forecast.Autumn 2009, European Economy

(21)10/2009.

5. COMPETITIVENESS ADJUSTMENT WITHIN THE EURO AREA

28

The analysis presented in the previous sections ofthis report shows that notwithstanding someconvergence in current accounts in the past twoyears, prices and wages have – with the exceptionof Ireland – adjusted very little to date. Significantimbalances continue to exist in EMU and will putconsiderable pressure on Member Statesadjustment capacity in the years to come. Thissection starts with presenting the size of thecompetitiveness adjustment needs based onCommission estimates of equilibrium REER. Itthen assesses the implications of the financialcrisis for the functioning of the competitivenessadjustment mechanism and discusses structuralfeatures of the Member States' economies thatcould contribute to facilitate adjustment. It alsodiscusses the benefits of coordinatingcompetitiveness adjustment across Member States.

5.1. ASSESSING THE MAGNITUDE OF THEREQUIRED ADJUSTMENT

Estimates of equilibrium REER can provide auseful benchmark of the required competitivenessadjustments within the euro area. Not surprisingly,the countries with the largest observed currentaccount imbalances exhibit the most pronouncedREER misalignments (see Box I.5.1).(22)

The 2009 estimates of equilibrium REER point topersistent competitiveness misalignments but themagnitude of the misalignments is, in most cases,smaller than in the case of the estimates based on2008 data. The 2009 estimates should however beinterpreted with prudence. Assessing equilibriumexchange rates is particularly challenging in timesof severe financial and economic crises especiallybecause it is difficult to distinguish temporaryfrom permanent changes in current accounts in

(22) Estimates of equilibrium REER are generally calculated asthe level of the REER which is consistent with somespecific medium-term macroeconomic or statisticalrequirement. Various approaches have been proposed inthe economic literature. They all have their pros and consand are surrounded by significant uncertainty. Combiningthe information provided by different methodologies as isdone in this report (which proposes two approaches) canhelp reduce this uncertainty. Nevertheless, any assessmentbased on estimates of equilibrium REER should be madewith considerable prudence.

times of severe market turbulences (see Box I.5.1for details). Methodological difficulties related tothe exceptional circumstances of the crisis suggestthat it is safer to use 2008 estimates of REERmisalignments when trying to assess price andwage adjustment needs within the euro area.

Overall, estimates point to the need for asubstantial rebalancing of relative prices acrossMember States. Available evidence suggests thatthe competitiveness adjustment channel isoperational in the euro area. (23) However, in theabsence of additional reform effort, there is a riskthat competitiveness rebalancing will be a drawn-out process. Adjustment of the euro-area economycould be hampered by the significant labour andproduct market rigidity which characterise theeconomies of most Member States. Rigidities tendto lengthen the period of adjustment and makethem more costly in terms of unemployment.Measures of product and labour market regulationsindicate that rigidity tends to be particularly highin the Member States which currently show highcompetitiveness adjustment needs (Table I.5.1).

The cost of rigidity could be further magnified byasymmetries in the functioning of thecompetitiveness adjustment channel. Availableevidence shows that relative prices within the euroarea do respond to relative cyclical positions insuch a way as to moderate cyclical differences butthe process is asymmetric: in relative terms, wagesand prices rise more strongly when the output gapis positive, than fall when the output gap isnegative. The asymmetry appears to be large insome of the countries which currently show highdownward adjustment needs (see Graph I.5.1). (24)

(23) See e.g. European Commission (2006), The EU Economy2006 Review: Adjustment dynamics in the euro area –Experiences and challenges;European Commission (2008), EMU@10 – Successes andchallenges after 10 years of Economic and MonetaryUnion, European Economy No. 2/2008, EuropeanCommission, DG Economic and Financial Affairs.

(24) Arpaia, A. and K. Picwage flexibility in EMU' icPaper No. 281 (June), European Commission, DGEconomic and Financial Affairs.

helmann (2007), 'Nominal and real, European Economy, Econom


Box I.5.1: Assessing competitiveness adjustment needs on the basis of equilibriumexchange rate estimates

This box presents estimates of the competitiveness adjustment needs in individual euro-area Member States.The adjustment needs are calculated as the change in the REER required to close the gap between estimatesof the equilibrium current account and the underlying value of the current account. The required exchangerate adjustment is obtained by means of country-specific elasticities of the current account with respect tothe real exchange rate. The underlying value of the current account is the actual value of the current accountcorrected for an estimated impact of the cycle (the output gap) and of past changes in real effective exchangerates. Two approaches are used to assess the equilibrium current account:

• The current account norms (CAN). This approach estimates the current account that would prevailover the medium to long-term on the basis of a set of fundamentals variables including, inter-alia thedeterminants of the saving-investment balance of the economy.* The relation between current accountbalances and fundamentals is estimated on a large panel of industrial and emerging economies. Theprediction from this estimation based on average values of the fundamental variables for the last 7 yearsis the current account norm.

• The net foreign asset stabilisation (NFAS). The benchmark current account is, in this case, the one thatguarantees the stabilisation of the NFA/ GDP ratio at a given level. In the present analysis, therequirement is that the NFA/ GDP ratio is stabilised at the most recent available value (referring to2007).

Current accounts, current account norms according to the CAN and NFAS approach andestimated over-/undervaluation in REER

2008 2009

Estimated over-/undervaluation

(%)

Estimated over-/undervaluation

(%)account

(% GDP, 2008)

Underlyingcurrent account(% GDP,2008)

Current accounnorm (% GDP,

2008)

N NFAS CAN NFAS

t Current accountthat stabilises theNFA position (%

GDP, 2008)CA

Actual current

BE 0.2 -1.6 0.5 1.0 1.5 1.8 2.0 2.2DE 6.6 7.3 -1.2IE -5.1 -8.8 -0.5EL -13.8 -13.7 -6.6ES -9.5 -10.4 -3.5FR -3.3 -3.8 -1.0IT -3.0 -3.4 -1.9NL 4.2 5.3 1.7AT 3.6 4.4 -1.4PT -12.1 -12.9 -5.3SI -6.1 -4.7 -1.7

0.4 -11.3 -9.1 -5.1 -3.1-0.2 5.9 6.1 5.6 6.2-5.3 16.8 20.0 7.2 13.7-2.7 14.6 16.2 6.4 12.20.0 6.0 8.3 4.8 7.10.0 3.1 7.2 3.6 7.71.1 -2.9 -3.4 1.6 0.9-0.4 -6.0 -4.9 -1.1 0.1-2.1 13.5 19.3 10.6 18.5-1.4 2.6 2.8 2.2 3.0-3.2 5.3 5.5 8.0 8.3-1.3 -3.9 -5.3 1.7 1.0

SK -6.8 -11.0 -3.5FI 2.6 2.7 -0.3Source: Commission services.

ignificThe current financial crisis sestimates of competitiveness adju

antly complicastment needs are base

substantially. This is true for the value of current-accou s of the output gapused to calculate the underlying current account. Second

uHo elikely to be driven to a greater extent by temporary f

tes the estimation of misalignments. First, thed on preliminary data for 2009 that could be revisednt balances but also for estimate, the correction for output gaps and lagged REER

nt figures that better reflect structural positions.ry sharp contraction in activity, current accounts areactors which cannot properly be corrected with the

effects permits to estimate underlying current accowever, during periods of financial turbulence and v

estimation approach. While the approaches are able to account for the business cycle, the severe crisis is

(Continued on the next page)

29


Graph I.5.1: Asymmetries in the response ofcompetitiveness to the business cycle, euro-area countries (1)

-1.0

-0.5

0.0

0.5

1.0

1.5

BE DE IE EL ES FR IT NL AT PT FI

Total economyManufacturing

(1) The asymmetries are calculated as the difference in thecyclical response of ULC in times of positive and negativeoutput gaps. The cyclical response is measured by theelasticity of ULC (relative to the rest of the other euro area)to the output gap (relative to the rest of the euro area).Estimations are done for the period 1970-2005.Source: Arpaia and Pichelmann (2007).

5.2. POSSIBLE IMPACT OF THE CRISIS ONMEMBER STATES' ADJUSTMENT CAPACITY

lo

In the absence of policy responses, there is anitional risk that the global economic andncial crisis could further hamper

addfina

rocesses and

pirical evidence suggest

w

rigeur

tcom

competitiveness adjustment due to: i) theinteraction between nominal rigidities and theperiod of low inflation brought by the crisis; ii) theimpact of the crisis on corporate balance sheets;and iii) the possible negative impact of the crisison potential output.

In the current context of low inflation, nominalwage rigidities emerge as a distinct source ofconcern. A distinction can be made betweennominal and real downward rigidities whichcorrespond, broadly speaking, to workers'reluctance to accept, respectively, nominal and realwage cuts. In theory, both types of rigidities havethe potential to slow adjustment praise the associated costs in terms ofunemployment. In the current environment of lowinflation, however, concerns about nominalrigidities have come to the fore. Indeed, botheconomic theory and emthat nominal rigidities become more binding the

er the level of inflation.

Evidence from firm-level data shows that nominalidities are, to various degrees, prevalent in mosto-area Member States. But nominal rigidities

seem to be particularly prevalent in those MemberS ates that experienced large losses in

petitiveness prior to the financial crisis

Box (continued)

associated with many very significant temporary phenomimport elasticities to GDP during the crisis have led toand Spain because imports fell more strongly than thethis as a permanent improvement while it is conceivabto the crisis. Similarly, surplus countries' exports havemight be a temporary effect linked to the sectoral natur

ena that cannot be catered for. For example, highermarked improvements in current accounts in Greececycle would suggest. The estimation approach takesthat the elasticity has changed only temporarily due

been severely hit but the sharp reduction in exportsof the collapse of world trade. This effect would not

le

ebe catered for in the estimation approach. The uncertrates in times of sever crisis are, to some extent, reflethe two approaches in some countries.

Overall, estimation results should therefore not betherefore presents the estimated over-/undervaluation fof the current account norm and the current account levalues appear to better suited for the analysis sinceexceptional crisis situation.

(*) See for instance Chinn, M.D. and E.S. Prasad, (200industrial and developing countries: an empirical exppp. 47-76, and Lee, J., G.M. Milesi-Ferretti, J. Ostassessments: CGER methodologies', IMF Occasional P

aincted i

ior 2009 and 2008 alongside the underlying estimates

th

3lor

ties surrounding estimates of equilibrium exchangen large differences in the estimates provided by

nterpreted mechanistically. The table in this box

vel that stabilizes the NFA, both for 2008. The 2008e 2009 estimates are significantly affected by the

), 'Medium-term determinants of current accounts ination', Journal of International Economics, Vol. 59,

ry, A. Prati, and L. Ricci (2008), 'Exchange rateaper No. 261.

30


wagelabour costs (e.g. bonuses, rates of promotions,new recruitment at lower wages, etc.). (26) It is

becom riodof low inflation as actors on the labour market

genegotiations.

(Graph I.5.2). (25) Evidence based on micro datashould be interpreted with prudence as itsmacroeconomic implications are not fullyestablished yet. For instance, company surveysshow that firms can at least partly circumscribenominal wage rigidities by cuts in non-

also possible that nominal wage rigidities maye less widespread after a protracted pe

become more used to nominal wage cuts and lessprone to nominal illusions. Overall, however,micro data point to an increased risk of protractedprice adjustment in a context of low inflation. Thisrisk calls for reforms aimed at reducing nominalrigidities. The recent experience in Ireland andGreece also shows that determined policy action interms of public wages can facilitate overallcompetitiveness adjustment when changes inpublic wages influence private-sector wa

Graph I.5.2: Micro evidence on nominal and real wagerigidities, euro-area countries

0

2

4

6

BE DE IE EL FR IT NL AT PT FI

8Real wage rigidityNominal wage rigidity

Source: Dickens, Goette, Groshen, Holden, Messina,Schweitzer, Tutunen, Ward-Warmedinger (2008) "Downwardreal and nominal rigidity: micro evidence from theinternational wage flexibibility project", updated data fromJournal of Economic Perspectives, 21(2), pp.195-214, 2007.

As discussed in the previous section, pre-crisisbalance-sheet stress has been severelycompounded by the crisis-induced drop in assetprices and changes to risk attitudes. The ongoing

phase of balance sheet correction is likely topersist for some time, at least in the corporatesector. Member States which face considerableadjustment needs in terms of both pricecompetitiveness and corporate balance sheets willhave to strike a delicate balance between raisingcorporate cash flow to fix balance sheets andlowering prices to restore competitiveness. In otherwords, corporate balance sheet correction mayslow the speed of the adjustment process byreducing firms’ capacity to pass through lowerwage costs into output prices.

Finally, the functioning of the competitivenesschannel could also be impaired by the negativeimpact of the crisis on potential growth. Manyeconomists argue that, unless appropriate policiesare put in place, the crisis will entail a significantand lasting fall in the level of potential output andcould, possi

(25) See for instance: ECB (2009), 'New survey evidence on

(26)

bly, shift potential growth below itspre-crisis trend during a protracted period. (27)

This negat sein the NAIR oductivity.A rise in the NAIRU reduces the unemploymentgap and could therefore contain downsidepressures on wages resulting from the ongoing risein unemployment. Furthermore, to the extent thatchanges in trend productivity tend to be reflectedin wages with a lag, negative shocks toproductivity can lead to a temporary increase inunit labour costs. (28) The combination of thesetwo mechanisms could lead to relative labour costpressures in Member States where either i) thecrisis-induced slowdown in productivity iscomparatively stronger or ii) the response of wagesto changes in productivity is slower.

inStates with large

wage setting in Europe', ECB Monthly Bulletin, February2009. Dickens et al(2007), 'How wages change: microevidence from the International Wage Flexibility Project',Journal of Economic Perspective, No. 21(2), pp. 195-214.ECB (2009), op. cit.

ive effect reflects a temporary increaU but also a downshift in pr

As highlighted in Section I.4., Commissionestimates point to a risk of larger losses

emberpotential growth in M

(27) See for instance:European Commission (2009), 'The impact of theeconomic and financial crisis on potential growth',Quarterly Report on the Euro Area, Vol. 8 No.2.European Commission (2009),' Impact of the currenteconomic and financial crisis on potential output',European Economy, Occasional Papers No. 49 (June),European Commission, DG Economic and FinancialAffairs.

(28) The existence of such lags in European countries (but notin the US) is well documented. See the seminalcontribution of Blanchard, O. J. and L. Katz (1999), 'Wagedynamics. Reconciling theory and evidence', AmericanEconomic Review, No. 89, May 1999, pp. 69-74.

31


ystems face thedouble challenge of having to adjust to past losses

inal and realrigidities; ii) structural reforms that counter the

(i.e. the price of exports relative to the prices of

particularly visible in some

competitiveness adjustment needs. In thesecountries, wage bargaining s

in competitiveness as well as to weakerproductivity growth. Clearly, policies to boostpotential growth would be highly beneficial.

5.3. STRUCTURAL FACTORS WHICH COULDFACILITATE ADJUSTMENT PROCESSES

The fact that the crisis may weigh on MemberStates' adjustment capacity calls for an ambitiouspolicy response. The previous discussion in thissection has already suggested three areas wherepolicy action would facilitate adjustment:i) structural reforms that reduce nom

impact of the crisis on potential output;iii) measures that facilitate balance sheetadjustment, particularly in the corporate sector.

The remainder of this section looks at twoadditional areas where reform could help tofacilitate adjustment processes: internal adjustmentand non-price competitiveness. It also discussesthe possible benefits of a coordinated policyresponse in the euro area.

Adjustment to external imbalances will not onlyrequire rebalancing of relative export prices butalso changes in domestic relative prices. Empiricalevidence shows that sustainable changes in thecurrent account must be supported by changes inthe internal exchange rate (i.e. the price of non-tradable goods and services relative to the prices ofexports), as much as the external exchange rate

foreign competitors). (29) For euro-area MemberStates, the importance of this internal adjustmentprocess has, if anything, increased with theintroduction of the euro as the suppression ofnominal exchange rate realignments has eliminateda key channel of adjustment of the externalexchange rate.

The underlying mechanics of the internaladjustment has been

ed to a shift of demand towards thetradable sector. These economies also experienced

(29) Ruscher, E. and G.B. Wolff, (2009)' External rebalancing isnot just an exporters' story: real exchange rates, the non-tradable sector and the euro', European Economy,Economic Papers No. 375 (March), European Commission,DG Economic and Financial Affairs.

parts of the euro area in recent years. Before thecrisis, Member States with large current accountdeficits were suffering from excessive domesticdemand pressures with price pressures particularlymarked in the non-tradable sector (notablyhousing) where supply tends to respond less ormore slowly to price signals than in the tradablesector. This l

an opposite shift of supply from the tradable to thenon-tradable sector as the comparatively highprices of non-tradable attracted capital and labour.Both shifts contributed to raise the current-accountdeficit. Graph I.5.3 provides evidence of thesesectoral changes: employment growth in the non-tradable sector has significantly exceededemployment growth in the tradable sector in mostcountries which have built-up large current-account deficits (and conversely in surpluscountries).

Graph I.5.3: Employment growth in the non-tradablesector relative to the tradable sector, euro-area countries (2001-07 in %) (1)

-2BE DE IE EL ES FR IT CY LU NL AT PT SI SK FI

Average annual growth of employment in the non-

-1

0

1

2

3

(1)tradtheconcomSou

able sector relative to the tradable sector in relation toeuro area. Non-tradable sector is approximated bystruction and market services while tradable sectorprises agriculture and industry.

rce: Commission services.

These changes in the relative prices of the tradablenon-tradable sectors will now have to beand

unwacchas

ba

nec

reversed as the crisis has prompted a brutalinding of upward demand pressures in current-

ount deficit countries. The collapse in demandbeen associated with a decrease of the current-

account deficits but also the emergence ofstantial excess capacity, particularly in the non-

dable sector. Regaining competitiveness isessary to achieve a sustainable improvement in

sutr

32


ricecompetitiveness of the export sector but also

capacity therefore relates to its capacity toreallocate capital and labour resources acrosssectors. The magnitude of the change in theinternal exchange rate necessary to put theeconomies with large current-account deficits backon a sustainable path will depend on howresponsive supply and demand are to changes inrelative prices. In particular, the requiredadjustment of the internal exchange rate will belarger the more rigid supply is. If resources,particularly labour, are characterised by littlemobility across sectors, the burden of adjustmentwill fall more on consumption and will requirelarger price changes (with a risk of more slack inthe economy during the phase of adjustment).Overall, boosting adjustment capacity will not onlyrequire policy measures targeted at the exportsector but also reforms in the non-tradable sector.

The need to reallocate capital and labour acrosssectors involved in adjustment processes points atthe importance of a well-functioning financialsector. The crisis has negatively affected financialintermediation, thereby hampering the necessaryreallocation of capital and, consequently, labouracross sectors. Ongoing efforts to restore the full-functioning of the financial sector are thereforecrucial for competitiveness adjustment processeswithin the euro area.

Another area where reform could facilitatecompetitiveness adjustment is non-pricecompetitiveness. The adjustment capacity will alsodepend on Member States' degree of non-price

hted as an importantchannel in the case of the positive impact of theeuro on trade. (32) The introduction of the euroseems to have reduced fixed costs related toexternal trade, allowing companies which werepreviously not exporting to offer their product onthe intra-euro-area market and those alreadyexporting to extend the range of products soldabroad. This effect seems to have played outrelatively rapidly without involving the traditionalprice channel where export market shares aregained by undercutting competitors' prices. (33)Further work is probably needed before theextensive margin can be turned into an operationalpolicy lever. There might, however, be a case for

the current account that is associated with full useof labour and capital resources.

Moving the economy to a more sustainable pathwill require unwinding all past excesses andtherefore not only improving the p

reducing the relative prices of non-tradable. Theprice rebalancing will be associated with re-channelling of capital and labour resources fromthe non-tradable to the tradable sector. Overall, thechange in the price of non-tradable will be neededto avoid a protracted period of underutilisation ofcapital and labour resources. This means thatprice/wage flexibility in the non-tradable sector(mostly services) will partly determine the speedof the competitiveness adjustment.

An important dimension of a country's adjustment

competition. Measures aimed at fuellinginnovation and raising product quality wouldclearly alleviate the necessary price adjustment incountries which have lost significant pricecompetitiveness. Many of these measures,however, are characterised by long lags whichlimit their usefulness in the current adjustmentprocess. (30)

A maybe more promising avenue to enhance non-price competitiveness relates to the so-called"extensive margin" or product variety. Empiricaltrade studies have pinpointed the important roleplayed by increased product variety in the tradecreation among advanced economies. For instance,Hummels and Klenow (2005), conclude that newproduct varieties account for about 60% of tradecreation in larger economies. (31) The extensivemargin has also been highlig

(30) There is evidence that increases in product quality havecontributed substantially to the strong export growthregistered in Central and Eastern European countries overthe past decade. This may, however, be largely explainedby a technological catching-up process. Whether similarrapid gains in product quality can be achieved in countrieswhich are already well integrated in the global economy isquestionable. See: Fabrizio, S., D. Igan and A. Mody, 'Thedynamics of product quality and internationalcompetitiveness', IMF working Paper, No. WP/07/97.

(31) Hummels, D. and P. J. Klenow, 2005, 'The variety andquality of a nation’s exports', American Economic Review,Vol. 95, No. 3, pp. 704-723.

(32) See for instance, Baldwin et al (2008), 'Study on the impactof the euro on trade and foreign direct investment',European Economy, Economic Papers No. 321 (May),European Commission, DG Economic and FinancialAffairs.

(33) Several studies estimating the time pattern of the effect ofthe euro on trade report a euro-induced increase in tradealready in 1999. See for instance Flam, H. and H.Nordström (2006), 'Euro effects on the intensive andextensive margins of trade', CESIfo Working Paper No.1881, December.

33


looking into measures that could facilitate theaccess to foreign markets by small and mediumsized companies. As these companies' productsalready exist, policies relying on the extensivemargin could prop up exports more rapidly thanpolicies aimed at raising product quality.

Finally, it is worth stressing the potential benefitsof policy coordination across Member States inadjustment processes. Scope for coordinationarises from the existence of financial,competitiveness and trade spillovers. The financialcrisis has amply demonstrated the potentialstrength of financial spillovers either via cross-border bank links or via cross-border contagioneffects, particularly on sovereign bond markets.Scope for coordination also arises from the factthat competitiveness imbalances within the euroarea feature in both current account surpluses and

deficits. A coordinated pr uld thereforehelp reduce the amount of demand andprice adjustment to be done iven MemberState. In addition, an adjustment(involving some M tes withcompetitiveness adjustm t all ofthem) is likely to affect th unt and thecompetitive position of t tates whichshow no adjustment need d efforts torebalance demand and ess couldproduce a smoother adju ith smalleradjustment costs for s a whole.However, the adjust mains theresponsibility of each ber State.Any country with a need mustprimarily adjust its ow Gains fromchanges in inflation an and in thetrade partners depend de weightsand are only of second

ocess wodomesticin any g

asymmetricember Sta

ent needs but noe current accohe Member Ss. Coordinate

competitivenstment path w

the euro area ament effort reindividual Mem

n adjustmentn imbalances.d domestic demon bilateral tra

order.

34


35

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461

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611

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230

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311

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559

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120

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Part IIOverall Assessment and Policy Implications

1. OVERALL COMPETITIVENESS ASSESSEMENT

38

rearecovery gathers momentum.

ess are, at best, moderate, andeffective real exchange rates are still substantially

likely to have a lasting economic impact

alstha

it, weak competitiveness and veryhigh public debt.

bsizeable current account surpluses (DE, NL, LU,

he crisis (BE, FR, IT, FI). Both Belgiumand France suffer from unfavourable geographical

While the financial crisis has triggered an abrupt(and partly temporary) unwinding of some of theexternal imbalances that have hampered thefunctioning of EMU, significant imbalancesremain in place. The present report shows that theobserved correction process is far from beingcompleted as both external imbalances andunderlying domestic imbalances have only partlybeen resolved. Most notably, in most MemberStates concerned, recent corrections in externalimbalances have been bearing more on quantitiesthan on prices, and changes in relative prices andcompetitiveness adjustment have so far beenlimited. There is a significant risk that externalimbalances increase again once the euro-a

On the basis of the horizontal analysis presented inPart 1 of the report and the detailed countryanalysis presented in Part 3, the following overallcompetitiveness assessment can be made for euro-area Member States.

Member States which have accumulated largecurrent account deficits since the late 1990s andentered the crisis with largely overvalued realexchange rates (ES, PT and in particular EL) stillface substantial competitiveness adjustment needs.Greece is a case apart in the light of the extent ofthe imbalances, its structural weaknesses andpersistent losses in competitiveness. In some ofthese countries, the crisis has brought a reductionin current account deficits mostly via its effect onprivate sector balance sheets. However, part of theobserved current account correction could provetemporary and revert when the economy recovers.Furthermore, signs of improvements in price/costcompetitiven

overvalued. Net foreign liabilities also remainlarge in the three countries. These countriesentered the crisis with overstretched balance sheetsin the private sector and, particularly in Spain,oversized housing markets. There have beenimprovements in these underlying domesticimbalances but further significant progress isneeded and the burst of the real estate bubble is

aggravate the burden of external liabilities and,together with a high degree of labour and productmarket rigidities, could hamper competitivenessadjustment. Overall, these countries can be said tosuffer from large external imbalances with Greecestanding out due to a combination of large currentaccount defic

particularly on employment. Potential output couldo be more affected by the crisis in this groupn in the rest of the euro area. This would

Mem er States which entered the crisis with

AT) have seen a significant cut in their externalbalances over 2008-09. This reflects the combinedeffect of relatively resilient domestic demand inthe face of the crisis and a strong exposure to theslump in world trade. Much of the rebalancing ofthe current accounts seems, however, to be of acyclical nature and could be reversed when therecovery gathers momentum.

Member States that have recently joined the euro(CY, MT, SI, SK) face varying degrees ofcompetitiveness problems. Due to limitedstatistical information, the competitivenessassessment of these countries should be consideredwith caution. Special mention should be made ofCyprus which has experienced large currentaccount imbalances

A number of Member States do not register largecurrent account deficits but showed worryingstructural weaknesses in the export sector alreadybefore t

and sectoral export composition, which threatenstheir export performance in the long run. Italycontinues to underperform due to persistentchallenges in product and labour markets. Thefinancial crisis has exposed severe structuralweaknesses in the export sector of Finland, whichare reflected in a lasting reduction of its currentaccount surplus.

Special mention should also be made of Irelandwhere the impact of the crisis has been particularlystrong. In terms of the existing imbalances, thecountry shares a number of features with thecountries in the large current-account deficitgroup. However, the assessment of thecompetitiveness situation is more favourable forIreland than for other deficit countries due to its


39

proven adjustment capacity and its lower currentaccount deficit. In fact, Ireland has already beenable to regain substantially competitiveness due to

strong wage moderation – in particular in thepublic sector – and flexible labour markets.

2. POLICY IMPLICATIONS

40

Reducing imbalances requires a co-ordinated effortith current-accountoordination across

This report has shown that external imbalances andunderlying domestic imbalances remain a sourceof concern in the euro area. In order to improve thefunctioning of EMU, to reduce the significanteconomic hardship imposed by the crisis on partsof the population and to ensure a sustainablerecovery, these imbalances need to be addressed.The present section discusses a set of policymeasures geared at speeding up and improvingintra-area adjustment mechanisms. In particular,steps should be taken in four key areas:macroeconomic policies, credit markets, labourmarkets, and product markets. Reflectingdifferences in Member States' adjustment needs,these policy measures are country specific.(34)

involving both countries wdeficits and surpluses. CMember States would facilitate competitivenessadjustment because of the existence of pricecompetitiveness, trade and financial cross-borderspillovers. The need for coordination also derivesfrom the fact that the smooth adjustment of theeuro area is a responsibility for all of its members.The adjustment effort remains the responsibility ofeach individual Member State. But coordinatedefforts to rebalance demand and prices wouldproduce a smoother adjustment path and smalleradjustment costs. Coordination could take variousforms, including agreement on a commondiagnosis and on the nature of the policy responseneeded, regular exchanges of information aboutpolicy measures with competitiveness implicationsfor the euro area, etc.. The Eurogroup can play akey role in the coordination process by identifyingadjustment needs and fostering a commondiagnosis.

The range of policy measures discussed hereaftershould also be seen in the context of the design ofexit strategies. As the economy is firming, policyresponses to the crisis need to be broadenedbeyond short-term demand management to redressthe supply-side forces of euro-area economies. Thecomprehensive and coordinated exit strategies ineuro-area Member States need to take into account

(34) Country references build upon and are fully consistent withthe Commission's existing policy priorities as identified inthe Council Opinions on the Stability and ConvergenceProgrammes as well as recommendations under the Lisbonstrategy.

their impact on competitiveness and currentaccount imbalances. In particular, the supply sidemeasures taken in the context of exit strategiesshould contribute as much as possible torebalancing competitiveness within the euro areaand to facilitating necessary labour and capitalreallocation.

2.1. GENERAL MACROECONOMIC POLICIES

e

A coordinated approach does not mean an identicalpolicy response in all Member States. Due to largedifferences in the scope and nature of adjustmentneeds, the mix of proposed policy measures shouldbe country specific. In particular, an importantdistinction should be made between currentaccount deficit and surplus countries. MemberStates which have accumulated large currentaccount deficits have also incurred largecompetitiveness losses. They need both to regaincompetitiveness and address the sources ofpersistent weakness in domestic savings. Incontrast, surplus countries should tackle structuralimpediments to domestic demand. The policyresponse to intra-euro-area macroeconomicimbalances should obviously not include a call forreduced competitiveness in surplus countries asthis could only lead to higher unemployment inthese countries. Moreover, strong competitivenessof all euro-area Member States, including surpluscountries, is in the interest of the euro area as awhole.

A few Member States face large accumulatedlosses in price/cost competitiveness which must beaddressed urgently. Commission Autumn 2009projections suggest that with unchanged policies,there will be little rebalancing of competitivepositions in 2010-11. In the absence of policyintervention, there is a high risk that current-account differences will widen again in the euro

prireaneelar

ffconrelcom

area in the coming years. To avoid such a scenario,ce and cost adjustment (i.e. depreciation of thel effective exchange rate) would be particularlyded in Member States which have accumulated

ge losses in competitiveness in recent years. InIreland, the ongoing depreciation of the real

ective exchange rate should be allowed totinue. In all the countries concerned, the cuts in

ative unit labour costs needed to restorepetitiveness should be achieved via a


ided that this does notaffect public finances, measures to reduce non-wage costs could also be considered.

Even in the absence of national monetary policy,

ding wage formationshould be seen as quite important in Member

To avoid such a scenario, there is a need toidentify and tackle the structural sources ofpersistent weakness in some parts of private sector

of possible factorsincluding the drivers of household savings and ofdisposable income, balance sheet consolidation

ector, the sources ofpersistent weakness in investment and insufficient

have strong sectoralimplications which will require specific policy

benefit from policies aimed at facilitating labour

tratheemcon

Poadj

combination of wage adjustments and faster gainsin labour productivity. Prov

policy makers can influence inflation rates andwages. In most Member States, wages are formedin a collective bargaining process betweenemployers' and employees' representatives withoutformal involvement of governments. Nevertheless,policy-makers can affect wage setting processesvia a number of ways, including the provision ofinformation or wage rules, tripartite agreementsand changes to wage-indexation rules.Governments may also try to influence theoutcome of wage bargaining by offering changesto labour taxation, including social securitycontributions to increase wage-earners' net income.In the current context, it is important that suchchanges do not weigh on public finance conditionsby increasing deficits; the measures should becompensated elsewhere. As the recent example ofIreland shows, they can also set a signal throughagreements on public sector wages. As discussedin Part III, bringing public sector wages in linewith inflation and productivity trends emerges asan important issue in Member States such asGreece, Italy, Cyprus and Malta. More generally,the role of government in gui

States facing large competitiveness adjustments.Competitiveness adjustment processes revertingcompetitiveness losses tend to be more orderly andless costly in terms of employment if they are theresult of coordinated efforts by social partnersrather than deteriorating labour market conditions.This, however, necessitates the emergence of astrong consensus among social partners about theneed to monitor competitiveness, avoid externalimbalances or correct them once they have arisen.

The correction of external imbalances within theeuro area will also be helped if Member Stateswhich accumulated large current account surplusesin pre-crisis years address the sources of structuralweakness in domestic demand. As highlightedabove, in the absence of policy intervention, thereis a high risk that current-account differences willwiden again in the euro area in the coming years.

demand in current-account surplus countries. Thisimplies looking at a range

processes in the corporate s

growth in the service sector.

Continued surveillance of the domestic imbalancesthat underlie external imbalances appearswarranted. This is particularly true of domesticimbalances rooted in credit and housing markets.In spite of recent signs of balance sheet adjustmentin the private sector, further consolidation appearsneeded in some Member States with large currentaccount deficits, particularly in the corporatesector. Furthermore, it is difficult to assess to whatextent the ongoing adjustment is of a cyclical or amore permanent nature. As the recovery sets in,signs of re-emergence of excesses in some of thesemarkets cannot be excluded and would then callfor appropriate policy measures. As discussedfurther in Sections II.2.4 and II.2.5, there is also aneed to address the factors that hinder competitionand the adjustment capacity of both surplus anddeficit countries. In particular, in some surpluscountries more competition is needed to unleashthe growth potential of the service sector.

Adjustment will also

measures. Member States facing a competitivenessadjustment problem will need to redirect bothcapital and labour resources from the non-tradablesector to the export sector. Conversely, MemberStates which accumulated large current accountsurpluses in pre-crisis years will need to boost theirnon-tradable sector (particularly services).Additional sectoral challenges relate to the impactof the crisis on specific industries (particularlyfinancial services and automotive construction).Overall, sectoral reallocation processes associatedwith the correction of external imbalances willrequire an effective financial sector and would

and capital mobility. This could, however, implyde-offs between the short-term needs to cushion

impact of the crisis (particularly onployment) and competitiveness rebalancingsiderations.

licies aimed at facilitating competitivenessustment should also take into account the likely

41


effect of the crisis on potential output. CurrentEuropean Commission estimates suggest that thenegative impact of the economic and financialcrisis on potential growth could be significantlystronger in some countries also facing significantcompetitiveness adjustment needs. In thesecountries, the case for implementing policiestargeted at raising potential output and offsettingthe effect of the crisis is even stronger than in therest of the euro area. As such policies take time toplay out – and to the extent that the crisis impactspotential via reduced productivity growth – it isalso critical that wage bargaining systems fullytake account of the combined constraints posed bycompetitiveness rebalancing and reducedproductivity.

2.2. PUBLIC FINANCES

er States with large currentaccount deficits, are required to undertake

needs. Swift and determined consolidation efforts

ll respect ofe overall consolidation needs, countries with

large external deficits and competitiveness

labour hereby contribute to adepreciation of the real exchange rate. Conversely,

Fiscal consolidation requirements must give dueweight to the impact of competitivenessadjustment on revenues and debt dynamics. In thecountries with large current account deficits andaccumulated losses in competitiveness, publicfinances were particularly hard hit in the downturnand now face serious challenges. These countriesare likely to experience sluggish growth in theyears to come due to persistent balance sheetadjustment, sectoral re-allocations and a possiblereduction of potential growth. In addition, fiscalrevenues could be particularly affected as tax-richincome components shrink. For example, taxrevenues related to the property market havealready fallen strongly in Ireland and are likely toremain weak. Recent budgetary decisions inIreland have already responded to that challenge.

In order to forestall sustainability problems arisingfrom a drastic revision in growth, the December2009 Council decisions on the Excessive DeficitProcedures recognised for the first time explicitlythe role of external imbalances as an importantrelevant factor for determining the deadline forcorrection and the pace of fiscal adjustment,including the year when consolidation should start.Ceteris paribus, Memb

th

particularly sizeable fiscal consolidations,addressing the relatively large fiscal adjustment

fiscal imbalances can be considered one of the rootcauses of macroeconomic imbalances and wherefragilities and heightened sustainability concernsin the public sector finances are widelyacknowledged as a primary source of the country'svulnerabilities. In countries where weaknesses inthe fiscal framework contributed to fuellingexternal imbalances in the past, primaryexpenditure control and increasing theeffectiveness and efficiency of public finances willbe imperative.

Fiscal policies aimed at speeding up structuraladjustment and reducing current accountimbalances should be considered when designingexit strategies.(

– in line with the measures announced on 3 March– are particularly needed for Greece where sizable

35) The composition of theconsolidation should take into accountcompetitiveness challenges. The size ofconsolidation needs suggests for most MemberStates to pursue a consolidation strategy thatcombines measures on the expenditure and therevenue side. Competitiveness can be affected bychanging the composition of taxes andexpenditure. For example, raising VAT whilereducing labour taxes or corporate taxes raises thecompetitiveness of a country and reduces itsrelative unit labour cost. (36) Similarly, productive(e.g. R&D) vs. non-productive spending hascompetitiveness effects. While in fu

challenges could take measures that reduce unitcosts and t

countries with large external surpluses shouldrefrain from measures that would result in a furtherreduction of relative unit labour costs. Moregenerally, countries should avoid measures thatincrease competitiveness imbalances during theconsolidation process. Instead, fiscal policymeasures should facilitate necessary adjustment

( ) For further discussion see Barrios, S., S. Langedijk and L.

Occasional Papers, European Commission, DirectorateGeneral for Economic and Financial Affairs, forthcoming.

onetary policy?, CESifo Economic Studies 49(3), 3-

35

Pench (2010), "External imbalances and public finances inthe EU". Proceedings to the Annual Workshop on PublicFinances (27 November 2009) European Economy.

(36) See for example, Calmfors (2003), Fiscal policy to stabilizethe domestic economy in the EMU: What can we learnfrom m19 and Lane and Perotti (2003), The importance ofcomposition of fiscal policy: evidence from differentexchange rate regimes, Journal of Public Economics 87,2253-2279.

42


full functioningof financial intermediation need to be taken

countrieswith significant competitiveness adjustment needs

Policy measures targeted at facilitating balance

use of external funding and at reducing the costwedge between external and internal funds (e.g. by

usenee

ductivity developmentscontribute to the adjustment of externalimbalances. Reform priorities differ considerably

smarket utions, and in terms ofconstraints on account of the fiscal situation and

f wages with(regional and sectoral) productivity developments

processes by, for example, facilitating labourreallocation across sectors.

2.3. CREDIT MARKETS AND BALANCE SHEETS

Effective measures to restore the

urgently to reduce the impact of the crisis onpotential growth and facilitate competitivenessadjustments. Financial sector measures will beespecially needed in countries with large and/orfragile banking sectors. The restoration of financialmarkets is also particularly important in

as, for example, the necessary reallocation ofproduction factors across sectors requires well-functioning financial intermediation. Moreover, inmost current-account deficit countries the bankingsector also plays a critical role in channellingforeign capital inflows to the private sector. In theongoing crisis, banks in the concerned MemberStates have continued to receive capital throughthe generous liquidity provision of the Eurosystem.Once the recovery takes hold and the ECBwithdraws its exceptional liquidity provision, thefinancing of current account deficits will cruciallydepend on the ability of banks in the respectiveMember States to secure financing in theinternational capital market.

sheet adjustment in the non-financial sector wouldalso ease the adjustment to external imbalances.Member States which entered the crisis withcompetitiveness problems also face variousdegrees of balance sheet stress in the privatesector. The partial correction of these balance sheetproblems has contributed to the sharp falls indomestic demand observed during the crisis andfurther correction will likely take place in the shortto medium-term. Policy measures targeted atspeeding up balance sheet adjustment would alsofacilitate competitiveness adjustment. Forexample, measures aimed at fostering companies'

persistent corporate balance sheet consolidation insome surplus countries. (

facilitating access to securities market) could beful in this respect. In addition, there is also ad to look into the determinants of past and

37)

2.4. LABOUR MARKETS

Reforms in labour markets should naturally be topof the agenda to improve the functioning ofcompetitiveness adjustment. Econometric evidenceconfirms that structural characteristics of thelabour markets affect the effectiveness and speedof the competitiveness channel. (38) Low labourmobility hinders the reallocation of productionfactors across sectors and increases the burden ofnominal adjustment. Moreover, some features ofwage formation processes can reduce wageflexibility and fuel unit labour cost growth.Finally, labour market reforms should beconducive to increasing labour supply, which isparticularly pertinent in the current situation ofdecelerating potential growth. Reforms thatimprove flexicurity, promote labour mobilityacross regions and occupations and enhance theresponse of wages to pro

acros euro-area countries, both in terms of labouroutcomes and instit

external competitiveness.

The detailed assessment in Part III shows thatissues related to wage setting are importantcompetitiveness factors. It is especially the case incountries with significant external deficits,including the catching-up new euro-area members,but also for several countries in surplus or withmoderate deficits. The realignment o

appears important in Italy, given the markeddeterioration in cost and price competitiveness,and against the background of severe market sharelosses. In Germany, against the background of lowaggregate wage growth, insufficient wage

(37) As suggested by the German example, incentives imbeddedin the tax system could be examined in that context. Formore discussion see European Commission (2010), 'Theimpact of the global crisis on competitiveness and currentaccount divergence in the euro area', Quarterly Report onthe Euro Area, No. 1.

(38) European Commission (2008), 'EMU@10 – Successes andchallenges after 10 years of Economic and MonetaryUnion', European Economy No. 2/2008, EuropeanCommission, DG Economic and Financial Affairs.

43


ntral fortackling competitiveness challenges. Policies

stressed the importance ofreforms that shift the focus from protection on the

differentiation remains a key issue, hamperinginter alia the development of a services sector. Inthis country, reforms addressing the structuralweaknesses in the tax-benefit system wouldcontribute to strengthening the domestic sources ofgrowth and support a rebalancing of export-basedgrowth. Overall, an efficient wage setting processreflecting productivity developments and allowingfor sectoral wage differentiation is ce

should facilitate the reallocation of productionfactors across sectors and thereby reduce theburden of adjustment in particular regarding wagesand prices. Policy measures aimed at, for instance,retraining workers and reducing skills mismatcheswould be instrumental in allowing for a rapidreallocation of productive resources across sectorsand regions. Measures should secure employabilityrather than saving specific jobs and firms.

Rebalancing the degree of employment protectionlegislation between different segments of thelabour market while ensuring the provision ofadequate income support is needed especially incountries such as BE, DE, EL, ES, FR, IT, PT andSI. In line with the "flexicurity" approach, thisneeds to be implemented in parallel with theintroduction of ambitious and effective activationand training measures, along with increasedcapacity and cost-effectiveness of publicemployment services. Activation policies could beenhanced in most euro-area countries. TheCommission has

job to insurance in the market. (39) These reformsshould reconcile workers' demands for protectionfrom unemployment and income risks with theneed of firms to respond quickly to swings inconsumers' preferences and to the challenges andinstability created by technological progress andglobalisation. Increasing the effectiveness andefficiency of public employment services is alsoimportant in PT, SI and SK. Reducing benefitdependency is also important. In particular,countries such as BE, DE, EL, FR, MT, NL, AT,SI and FI should aim at removing inactivity andunemployment traps.

Finally, increasing participation and the effectiveretirement age are crucial to minimise the social

(39) European Commission Communication “TowardsCommon Principles of Flexicurity”, COM(2007) 359 final.

ultimately, to return to stronggrowth. ( ) Pressures on the labour market

es in pension systems should be highon the agenda of some countries, in particular in

Econometric evidence confirms that structural

consequences of the crisis, to preserve Europeanhuman capital and,

40

resulting from the strong fall in demand should notbe used to engage in early retirement schemes orlower participation as these would further burdenpotential growth and not resolve the underlyingcompetitiveness problems. As indicated in Part III,raising labour force participation levels should behigh on the agenda in Italy and Cyprus. Increasingthe effective retirement age by enabling andmotivating people to work longer through labourmarket policies promoting better age-managementpractices in work places and ambitious reforms ofwork incentiv

AT, BE, FR, EL, LU and SI. The effectiveimplementation of such measures would take placeover a longer period of time, but decisions takennow would help anchor expectations which, inturn, would help to underpin the present economicrecovery. In particular, pension reforms thatimprove the sustainability of public finances, evenonly in the long run, are likely to reduce riskpremiums particularly in high debt countries. Tothe extent that they increase labour supply, suchreforms would furthermore increase potentialoutput and help keep wage developmentssupportive of price competitiveness.

2.5. PRODUCT MARKETS, KNOWLEDGE ANDINNOVATION

Reforms in product markets are also instrumentalto reducing competitiveness divergence.

characteristics of the product markets affect theeffectiveness and speed of the competitivenesschannel. (41) Tight product market regulationappears either to reduce the responsiveness of thecompetitiveness channel to demand differences orto slow its functioning.

Measures that improve the functioning of productmarkets help to contain divergences in

(40) See European Commission "2009 Ageing Report",European Commission European Economy, No 2, May2009.

41) European Commission (2008), 'EMU@10 – Successes andchallenges after 10 years of Economic and MonetaryUnion', European Economy No. 2/2008, EuropeanCommission, DG Economic and Financial Affairs.

(

44


competitiveness and improve the adjustmentcapacity. More flexible product markets facilitatethe changes in relative prices necessary to adjust toaccumulated losses in competitiveness. Policiesthat support higher productivity developments arealso relevant, in particular policies to increase thelevel and quality of investments.

The role that prices of non-tradables play in theadjustment process suggests that policies thatimprove productivity, flexibility or competitionoutside the export sector also matter, in particularpolicies that promote competition in the servicessector (largely non-tradable) are useful.

The review provided in Part III shows that, in anumber of Member States, there is a need tostrengthen competition in domestic goods andservices markets and improve the businessenvironment. In countries with external deficits,accumulated losses in competitiveness or structuralweaknesses in the export performance,strengthened competition should help to achieve amore efficient allocation of resources and facilitateprice adjustment. With a view to unlocking the

tial of the services sector to spur domesticand, they are also relevant in some surplus

ntries (DE, NL). Improving the businessironment and reducing administrative burdenld also facilitate adjustment (EL, IT, LU, PTSK).

rts to boost non-prices competitiveness areded both in Member States facing large pricestment needs and those which suffer fromctural weakness in the export performance. Inent-account deficit countries, policies aimed atroving non-price competitiveness wouldce the necessary price adjustment. These

ude measures aimed at fuelling innovation,ing product quality, focusing more on fast-wing destinations and facilitating access toorts markets by small and medium sizedrprises. (42) In Belgium and France, there is a

d to tackle a structural weakness in the export

potendemcouenvwouand

Effoneeadjustrucurrimpreduinclraisgroexpentenee

For instance, a survey conducted for the EuropeanCommission shows that further harmonisation of regulationin the Single Market could have a significantly positiveeffect on the participation of small and medium sizedenterprises in the cross-border trade in the EU. SeeEuropean Commission, 2008, Business attitudes towardscross-border sales and consumer protection. FlashEurobarometer 224.

sector and marked losses in export market shares,which can only partly be explained by losses inprice competitiveness.

Accelerating productivity growth and raising thetechnology-intensity of the economy rank high onthe competitiveness agenda. Speeding upproductivity growth by improving the knowledgeeconomy would obviously be beneficial allMember States but benefits would be particularlyhigh in countries facing large competiti nessadjustment both because faster productivity growthwould facilitate necessary labour cost adju entand because productivity could be more stronglyimpaired by the crisis in these couMoreover, specific needs to improve parts of theknowledge economy also exist in some herMember States. For instance, there is scope toimprove R&D and innovation policies in IE, EL,ES, IT, CY, NL, SI, SK. Further challenges linkedto productivity developments in the longer termrelate to improvements in education systems andhuman capital formation (BE, DE, IE, ES, F , IT,CY, NL, AT, PT and SI).

2.6. LOOKING AHEAD – SOME MEDIUM-TERMCONSIDERATIONS

Looking further ahead, i.e. beyond pressingcompetitiveness adjustment needs, it is alsoimportant to reflect on possible avenues forimproving the surveillance of intra-eurimbalances and preventing/tackling their futureemergence. This sub-section briefly sketches anumber of policy areas where further reflection isnecessary to make surveillance of ex rnalimbalances in EMU more effective.

Countercyclical fiscal policy can dampencompetitiveness and current account dive ncebut its impact should not be overestimated. Inparticular, improving the government balance cancontribute to reduce the economy's current-accountdeficit by lowering domestic demand s.The empirical literature has generally nd thatfiscal policy affects aggregate dem , eventhough the fiscal multiplier is lower one.Nevertheless, the scope for active coun licalbudgetary policy to stem competitiven lossesand related overheating dynamics is relativelylimited. First of all, its effectiveness in dampeningurrent account divergence should not be

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45


overestimated since government savings are partlyoffset by private sector de-savings. Moreover, thelargest part of current account divergence in theeuro area in the last decade was driven by privatesector decision. While macroeconomic fiscalpolicy can somewhat counteract these privatesector dynamics, it cannot effectively address theirroot causes (e.g., exuberant expectations regardingasset prices or future income prospects).

Much of the intra-area external imbalancesaccumulated during the early years of EMU can betraced back to excessive credit cycles and assetprice bubbles. This has increased considerably theexposure of the countries concerned to thefinancial turmoil and led to much more abruptcorrection processes than had previously beenexpected on the basis of the sole working of thecompetitiveness adjustment mechanisms. A keychallenge for policy makers is therefore to detectthe emergence of excessive credit cycles and assetprice bubbles as well as prevent or reduce theirformation. Against this background, it is necessaryto devise and put in place structural reforms that

it the occurrence of credit and asset priceesses but also devise specific instruments tol-off credit and asset markets if necessary. Thee is particularly critical in the euro area whereit and monetary dynamics have proved to be

ogeneous across euro-area Memberes and where regional credit cycles that do note aggregate effects cannot be addressed byetary policy.

articular, reducing the pro-cyclicality of creditply via appropriate regulation appears to beicularly relevant in a monetary union.ulatory measures to reduce the pro-cyclicalityredit supply that are currently being discussedconomic and policy circles should also be seenthe context of country-specific credit cycles.ther work is necessary to assess whether and

gulatory measures on bank balance sheetsd also contribute to dampen regional – as

osed to euro-area wide – credit cycles and assetubbles. Without prejudice to the internal

ket, this could mean to ensure that bank capitalirements duly reflect regional differences int risks as measured, for instance, by regionalsures of overvaluations in asset prices. Forks operating across borders, capital

requirement could then be ked to the residencyof the borrower.

Structural features of the housing market such astax incentives as well as mortgage-relatedregulation clearly influence housing markets andcan increase the likelihood of housing bubbles. Acentral determinant of house prices is the after-taxnominal interest rate, which is the differencebetween the nominal interest rate and the taxwedge. Policymakers could therefore re-examinetheir taxation systems and carefully balance thecost and benefits of subsidies to the housing sectorsuch as allowing deductions for mortgage interestpayments.

The existence of financial imbalances underlyingcurrent account and competitiveness divergenceshould also be seen in the context of potentialsystemic risk implications. Strong and mutuallyreinforcing dynamics in credit markets and assetprices have been identified as key drivers ofcurrent account divergence in the euro area leadingto the build-up of significant imbalances in privatesector debt. The financial crisis has shown thatimbalances in some parts of the financial marketcan trigger chain reactions with effects on thesystem as a whole. Fast-growing credit in specificsectors or regions is therefore also a concern formacro-prudential supervision as it could imply abuild-up of systemic risk. These considerationsraise the issue of the link between competitivenesssurveillance, the prevention of harmfulcompetitiveness divergences within the euro areaand the macro-prudential risk assessment to becarried out by the European Systemic Risk Board.

Finally, in-depth assessment and monitoring of theallocation of capital inflows into current accountdeficit countries appears warranted in the euroarea. Since the inception of the euro, inflows offoreign capital into Member States with largecurrent-account deficits had ten to be mostlychannelled to the household an using sectorsvia the banking sector. In contr capital inflowsinto productive sectors via corporate bonds andequity markets had remained co aratively weak.Uncovering the determinants the relativeunattractiveness of corporate investment thereforeappears warranted.

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nced

grow

thst

ruct

ure

diff

eren

tiatio

n

need

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dequ

ate

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ese

tt

nom

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and/

orlle

nges

stab

lean

dse

ctor

alex

port

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grow

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depr

ecia

tion;

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mes

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ion

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ctor

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ti(U

LC);

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ther

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r

ing

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DE

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in10

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(slig

ht

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van

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din

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de de in

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prov

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ur ing

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ng

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0

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09 larg

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09ab

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-pr

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tivity

grow

th;r

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eed

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ate

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high

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limite

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nes

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de la 09

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en

uced

mey ti

n

nt ent

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in mar

in mar

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)

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es(sl

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(des

ups)

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over

trec

over

Sour

ce:

omm

issio

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es.

C

47


48

Tabl

eII.

2.2:

Syno

psis

ofco

untry

-sp

ecifi

cco

mp

etiti

vene

ssde

velo

pmen

tsan

dch

alle

nges

(II)

CY

(mar

ked)

appr

ecia

tion,

cont

inue

safte

r09

(dep

reci

atio

nin

07-0

9ba

sed

onU

LC)

NA

dete

riora

ting

until

08,v

ery

larg

edef

icit;

partl

yre

vers

edin

09m

arke

dlo

sses

high

priv

ates

ecto

rind

ebte

dnes

s,ra

pid

cred

itex

pans

ion

(unt

il20

08);

insu

ffici

ents

ecto

ralw

aged

iffer

entia

tion,

not

refle

ctin

gpr

oduc

tivity

grow

th;n

eed

forw

agem

oder

atio

nin

publ

icse

ctor

;low

fem

alea

ndol

d-ag

epar

ticip

atio

nra

tes

LUN

AN

Asta

ble,

larg

esur

plus

(dip

in08

)N

Aun

favo

urab

lege

ogra

phic

alex

port

com

posit

ion;

wag

efo

rmat

ion;

low

prod

uctiv

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owth

MT

stabl

e;ap

prec

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gtre

ndin

09-

11(U

LC)

NA

larg

edef

icit;

impr

ovin

gov

er07

-09

Ver

yla

rgel

osse

s

low

prod

uctiv

itygr

owth

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sect

oral

expo

rtdi

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ifica

tion;

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aged

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entia

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efle

ctin

gpr

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grow

th;n

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forw

age

mod

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blic

sect

or

NL

(slig

ht)a

ppre

ciat

ion;

upin

09-

11(U

LC)

sligh

tlyun

derv

alue

din

2008

,fai

rlyva

lued

in20

09str

ong

surp

lus;

dow

nin

08-

09sli

ghtg

ains

over

09-1

1str

ong

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ports

);lo

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AT

(slig

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09-

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08,f

airly

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2009

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lus,

dow

nin

09ga

ins,

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esin

ce02

unfa

vour

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expo

rtco

mpo

sitio

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iftto

high

erva

lue-

adde

dou

tput

need

ed

PT(s

light

)app

reci

atio

n,up

in09

-11

over

valu

edin

2008

and

2009

chro

nicv

ery

larg

edef

icit

Rela

tivel

yco

ntai

ned

loss

es,

sta-b

lesin

ce05

unfa

vour

able

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raph

ical

and

sect

oral

expo

rtco

mpo

sitio

n;in

suffi

cien

tcom

petit

ion;

rath

erlo

wpr

oduc

tivity

grow

th;h

igh

exte

rnal

debt

,risi

ngde

btse

rvic

ebu

rden

SIap

prec

iatio

nra

ther

fairl

yva

lued

in20

09an

d20

10de

terio

ratin

gto

larg

edef

icit

in08

;rev

ersa

lin

09str

ong

gain

s;lo

ssin

09,s

tabl

eaf

terw

ards

wag

eset

ting

inlin

ewith

prod

uctiv

itygr

owth

;cat

chin

g-up

(BS

effe

ct);

unfa

vour

able

sect

oral

expo

rtco

mpo

sitio

n

SKsh

arp

appr

ecia

tion;

slow

ing

dow

nov

er09

-11

over

valu

edin

2008

and

2009

stabl

elar

gede

ficit

stron

gga

ins;

loss

in09

,sta

ble

afte

rwar

ds

stron

gre

alap

prec

iatio

nv-à-

vno

n-eu

rone

ighb

ours

;ca

tchi

ngup

(BS

effe

ct);

wag

eset

ting

inlin

ewith

prod

uctiv

itygr

owth

FIde

prec

iatio

n(b

utU

LCup

in08

-09

,sta

blea

fter)

sligh

tlyun

derv

alue

din

2008

;fai

rlyva

lued

in20

09fa

lling

surp

lus(

clos

eto

bala

ncei

n09

)ga

ins;

stron

glo

ssin

09w

ageg

row

thno

tref

lect

ing

sect

oral

prod

uctiv

itydi

ffere

ntia

ls;lo

wse

ctor

alex

port

dive

rsifi

catio

n

Sour

ce:C

omm

issio

nse

rvic

es.

Part III

Co

we

e of indicators measuring competitiveness,ators, components of the balance of payments, exportfie

are as fo

s icc

• Ireland: Openness and exposure to non-euro-• Greece: Twin deficits in Greece and the role o• Spain: A permanent correction of the Spanish• France: Demography of firms - recent progre• Italy: Has there been a qualitative upgrading• Cyprus: The structure of the current account b• Luxembourg: Sectoral and geographical com• Malta: Diversifying the export sector towards• The Netherlands: Wage developments and un• Austria: Austrian FDI in the Central and East• Portugal: The external balance beyond the b

transfers and primary income in Portugal's ext• Slovenia: Preserving competitiveness in the e

ovakia lost its edge during thehind the vulnerability of e

e preceding sections to arrive at key messages and

mi

Competitiveness Developuntries

ments In Euro-Area

the same format. The first section sets the stage forristics of foreign trade and its performance, with aments in the balance of trade. The second section

range

The country-specific competitiveness fiches all follothe subsequent analysis by summarising the charactparticular focus on openness indicators and developprovides an overview of developments in a widincluding real effective exchange rates (REER) indicmarket shares, terms of trade, FDI flows and procharacterising sectoral specialisation and comparativ

The content of the subsequent focus section variesthe country in question. The individual topics a

tability measures, as well as structural indicatorsadvantages.43

ccording to the issue considered most pertinent forllows:

n manufacturing and servicesount surplusarea countries (especially the UK and the US)f fiscal and structural policiescurrent account balance?

ss in promoting the growth of firmsof Italian exportsalance and its financing

position of Luxembourg's exportsfast-growing sectors

it labour costsern European Countriesalance of goods and services – the importance ofernal balance

uro areae crisis?xports

• Belgium: Productivity and unit labour cost• Germany: Financial flows and the current a

• Slovakia: Has Sl• Finland: Factors b

The concluding section draws on the analysis in thdiscusses possible policy responses in case of harmimplications of competitiveness developments forreflecting structural challenges identified in earlierpotential growth, it also recalls earlier policy recomneeds issued under the opinions on updated Stabstrategy for growth and jobs.

ful divergence in competitiveness as well as theadjustment in the euro-area context. Apart from

notes to the Eurogroup on labour markets andendations and invitations on structural adjustment

lity Programmes, EDP recommendations and the

43 The cut-off date for all data in the country-specific fiches is mdraw on the Commission Services' autumn 2009 forecast.

id-March 2010. Where 2010 and 2011 are concerned, the fiches

1. BELGIUM

51

and its extensive (transport)

1.1. SETTING THE STAGE: FOREIGN TRADECHARACTERISTICS

Belgium has a very open economy, which is theresult, inter alia, of its central location within theeuro areainfrastructure. Measured in terms of export andimport volumes as a share of GDP, openness stoodat 172% of GDP at the end of 2008. The degree ofopenness has risen continuously in recent years,but declined in 2009 as a result of the sharp drop inboth imports and exports in conjunction with theglobal economic crisis. Goods account for 80%and 82% of total exports and imports, respectively,which exceed the euro area average (80% for bothexports and imports). The share of services in totaltrade has remained broadly stable since 2000.

Graph III.1.1: Evolution of the current account balance (% ofGDP)

-4

-2

0

2

4

6

8

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010f

Goods ServicesIncome Current transfersCurrent account balance


Exports are mainly oriented towards other euroarea countries, with neighbouring Germany,France and the Netherlands accounting for abouthalf of total exports. Belgium appears to bespecialised in medium-technology goods that areeasy to imitate, such as chemicals and steel andless in high technology goods that are difficult toimitate, such as telecom and office (ICT)

onwards, with the surplus shrinking to 0.2% ofGDP in 2008 (Graph III.1.1). The deterioration ofthe current account balance between 2003 and2008 resulted mainly from the goods balance,which evolved from a 4.8% of GDP surplus in2002 to a 1.6% of GDP deficit in 20

equipment.

of

08. Thedeterioration was particularly strong in 2008 (from

Abalancof GD mpared to 0.9% of GDP in

o 0.2%of GDP compared to 3.7% of GDP in 2007).Additionally, export volumes have been growingmore slowly than import volumes since 2003,which may be explained by the sustained growthof Belgian domestic demand, partly the result of anexpansionary fiscal policy, coupled with adisappointing export performance. Indeed, importvolumes increased by an average 5.6% per year,while export volumes only rose at an averageannual rate of 3.7% (compared to annual worldtrade growth of 8.2%). This effect was particularlymarked in 2008 as domestic demand, in particularinvestment, remained resilient while external

d softened, especially in the last quarter, inis.

ightly. This isThe current account balance improved between1981 and 1994, reaching a record surplus of 5.6%

GDP in the latter year. After a period ofctuations around 5% of Gflu DP, the current

account balance started to deteriorate from 2003

a surplus on 1.6% of GDP to a deficit of equalsize). t the same time, the surplus of the services

e showed a marked increase, reaching 2.4%P in 2008, co

2002.

The deterioration can be largely attributed to thedeterioration of the terms of trade (by 4% between2002 and 2008), as a result of the strong increasein oil and other commodity prices. The rise incommodity prices was particularly important in2008 and led, together with the depreciation of theeuro in the second half of the year, to a strongreduction in the current account surplus (t

demanview of the economic cris

In 2009 the current account balance improved to2.0% of GDP, while a smaller surplus of 0.9% ofGDP is expected in 2010. In 2009, the terms oftrade improved, mainly in view of the importantfall in commodity prices, and the fall in importvolumes was even sharper than the slide in exportvolumes. In 2010, the improvement stems from theweakness of imports in view of subduedconsumption and investment, in combination witha stronger pick-up of external demand. The termsof trade are forecast to deteriorate slprojected to continue in 2011 and would, togetherwith a considerable pick-up in domestic demand,lead to a slight decline of the current accountsurplus in that year (to 0.8% of GDP).


cular for high-tech products, such asoffice and communication equipment and, to a

ss ofmarket share beyond what other mature economieshave experienced in the recent past, points to adeterioration of the country's competitive position.

Belgium is more specialised than other euro areacountries in steel, chemicals and carmanufacturing. The strong demand for theseproducts in the recent past has led to an increase inBelgium's exports. On the other hand, Belgium isless specialised in office and telecom equipment(ICT), for which demand also rose strongly. As aresult, product specialisation only had a very smallpositive impact on Belgium's export performance.

he sectoral specialisationcharacterising other euro area countries, in

1.2. INDICATORS OF COMPETITIVENESS

Belgium's unsatisfactory export performance inrecent years is partly explained by its geographicalspecialisation: its exports are mainly orientedtowards other euro area countries, whose importgrowth has been considerably lower than worldtrade growth in recent years. On the other hand,the share of fast-growing markets in Belgianexports is relatively low. As a result, externaldemand addressed to Belgium has expanded byconsiderably less than world trade growth (withaverage annual growth rates in the period between2003 and 2008 of 5.3% and 8.2%, respectively). Inaddition, Belgium's weak export performance alsoresults from its structural loss of market share.(44)From 2003 to date, the cumulative loss of marketshare amounted to 8.5% and this appears to holdfor both goods and services. Belgium lost marketshare in parti

lesser extent, transport equipment. This lo

The positive impact of t

particular neighbouring countries, has beenconsiderably higher.(45) Moreover, the demand forproducts in which Belgium is specialised (inparticular low technology goods) may start to growmore slowly in the future, as already observed fortransport equipment, and price competition maybecome even stronger, thereby putting pressure onexport growth.

(44) As calculated by the grow

Graph III.1.2: Real effective exchange rate using differentdeflators (2000 = 100)

vis-à-vis IC35

95

100

105

110

115

120

1995 1997 1999 2001 2003 2005 2007 2009 2011f

ULC total economy GDP deflatorPrivate consumption deflator Export price deflator

vis-à-vis euro area

100

103

105

108

110

951995 1997 1999 2001 2003 2005 2007 2009 2011f


98

All four indicators of the real effective exchangerate (private consumption deflator, GDP deflator,export price deflator, ULC-total economy deflator)exhibit an appreciating trend from 2000 to 2008,both vis-à-vis a set of 35 industrialised countries

) a raph III.1.2).i r the real

(IC35 nd vis-à-vis the euro area (GThe h ghest appreciation was recorded foeffective exchange rate (REER) deflated by exportprices (17.2% and 8.1%, respectively). At the sametime, the REER deflated by unit labour costs hasappreciated by 14.2% vis-à-vis IC35 and by only2.2% vis-à-vis the euro area since 2000. Labourcosts increases can thus only explain part of therather strong increase in relative export prices, inparticular vis-à-vis the euro area. The remainingpart may be explained by a more rapid increase inunit capital costs, including a dynamicdevelopment of profit margins. Between 2000 and

on than in the EU15.(46)

2005, unit capital costs in manufacturing andmarket services increased by 1.9 pps per year more

average in Belgium

Biatour, B. and C. Kegels (2009), "La position relative del'économie belge en Europe, Federal Planning Bureau,Working Paper, n. 5-09.

(46)th differential between Belgianexport markets and Belgian exports.

(45) National Bank of Belgium (2009), "Rapport Annuel 2008".

52

Part IIICompetitiveness Developments In Euro-Area Countries

tential. For instance, thesale of new-to-market products is much more

area, only a limited number of mainly large

sts are high; and (ii) few of them have thenecessary (technological) competitive advantage tosuccessfully compete in international markets.(49)This is similar to the situation in France. Finally,some existing weaknesses in the businessenvironment may also have a negative impact on

Another explanation may be that Belgium isrelatively specialised in exporting goods for whichprices have increased substantially, such asplastics, steel and iron. Indeed, these three goodsaccounted for 9.2% of Belgium's exports onaverage since 2000, compared to 5.4% in the euroarea.

Technological competitiveness, driven by thecapacity to innovate as well as to increaseefficiency and reduce costs, is also an importantelement influencing export performance. R&Dspending as a percentage of GDP (providing anindication of technological potential) amounted to1.8% in Belgium in 2006; this is equal to the euroarea average, but lower than the average forBelgium's main competitors. R&D expenditure ismoreover concentrated in a limited number ofoften foreign-owned companies. Finally,Belgium’s R&D expenditure is geared moretowards low and medium-to-low-tech industriesand less to medium-to-high-tech industries, whichseems to be related to the sectoral composition ofthe Belgian economy.(47) The relatively low level,high concentration and adverse composition ofBelgian R&D have a negative impact on thecountry's innovation po

limited in Belgium than in the euro area. Also, theshare of high tech exports in total exports is muchlower than the euro area average. Anotherstructural element which may negatively influenceexport performance is that, compared to the euro

Belgian firms are involved in exporting.(48) Thisconcentration is related to the fact that small andmedium sized companies (SMEs), which are veryimportant in Belgium, tend to export considerablyless as a result of the fact that: (i) SMEs' fixedco

the country's competitive position. According tothe World Bank's most recent "Doing Business"ranking, Belgium is placed 22nd among 183economies for "ease of doing business". Thecountry's weakest points include the level of taxesand the time needed to register a property.

1.3. SPECIAL FOCUS: PRODUCTIVITY AND UNITLABOUR COST IN MANUFACTURING ANDSERVICES

One of the most quoted factors behind Belgium'sweak export performance compared to other euroarea countries is its high wage cost. Given thatBelgium is specialised in products that arerelatively easy to imitate and is thus increasinglysubject to competition from lower-cost countries,unit labour cost (ULC) developments are indeed animportant determinant of its competitive position.

Graph III.1.3: Nominal unit labour costs (2000=100)

80

90

100

110

120

130

1995 1997 1999 2001 2003 2005 2007 2009 2011f

BE DE FR NL EA-16


Over the period 2000-2008, unit labour costsdeveloped more or less in line with the average for

ph III.1.3), suggesting that costompetitiveness has remained more or less intact.

However, ULC tended to increase somewhat morein Belgium than in the euro area from 2005onwards. While this should not be the case in2009, the Commission services autumn 2009forecast expects this trend to continue in 2010 and2011. Divergences in both productivity and wagedevelopments are behind this trend.

In order to moderate wage growth, the governmenthas gradually reduced the tax wedge on laboursince the beginning of the decade and introduced a

the euro area (Grac

(47) Conseil central de l’économie (2006), "Diagnose van hetBelgisch innovatiesysteem".

(48) Muuls, M. and M. Pisu (2007), “Imports and exports at thelevel of the firm: evidence from Belgium”, Working Paper,n. 114, National Bank of Belgium.

(49) Moen, O. (1999), "The relationship between firm size,competitive advantages and export performance",International Small Business Journal, 18/53.

53


mechanism in 1996 to ensure that wages wouldp

social ermine biennially an

develo in line with those in Germany, France andthe Netherlands. According to this mechanism,

partners must detindicative maximum rate of hourly wage increasesfor the subsequent two years (i.e. the wage norm),taking into account projected wage growth in thethree neighbouring countries. On the basis of thisindicative norm, further wage negotiations takeplace at sector and firm levels. Since the entry-into-force of the mechanism, six wage norms havebeen adopted. Taking into account actual wagedevelopments in the neighbouring countries, datashow that the wage norm was respected during theperiods 1997-1998, 1999-2000 and 2003-2004, butlabour cost increases in 2001-2002, 2005-2006 and2007-2008 exceeded those set by the norm. Thisillustrates that the mechanism of automatic wageindexation in Belgium may hamper wageadjustment.

Graph III.1.4: Compensation/employee (2000=100)

80

90

100

110

120

140

150

130

1995 1997 1999 2001 2003 2005 2007 2009 2011fBE DE FR NL EA-16


In spite of this, wages increased in Belgium onaverage at the same pace as in the euro area until2005. Thereafter, slippages seem to have occurredin 2006 and 2007 (Graph III.1.4), which havecontributed to the more rapid increase in ULC inthese years. In addition, as of 2005, productivity

reaributed to the more rapid

rise in ULC since then. The lacklustre

of TFP was low, as wasthe case in manufacturing. Belgium is specialised

ad and airtransport and financial services.

It appears that in both manufacturing and services,the same factors have been at work also after 2005.In particular, productivity in manufacturing hasdeteriorated further. This might be explained tosome extent by the fact that Belgium is specialisedin mature sectors, where it is more difficult toachieve further technological progress and, thus,further increases in TFP.

1.4. THE NEED FOR ADJUSTMENT (51)

The continuous deterioration of the Belgian currentaccount since 2003 is due to sustained domestic

growth in Belgium fell below the euro aaverage, which also cont

development of productivity may be due to the factthat less productive workers started to enter thelabour market, i.a. as a result of governmentschemes to increase the employment of low-skilled(e.g. cheques services).

However, marked differences appear to existbetween the development of unit labour costs andproductivity in the manufacturing sector and thesector of market services, as illustrated byEUKLEMS data for 2000-2005.(50) Inmanufacturing, unit labour costs in Belgiumincreased by more than in the euro area, asproductivity growth in Belgium was slightly lowerthan in the euro area. The main reason for this wasthe lacklustre performance of total factorproductivity, which measures the efficiency withwhich production factors are combined, inter alia,reflecting the innovation capacity, economies ofscale, the degree of competition and the businessenvironment. In the case of market services, theevolution of ULC was more favourable in Belgiumthan in the euro area, because labour productivitygrew more rapidly in Belgium. This reflects amore significant increase in (ICT) capital intensity,whereas the contribution

in services to businesses, logistics, ro

demand (which boosted imports), a deteriorationof the terms of trade (as a result of rising oilprices), and a disappointing export performance.Indeed, Belgian exports grew more slowly thanthose of its main competitors which can beexplained by a number of factors. First, theincrease in relative export prices, which seems to

(50) See Biatour B. and C. Kegels (2008), "Growth andproductivity in Belgium", Federal Planning Bureau,Working Paper, n. 17-08.

(51) The text which follows, including policy challenges, draws,inter alia, on already issued policy invitations andrecommendations under various Community instruments,such as the updated Stability Programme, the EDPrecommendations and the strategy for growth and jobs.

54


55

especially from 2005onwards. Second, Belgian exports also suffer from

and aspecialisation in goods with a relatively lowtechnology content for which price competition isrelatively high. Finally, the generally small size offirms and the low capacity and/or propensity ofSMEs to export may contribute to the relativelyweak export performance. Wage costs remain animportant determinant of competitiveness,especially as Belgium is still specialised inintermediate products and will thus probably beincreasingly subject to competition from lower-cost countries. The current economic downturnmay have added to the need to take measures torestore competitiveness, as the most competitive

er advantage of the pick-up in world demand. The permanent increase in

age subsidies for certain target groups as ofge,he

required fiscal consolidation from 2010 onwardswill make further cuts more difficult, even thoughwell-targeted measures should not be excluded tothe extent that they are fully compensated and donot delay consolidation.

In view of Belgium's competitiveness position inthe euro area and its current account balance,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against this background, an examination isxisting wage setting

mechanisms, including the Competitiveness Law

rove the business environment andto allow companies to benefit more fromtechnological progress. In the area of the labour

ntivesfor labour market participation through, inter alia,

be partly due to a more dynamic development ofproduction costs in Belgium,

an adverse geographical composition

economies will take great

w2009, introduced as part of the stimulus packahas helped to lower labour taxation, but t

warranted on the e

and the automatic indexation of wages, with aview to increasing wage flexibility. It is also

important, in particular at the current juncturewhen ULC are coming under increasing pressure,to take measures to improve productivity growth,which has been rather disappointing in recentyears. Such measures should specifically aim atimproving total factor productivity, thus includingmeasures to imp

market, reforms could aim at increasing ince

a reduction in the tax burden on labour and a bettermodulation of the level of unemployment benefits,as well as reinforcing activation programmes.Some steps to improve labour market efficiencywere taken in 2009, including a further reductionof labour taxation, some reinforcement ofactivation and reorientation policies and anintroduction of some regressivity over time forunemployment benefits. Household purchasingpower may be usefully supported by improvingcompetition and general market functioning indomestic markets, in particular in the networksectors and services. In addition, intensifying theties with fast-expanding economies, includingthose outside the EU, and taking advantage of theopening-up of new markets should support exportgrowth. Belgium will also need to diversify andfocus on new goods and services for whichdemand is growing and where price competition isless fierce, in particular by reallocating resourcestowards products with a higher technologicalcontent. Export growth may also be supported byfacilitating technological upgrading andspecialisation in products and services with ahigher technological content through focussing onkey sectors such as biotechnology and health careand improving R&D intensity, as well asimproving the business environment.

2. GERMANY

56

m etitiveness in terms of theEER) remaining

broadly intact, Germany is well placed to benefitfrom the recovery especially in emerging marketeconomies and should be able to reverse the loss inmarket shares encountered during the crisis.Exports already started to recover in the course of2009 with export-orders indicating a further pick-


Despite its strong competitiveness position,Germany has been among the hardest hiteconomies in the current financial and economiccrisis. Relying on a largely export-orientedeconomy with a strong focus on investment goods,Germany has been particularly vulnerable to theslump in global trade triggered by the crisis.German exports declined by around 14% in 2009,slashing the current account surplus by about 2pps.to 5% of GDP. As a result, the contraction of realGDP in Germany in 2009 was one of the deepestamong all industrialised countries. However, withits comparative advantage in investment goods andits cost and price co preal effective exchange rate (R

up in 2010 and 2011 (Graph III.2.1).

Graph III.2.1: Growth of exports and REER

-15

-10

-5

0

80

90

100

110

5

10

15

1995 1997 1999 2001 2003 2005 2007 2009 2011f

120

130

140

German exports growth Euro-area exports growth (without Germany)

REER Germany (rhs)

(1) REER (unit labour cost) vis-à-vis 35 industrial countriesSource: Commission services.

Germany's export-orientation is rooted in the long-ablished openness of the economy, strongnufacturing traditions (Mittelstand) and the factt Germany is relatively poorly endowed withural resources. The degree of openness –asured by exports and imports as a percentage

estmathanatme

uring the course of the% of

all world e l euro areaimports). So far, Germany is the only countryamong the large euro area Member States that wasable to increase its share in world export marketsdespite stronger competition from Asian countriesover the last few years.

Graph III.2.2: Degree of openness (% of GDP)

of GDP - rose by 35 pps. since 1991, peaking at88% in 2008 (compared with 83% for the euroarea average). This was due in particular to thestrong expansion of trade in goods, while trade inservices expanded only slightly and amounted to19% of total trade (Graph III.2.2). Themerchandise trade balance has been the maincontributor to the large current account surplus inthe recent years; the balance on services is slightlynegative, which in particular reflects the negativetourism balance. With an loss in export marketshares of about ½ pp. dcrisis, German exports accounted for about 9

xports in 2009 (13% of al

40

60

70

80

90

100

2

4

6

8

10Export and import of servicesExport and import of goodsNet exports of services, rhsNet exports of goods, rhs

0

10

20

30

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f-4

-2

0

50


The main trading partners of Germany are theother Member States of the EU, which absorbabout 2/3 of all exports (Graph III.2.3). Within theEU, the share of exports shifted slightly in favourof the new Member States, now amounting toabout 1/3 of the total. The share of exports goingto the USA, Germany's most important tradingpartner next to the EU, declined slightly in thecurrent decade, to 7.2% in 2008. Germany's exportshare to Asia has been relatively stable: between1991 and 2008, the share of exports to Chinaincreased by 3 pps. to 3.5%, while Russia's sharemore than doubled to 3.3% in 2008. Overall, the


trade pattern has not diversified significantlyduring the last two decades.

Graph III.2.3: Direction of trade (% of total exports)

0

10

20

30

40

50

60

70

80

90

100

1991-95 1996-00 2001-05 2006 2007 2008

Other

Latin America

Russia

China

Africa and Middle East

Asia (excl. China)

USA

Non euro area EU-MS

Euro area 15


Graph III.2.4: Structure of trade (RCA for all exports (vs.world))

0

0.5

1

1.5

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

2

raw-material-intensive labour-intensivecapital-intensive difficult-to-imitate research-intensive


Compared with the rest of the euro area, thestructure of German exports has shifted somewhatfrom capital-intensive to labour-intensive goods(Graph III.2.4). While retaining a (historical)comparative advantage in capital intensive goods(Balassa index(52) above 1), Germany also gainedin relative terms in labour-intensive goods duringthe last decade in line with sustained wagemoderation. With the parallel improvement in thefield of labour-intensive goods, the number of

(52) The measure used is the classic Balassa index of revealedcomparative advantage, computed as the share of a goodscategory in the country's total exports, relative to the exportshare of that goods category for a benchmark region, herethe euro area aggregate.

persons employed in the German export sector hasincreased steadily in the last few years.Furthermore, Germany has largely maintained itsspecialisation in the sector of research-intensivegoods, although public investment in basicresearch has not been reinforced substantially inthe last decade.


Over the last 20 years, Germany's externalcompetitiveness had been exposed to three majorchallenges: German reunification, global marketliberalisation and integration into the euro area. Inthe course of the reunification-boom, the positivedemand shock arising from gains in East Germanhouseholds' purchasing power pushed up wagesand inflation, which led to a considerable loss incompetitiveness in the first half of the nineties. AllREER indicators appreciated markedly and exportgrowth even turned negative in 1992/93. This wasexacerbated by an effective appreciation of the

53)Germany's post-reunification loss in externalompetitiveness peaked in 1995, when the REER

neds

averaging only 1.2% p.a., together with strongeraverage productivity growth of 1.7% driven byincreased labour shedding, contributedsubstantially to the turnaround thereafter. Whilewage moderation clearly dampened privateconsumption, external price and costcompetitiveness were restored. Since 1995, allREER indicators have exhibited a trenddepreciation vis-à-vis the rest of the euro area(Graph III.2.5). This trend depreciation alsobenefitted from a sustained negative inflationdifferential compared with the euro area andsluggish demand in the aftermath of the

ow

Deutsche Mark during the ERM crisis.(

cwas some 20% higher than in 1991. Sustaiwage moderation, with nominal wage increase

reunification boom. In addition to lconsumption, the latter reflects the correction ofoverinvestment in housing after the reunification-induced construction boom, weak corporateinvestment – which was dragged down by therelatively low efficiency and profitability of theGerman banking sector by European standards – as

(53) Furthermore, the Deutsche Mark did not depreciate whenreunification led to a significant downward shift in theproductivity level due to the integration of non-competitivecompanies from eastern Germany.

57


well as the fact that Germany entered the euro at aslightly overvalued exchange rate.(54) As a resultof continued depreciation, the REER vis-à-vis theeuro area fell even below its reunification level.

In the course of the financial and economic crisis,the REER vis-à-vis the rest of the euro area basedon unit labour cost appreciated slightly. Thisresulted from the adverse effect on productivityarising from the slump in the mainly export-basedGDP growth in Germany, which exceeded the euroarea average, and the increased use of short-timework, which shielded the labour market to a largeextent from recession. However, with some laggedcutback in employment expected and a rebound ofexports already apparent, productivity is set to pickup, leading to an improvement in competitivenessfrom 2010 onwards.(55)

Graph III.2.5: REER vs. rest of euro area

80

85

90

95

100

105

110

115

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

Unit labour costGDP deflatorExport price deflatorPrivate consumption deflator


A different picture appears when the REER vis-à-vis a wider peer group of 35 industrial countries isexamined (Graph III.2.5). While Germany's realdepreciation was even more marked between 1995and 2000 (refle ting ic n part the nominal effective

(54) Estimates provided by Hansen and Roeger suggest anovervaluation in effective terms of 2%. See Hansen andRoeger (2000), "Estimation of real equilibrium exchangerates", Directorate General for Economic and FinancialAffairs (European Commission), Economic Paper, No 144.

depreciation of the ECU and the euro), Germany'sREER has been rather flat thereafter. Thus, thecompetitiveness position of Germany outside theeuro area (notably relative to the US and Japan)has effectively worsened, with the strong euroappreciation offsetting the steady reduction inrelative unit labour cost through wage moderation.However, the corresponding REER for theremainder of the euro area countries started toappreciate in 2000 and a 30% gap in the REER hasopened up since then between German

(55) While this note focuses on competitiveness, IMF analysisalso points to the importance of demand-pull and

conomies experiencing asset price

y and therest of the euro area.

II ting

composition effects as a source of the strong German tradeand current account surplus, with global demand forGerman investment goods rising substantially in catching-up economies and ebubbles. See Danninger and Joutz (2007), "What explainsGermany's rebounding export market share?", IMFWorking Paper No. 07/24.

Graph I.2.6: Corporate profitability (Gross operasurplus/Gross value added (%))

39

40

41

42

43

44

45

46

1995 1997 1999 2001 2003 2005 2007 2009 2011f

GermanyEuro area


Rising labour cost during the short-livedreunification boom, the rapid catching up of EastGerman wages towards western levels in thenineties and the relatively weak total factorproductivity growth were also reflected in ashrinking profitability gap of the German corporatesector vis-à-vis that of the euro area (Graph

Outsourcing inparticular characterised the trade pattern with the

value end. This implied German gains not only in

agacom

III.2.6). As a consequence, the corporate sectorsought to restore profitability by holding backdomestic investment and resorting to labour-savingrationalisation or the relocation and outsourcing ofproduction to lower-cost areas.

new Member States, where increased bilateraltrade and one-way foreign direct investment to theEast suggest that parts of the low end of the value-added chain were located in the East, leavingproduction in Germany to specialise in the high-

productivity but also in employment, when setinst the alternatives of possible closure ofpanies or relocation of production further

58


oss value added - narrowed considerablybetween 1995 and 2007. With unit labour coststemporarily rising (Graph III.2.5), profitability wasdampened by the delayed response of the labourmarket during the economic crisis. However, asemployment may still decline in 2010, theprofitability gap vis-à-vis the euro area shouldnarrow once again in 2010.

2.3. SPECIAL FOCUS: FINANCIAL FLOWS ANDTHE CURRENT ACCOUNT SURPLUS

The large merchandise trade surplus since 2001(Graph III.2.2) more than offset the negativebalance of services and net transfers and pushedthe current account balance into surplus in 2002for the first time since German reunification. Thecurrent account surplus widened considerably,reaching a high of 8% of GDP in 2007, while thefinancial account turned negative, peaking atalmost 10% of GDP in 2007 (Graph III.2.7). Thelarge current account surplus reflects increasedprivate household savings as well as the decreasedneeds of companies to finance investment – bothtranslating into a net lending position ofhouseholds and corporations (Graph III.2.8). Alower net borrowing position of the public sectorin the last few years is set to be reversed in2009/10 as a consequence of fiscal stimulus andstabilisation measures undertaken in the context ofthe financial and economic crisis. The traditionallyhigh household saving rate stood at 12% ofdisposable income in 2008 (well above the euroarea average of 8%) but fell temporarily by morethan 1 pps in 2009 due to the crisis. Thecontribution of the corporate sector to net externallending became positive in the last few years. Thisis due to both efforts by the corporate sector tostrengthen its balance sheets and weaker gross

away, involving consequently weaker supply linkswith the parent company. Rationalisationmeasures, together with moderate settlements inwage negotiations, allowed nominal unit labourcost to fall by around 20% since 1995 against theaverage of Germany's major trading partners.Furthermore, the wedge between declining unitlabour cost and rising export prices suggests thatthe profit margins of German exporters had alsorisen significantly in the later years. Consequently,gap between the profitability of the corporatesector and the corresponding euro area average - interms of the ratio of gross operating surplus togr

capital formation, which stood at 18% of GDP in2009, down from more than 23% in 1991. Giventhat gross capital formation of the euro area ishigher by about 2 pps, this implies a decrease infinancing needs also in relative terms. Accordingto its high savings-investment ratio, Germanybecame a net lender among the larger EU MemberStates.

Graph III.2.7: Financial account (% of GDP)

6

8

-8

-6

-4

-2

0

2

4

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Foreign direct investment Portfolio investmentOther Currency reservesFinancial account

Source: German Bundesbank and Commission services.

Graph III.2.8: Net lending (+) / borrowing (-) (% of GDP)

-8-6-4-202468

10

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

Corporations General governmentHouseholds and NPISH Total economy

Source: German Bundesbank and Commission services.

The biggest part of Germany's net foreigninvestment subsumed under "Other" itemsincludes loans and trade credits (55%), bankdeposits (40%) and other capital investment (5%)of notably monetary financial institutions andhouseholds. "Portfolio investment" shows no cleartemporal pattern and has fluctuated around balanceduring the last two decades. The strong net inflowof portfolio investment since 2007 was dominatedby net acquisitions of bonds, money market

59


certificates, while there were net outflows ofm

2000 investment"

he nineties, the German FDI stock

invest ent certificates and financial derivatives.Following a period of capital imports between

and 2003, net "foreign direct(FDI) became negative afterwards and contributedsignificantly to overall capital exports in the lastfew years. The majority of net foreign directinvestment is composed of re-invested gains(50%), equity capital financing (30%) and long-and short-term granting of credit by and borrowingfrom subsidiaries abroad (20%). The sectoralbreakdown shows that only 25% of German FDIabroad is in manufacturing (in particular, the carand chemical industries) and about 75% is inservices and venture capital companies. Since thebeginning of thas increased more than six-fold, with the majorityof the stock located in the EU and the USA.

With respect to their destination, a breakdown oftotal German net capital flows on average over thelast 5 years shows that most of the capitalmovement of some 470 bn EUR or about 19% ofGDP p.a. took place within the euro area, whereGermany is a net exporter of capital. Arguably,German companies took advantage of theopportunities offered by the creation of the singlecurrency and later by the enlargement of the EU.The relocation of production increased net capitalexports (especially FDI) to the new EU MemberStates considerably, although starting from a lowbase in the early nineties.(56) Taking into accountthe strong – largely portfolio-driven – net capitalimports from the UK, the net capital flow to theEU as a whole is only slightly negative. Strong netcapital exports to North and Central America werealso recorded. The net capital flow to and fromRussia is broadly balanced, while net capital flowto Asia became positive (net capital imports) in thelast few years.(57)

Overall, net lending of private households andcorporations contributed strongly to the rise in theaccumulated stock of net foreign assets and turnedaround the negative trend that had prevailed sinceGerman reunification. At the end of 2008 net

(56) The FDI stock of Germany in the EU10 is now around 60

(57)

momentum, the current

market to the economic

productivity developments. Furthermore, shouldbn EUR, which is about 1% of the German capital stock.Most of the current stock (nearly 2/3) was built up ahead ofenlargement in 2004.See German Bundesbank (2009), "Balance of paymentsstatistics" and "Foreign direct investment stock statistics",Special statistical publication 10.

foreign assets amounted to about 670 bn EUR or27% of GDP, up from a trough of only 1% of GDPin 1998. The share of households and non-financialcorporations in total net foreign assets currentlyamounts to 33% of GDP. While the contribution ofmonetary financial institutions (excl. the centralbank), at 19% of GDP, is also strongly positive,that of general government is negative with netforeign liabilities amounting to 32% of GDP. Theappreciation of the euro since 2006 has dampenedthe accumulated stock of foreign assets.


Germany's external competitiveness has beenrestored to pre-reunification-levels and, in relationto other euro-area Member States, Germany haseven become more competitive than in the early1990s. Since 2000, the increase in the degree ofopenness has gainedaccount balance has moved into surplus, and thenet external position has increased considerably,reflecting a healthy financial position ofhouseholds and corporations. The slump of theGerman economy in the course of the financial andeconomic crisis only temporarily worsenedcorporate profitability and competitiveness in2009, as productivity fell due to the delayedresponse of the labourdownturn. However, with the overall price andcost competitiveness position remaining broadlyintact and global demand for German investmentgoods expected to continue rising in catching-upeconomies, Germany's export sector is wellpositioned to benefit from the global recovery.

In view of Germany's strong competitiveness inthe euro area and its current account surplus,adjustment in the context of the euro area would befacilitated by a particular focus on strengtheningthe sources of domestic demand.

Against this background, insufficient wagedifferentiation to reflect productivity differentialsremains a key issue, thus calling for reforms toenhance wage setting behaviour tailored to

(58)

endations and the strategy for growth and jobs.

The text which follows, including policy challenges, draws,inter alia, on already issued policy invitations andrecommendations under various Community instruments,such as the updated Stability Programme, the EDPrecomm

60


61

io, moderate overall wage growth hascontributed to the modest growth of privateconsumption. In order to contribute to

gt ctural)competitiveness in the future and support a

pping thepotential of the services sector, which has already

Germany succeed in raising productivity andpotential growth more strongly, wages would showa more dynamic behaviour. In addition to a highsavings rat

stren hening Germany's (stru

rebalancing of export-based growth, there is a needfor reforms to address the weaknesses in the tax-benefit system, ensure high-quality education andan adequate education infrastructure to sustaincomparative advantage in knowledge and research

based growth. Such reforms include: reducing thehigh tax wedge to provide incentives for jobcreation, private investment, consumption andlabour market participation as well as enhancingthe framework for competition in services byfurther relaxing restrictive rules in regulated tradesand services, lowering high entry and otherregulatory barriers and improving publicprocurement procedures. Further ta

seen a dynamic growth recently, could lead to afurther broadening of domestic demand inGermany.

3. IRELAND

62

REIGN TRADE

e of the most open economies of

di -term perspective, this move is

3.1. SETTING THE STAGE: FOCHARACTERISTICS

Export growth played a critical role in the 1990s,when the export-based growth model enabled arapid increase in Irish incomes. While exports andimports had accounted for around 80% of GDP inconstant prices in the 1980s, this ratio peaked at186% of GDP in 2001 and decreased, slightly, tosome 180% in 2008. This reflects the move todomestic demand-driven growth, especially fromthe growing construction sector. Despite this,Ireland remains onthe euro area.

The trade balance moved into positive territory inthe late 1980s and improved during the period ofhigh export growth rates. On the goods side, therapid expansion of exports led to an increase in thetrade surplus in goods, which peaked at 28% ofGDP in 2002 before declining to 14% in 2008. Theservices trade balance, traditionally negative, hasbeen improving rapidly in the last few years, froma trough of -13% of GDP in 2000 to just -2% in2008. This reflects a structural shift from exportsof goods to exports of services since the beginningof this decade, with the share of goods in totalexports declining from 78% in 2000 to 66% in2008. Real exports of services grew by 16% onaverage over the period 2000-2008 and goodsexports by only 2%. These developments arerelated to Ireland’s long-standing strategy ofdeveloping knowledge-based export industriesthrough an FDI-based strategy, thereby moving upthe value-added chain faster than competitorcountries. In a first phase, this took the form ofmoving towards manufacturing industries withhigher technology intensity. A second phase,which may have begun at about the turn of thecentury, involves a gradual move frommanufacturing to human-capital-intensive services.In a me umbeneficial to the current account position as theterms of trade for services are more favourable.(59)

More than 90% of export goods are industrialproducts, while the bulk of imports consist ofmaterials for production (55% in 2008). The maincategories for goods exports are chemicals (51% oftotal goods exports in 2008), especially organicchemicals and medical and pharmaceuticalproducts, and machinery and transport equipment(21%), especially office machines. The sectoralcomposition of exports, in particular theimportance of relatively acyclical chemical andpharmaceutical goods in total exports, has helpedto contain the decline of Irish exports in the currentcrisis (by “only” 4.4% y-o-y in volume in the firstthree quarters of 2009) compared to other euro

(59) The switch to services is probably more apparent than realwhen it comes to computer services, which increased as a

and a corresponding part of the

s.

area Member States. Excluding the above-

likewisof total imrelated ucts (15%).

housing-boom-related pick-up in the investment

the

0

share of total exports from around 8% in 2000 to 15½% in2008. Part of this increase,decline in the goods share of total exports, reflects a changein the method of delivering software to customer

mentioned sectors, the decline was similar to thatin other countries. The main import goods are

e machinery and transport equipment (34%ports in 2008), and chemicals and

prod

For services, the main exports relate to computerservices (34% in 2008) and business services(31%). The latter category is the largest on theimport side (44% in 2008), followed by royalties& licences (28%). Computer services make a largepositive contribution to net exports, while royalties& licences and business services make largenegative contributions.

Current account developments are mainly drivenby the trade balance on goods and services. Inparticular, the deterioration from a broadlybalanced current account position in the sevenyears up to 2004 to a deficit of more than 5% ofGDP in 2007 is broadly explained by a weakeningof the trade balance on goods and services to alevel that was insufficient to cover the sizeablenegative income balance. Looked at from thesavings-investment side, the opening up of adeficit on the current account mainly reflected a

ratio (from an already high level compared withEU average) since 2005 in particular,

cerbated by a reduction in the savinexa gs rate in2 07. In 2008 and the first three quarters of 2009,

Previously software delivered as part of computer hardwareof physical media was counted as a merchandise exportbut, as technological change has allowed software to bedelivered electronically, it is now recorded as a servicesexport.


of the crisis, which led to a strong decline ininvestment associated with a marked decline inimports.


Since 1995, Ireland has experienced a realappreciation vis-à-vis the euro area. Looking at the

ption and GDP, the appreciation took place

the external deficit narrowed slightly in the context

REER based on the deflators for privateconsumbetween 1995 and 2003 with a stabilisationthereafter, reflecting the low inflation differentialwith the euro area. The ULC-based REERindicator was relatively stable between 1997 and2003, but appreciated thereafter until 2008 bysome 18% as wage growth remained high whileproductivity gains declined to rates morecomparable with those in the euro area. Relative tothe IC35, the real and nominal effective exchangerates depreciated from 1977 to 2000, puttingIreland in a very competitive position at the start ofthe decade.

Graph III.3.1: Nominal and real (based on ULC) effectiveexchange rates (1995=100)

80

90

100

110

1995 1997 1999 2001 2003 2005 2007 2009 2011f

120

130

140NEER IC35 REER EA REER IC35


However, most of the REERs have appreciated

maintain the price competitiveness of its exports atthe cost of decreasing profit margins. As a small

inte

llow nominal exchange rate movements, notablyvis-à-vis the dollar and sterling.(60) In 2009,despite a mild appreciation in the nominaleffective exchange rate, some depreciation of allmeasures of the Irish real effective exchange rate isexpected to have taken place. Specifically, thedownward adjustment in prices and wages thatappears to be taking place is helping to initiate areversal of past competitiveness losses.

s, Ireland managed to increase its shareof exports to regions that grew more rapidly than

owing region,

n down by factor intensity) in research-

fo

In the 1990

since then, reflecting the appreciation of the euroas well as higher inflation and unit labour costgrowth in Ireland than in its partner countries.Only the export-price-based indicator has tended tobe relatively stable, pointing at Ireland's ability to

the world average, thus allowing for market sharegains. The increase in exports to the US, whichwas then the world's fastest gr

and very open economy, Ireland is a price-taker inrnational markets and its export prices closely

reflected the ability to attract US multinationalfirms in high-technology sectors; much of the tradebetween Ireland and the US represents intra-firmtrade between branches of US multinationals.Since 2000, Ireland has experienced losses in itsshare of world merchandise exports, which havehowever been offset by gains in its share of worldexports of commercial services. Indices ofrevealed comparative advantage, broken down bytechnology intensity, show that Ireland has a highdegree of specialisation vis-à-vis the euro area inhigh-technology products, especially in ICT.Ireland has also developed an advantage, albeitmuch less pronounced, in medium-high-techproducts, especially chemicals. This pattern ismirrored by a revealed comparative advantage(brokeintensive (easy-to-imitate) goods. Ireland’straditional advantage in raw-material-intensive orlabour-intensive goods has disappeared, with forinstance the share of food products in total

(60) Many of the usual macroeconomic data series for Irelandshould be interpreted with caution for two reasons. First,while economic growth is usually measured in terms ofGDP, GNI is probably a more appropriate measure for theIrish economy. The difference between GDP and GNI isnet factor income, which is significantly negative in Irelandbecause of profit repatriations by multinationals. Irish GNI,which is about 15% smaller than GDP, is seen as a moresuitable indicator of Irish living standards (among EUcountries, Luxembourg is the only other country where thedifference between the two measures is more than 10% ofGDP). Second, some sectors with a marked presence ofmultinational companies are likely to be characterised bytransfer pricing, attracted by Ireland’s low tax rate oncorporate profits. This distorts (i.e. exaggerates) standardmeasures of profits, output, productivity etc. (see PatrickHonohan and Brendan Walsh (2002), “Caching Up withthe Leaders: The Irish Hare”, Brookings Papers onEconomic Activity, No. 1/2002, pp. 1-77).

63


merchandise exports falling from some 23% in theearly 1990s to 8% in 2008.

The terms of trade for services were favourablehile

the termsProducer prices in the key merchandise exportsectors (ICT and chemicals) display a decliningtrend as these sectors experience substantialdownward pressure on output prices in the globalmarket. Overall, also in view of the increasingweight of services in total exports, the terms oftrade thus declined only slightly (by 7%) between2000 and 2008.

The ratio of gross operating surplus to gross valueadded (GVA) for the total economy increased from49% in 1995 to 57% in 2002, but has been on abroadly downward trend since then. At 54% in

cond highest in the euroarea after Greece (61%), reflecting the presence of

their share in the economicstructure as well as in total exports, accounting for

After the particularly high inflows of the 1990s,

Witren

between 2000 and 2008, increasing by 12%, wof trade for goods decreased by 13%.

2008, the ratio was the se

multinational companies recording huge profits inIreland (and generating huge profit outflows). In2007, two sectors had higher ratios than average:manufacturing (71%) and finance and businessservices (72%), which rank respectively in firstand second place in the euro area. Market serviceshave been expanding

44% of GVA in 2008. Business and financialservices make up about 60% of market servicesGVA(61) and generate about 65% of servicesexports. The net export position of internationalfinancial services companies amounted to 4% ofGDP in 2008. Given their generally lower importcontent, an increase in exports of services tends togenerate an increase in net exports. The crisis hashit the financial services industry more severelythan other services sectors, as reflected in a morepronounced decrease in the value of exports offinancial services (-11½% yoy in the first threequarters of 2009 versus -1½% for overall serviceexports).(62)

FDI inflows have been decreasing since 2003.th outflows continuing their general upwardd, the net liability position (stock) related to

They generated 26% of total valued added and 14% of totalemployment in 2008.According to Balance of Payments data for financialservices and national accounts

(61)

(62)data for overall services.

P in 2000to 12% of GDP in 2008. At the end of 2007 the

s, which offsets existingother capital investment in Ireland.

re foreign multinationalsaccounted for around 98% and 95% of GVA in

direct investment fell from 102% of GD

services sector represented 61% of the total inwardposition, with particular emphasis on financialintermediation and insurance. Similarly, most ofthe outward direct investment position wasaccounted for by the services sector. Within totalmanufacturing, the chemical sector accounted for65% of the inward FDI position in 2005. The sharedropped markedly to 35% in 2006 due to outflowsof other capital to affiliates abroad. This probablyreflects “reverse investment”, predominantly in theform of inter-affiliate loan

3.3. SPECIAL FOCUS: OPENNESS ANDEXPOSURE TO NON-EURO-AREACOUNTRIES (ESPECIALLY THE UK AND THEUS)

The Irish FDI- and export-based strategy forcatching-up, which took off some 20 years ago,was marked from the start by relatively importanteconomic ties to the US and the UK compared tocontinental Europe.(63) Two questions arise:whether these patterns have shifted since thecreation of monetary union; and whether they haveinfluenced Ireland's relatively resilient exportperformance in the current crisis.

There is a high degree of foreign ownership inmanufacturing and services. The significantgrowth in exports over the last two decades wasmainly driven by the foreign-owned sector.(64) Theso-called “modern” manufacturing sector(65),where production grew by 64% between 2000 and2008, is particularly dominated by foreignmultinationals. It includes the key export sectors“chemicals” and ICT, whe

(63) There are other channels, such as financial and migrationflows, which affect Ireland's potential exposure to US andUK. These fall outside the scope of this note.

(64) According to the 2005 Census of Industrial Production,non-Irish firms accounted for 82% of total manufacturinggross output, but for less than half of manufacturingemployment. Non-Irish firms exported 94% of their grossoutput, compared to just 33% for indigenous firms.

(65) As defined by the Irish statistical office (CSO), comprising“reproduction of recorded media” (NACE 223), chemicals(NACE 24), “computers and instrument engineering”(NACE 30, 33) and “electrical machinery and equipment”(NACE 31, 32).

64


crease for domestic sales than export sales, alsoreflecting the predominance of products withfalling world prices in the output of the “modern”sector.

In the services sector, the dominance of foreign-owned companies is less pronounced. However,they still accounted for 46% of the GVA of totalprivate services in 2005 (up from 37% in 2001). Ahigher-than-average degree of foreign ownershipcharacterises business services, computer servicesand recreational services (64%). As withmanufacturing, foreign ownership seems to beconcentrated in the most export-oriented and leastemployment-intensive services sectors.(66)

Data on the stock of FDI at the end of 2008 showthat EU countries accounted for the bulk of inwardinvestment into Ireland (78%), up from 58% in2001, with the UK share declining over this period,

2005, respectively, and exported around 98% and97% of gross output, respectively. The so-called“traditional” manufacturing sector, whereproduction grew by just 6% over the period 2000to 2008, tends to be more embedded in thedomestic economy in terms of employmentintensity, domestic economy expenditures and thelower likelihood of companies relocatingproduction to other countries. The mainrepresentative is the food sector, where the UK isthe main origin of Irish food imports as well as themain market for Irish food exports. In spite of thedifference in production growth rates, the nominalGVA shares of the modern and traditional sectorshave hardly changed due to the much higher pricein

(66) Business and computer services represented 42% of exportof services, while amounting only to 12% of total privateservices. Foreign-owned services companies employed24% of total employees in the sector in 2005.

phical distribution of trade in servicesdiffers from that for goods, especially on theimports side. From the limited data available, thereis no evidence of a clear shift in trade patterns overtime.

The outward orientation of the Irish economyremains very strong. However, the relativedominance of non-euro-area partners, namely theUS and the UK, in both trade and FDI flows seemsto have diminished since Ireland’s entry into theeuro area. This would imply that the scope forasymmetries in Ireland’s performance relative tothe euro area due to the particular orientation of itstrade flows and FDI links may have lessened.

As a result of its trade patterns, Ireland is moreexposed to movements in the exchange rate of theeuro vis-à-vis the dollar and sterling than any othereuro area member. Graph III.3.2 demonstrates theclose relationship between Ireland's nominaleffective exchange rate and the bilateral exchangerates USD/EUR and GBP/EUR. The euroappreciation of 64% against the USD and 28%against the GBP between 2001 and 2008 hassignificantly affected the competitiveness of

from 18% to 10%. The US share at end-2007 stoodat 8%, down from 21% in 2001.

Concerning trade flows, the share of exports to andimports from the euro area is relatively low incomparison with other euro area countries. Twonon-euro-area trade partners of particularsignificance are the UK and the US, which, takentogether, accounted for a larger share of Irishgoods exports than the euro area in 2000 (seeTable III.3.1). By 2007, the shares of the euro area,but also of the US, in Irish merchandise exportshad increased somewhat. On the imports side, theweight of the UK remains very high. Thegeogra

Table III.3.1: Geographical distribution of Ireland's external trade

2000 2008 2000EU 62.3 62.3 55.0of which euro area (1): 38.2 42.2 21.1UK 22.5 16.6 31.5US and Canada 17.4 19.8 17.3Rest of the world 20.2 17.9 27.7

in % Exports ImGoods

2008 2000 2008 2000 200863.5 62.4 62.9 50.7 46.228.1 33.5 35.0 33.3 26.831.1 25.2 22.0 15.3 17.112.3 14.1 9.8 32.5 35.424.2 23.5 27.4 16.8 18.4

Exports ImportstsServices

por

(1) Data for 2000 and 2003 exclude Slovenia and Slovakia, Cyprus and Malta.Source: CSO and Commission services.

65


Ireland's exports. By contrast, the recentdepreciation of the euro especially against theUSD might provide some support to Irish exports.

Graph III.3.2: USD/EUR, GBP/EUR and Ireland's nominaleffective exchange rate (1995=100)

60

70

80

90

100

110

120

1995 1997 1999 2001 2003 2005 2007 2009

GBP/EUR USD/EUR NEER_IC35


Recent empirical evidence confirms the highexposure of the Irish economy to developments inthe US when compared to the rest of the euro area:a 1% fall in US private demand (both consumptionand investment) would lead to a much moresignificant drop in GDP in Ireland than inGermany or Italy.(67)

In the current crisis, nominal goods exports to the

ort performance in the

UK have declined more markedly than those to therest of the EU (in the period January 2008-November 2009, the average year-on-year growthrates were -9.4% versus -2.3% respectively).However, the value of exports to the US actuallyincreased (at an average rate of +9.1% over thesame period). Together with the fact that thedecline in exports has been less drastic for Irelandthan for other export-oriented Member States, thisappears to indicate that the sectoral composition ofexports has played a more important role indetermining Ireland's expcurrent crisis than the geographical trade pattern.

(67) Germany represents countries with a trade exposure to therest of the world in line with the euro area average, whileItaly stands out for its specialisation in traditional sectorsand is thus more exposed to competition from emergingmarkets. See European Commission (2008), “EMU@10:successes and challenges after 10 years of Economic andMonetary Union”, European Economy 2/2008, box II.4.1:Simulations with DG ECFIN’s QUEST model. See alsoDaniel Kanda (2008), “Spillovers to Ireland”, IMFWorking Paper No WP/08/2.

3.4. THE NEED FOR ADJUSTMENT ( )

Price and wage inflation pressures together with adecline in productivity growth have graduallyeroded Ireland's competitive position and theexternal deficit has been on the increase since2004. The recent depreciation of sterling, to whichthe Irish economy is more exposed than other euroarea members, has added to this development. Atthe same time, in terms of savings/investmentbalances, the recent deterioration in the externalposition mainly reflects recent overinvestment innon-productive housing.

The latter stopped with the bursting of the housingmarket bubble which, together with globaldevelopments, has led to a deep economi

68

c and

xt of the euro area would be

fiscal slump in Ireland. A protracted recoveryphase is generally expected to follow the currentrecession given the extent of the necessaryadjustment. The need to rebalance growthdomestically (via the reallocation of resources tomore productive sectors and a corresponding re-skilling of workers) and restore fiscal stability -where significant first steps have already beentaken by the authorities in 2009 - makes for aparticularly challenging environment forpolicymakers and implies that domestic demandcould remain subdued during the adjustmentphase. This underlines the importance of ensuringthat Ireland can fully benefit from any upswing inexternal demand in the near to medium term.Sustainably reversing past losses incompetitiveness will therefore be crucial. Whilethe external deficit is set to improve markedly inthe current crisis and should narrow further as theeconomy returns to balanced growth, the high levelof external debt implies sustained net incomeoutflows, contributing to a (small) external deficiteven in the medium term.

In view of Ireland's competitiveness position in theeuro area and its current account balance,adjustment in the contefacilitated through the continuation of the ongoingrelative price and cost adjustments and the shift ofresources from the non-tradable to the tradablesector.


66


67

er footloose, it is essential tostrengthen the attractiveness and competitivenessof the domestic economy. In particular, within the

te thepublic finances, thereby providing a stable macro-

s evidently not been ableto prevent the current misalignment between

Against this background and in view of thepossibility of a subdued and drawn-out recovery ofdomestic demand, the Irish FDI-led strategy,which has been very successful in the last twodecades, should be continued. As foreign-ownedcompanies tend to be less well-connected to thedomestic economy and are, especially in theservices sector, rath

constraints imposed by the need to consolida

fiscal framework, adequate public services andgood infrastructure should be ensured, whilefurther productivity-enhancing measures should betaken to stimulate R&D investment and technologydiffusion from multinational companies to thewider economy. Especially given the possible shiftin migration patterns, continuing to guarantee awell-educated workforce will also be crucial. Inthis context, supporting the re- and up-skilling ofthe newly-unemployed will be important toprevent the latter from turning into long-termunemployed, especially since young and low-skilled workers are among the hardest hit. It willalso be important to improve product marketfunctioning (e.g. in network industries and

regulated services) to allow for a more active roleof competition in the allocation of resources.

While for internationally-traded services labourcosts proper may be less important than the factorsmentioned above, an adjustment to restore wagecompetitiveness seems essential for the economyas a whole. Indeed, with higher exposure than therest of the euro area to the downturn in the US andUK and to the appreciation of the euro vis-à-vistheir currencies over the last years, a strongeradjustment vis-à-vis the euro area will benecessary to regain competitiveness. After thesubstantial wage adjustment in the public sector in2009 helped to initiate the necessary change inlabour costs, adequate wage settlements in thissector should be sustained in the medium term toencourage wage moderation in the private sector.Whereas in the past, Ireland displayed flexibility insuccessive national wage agreements, the socialpartnership approach ha

wages and productivity. However, it could nowplay an important role in fostering and framing thenecessary adjustment process and ensure therequired labour cost flexibility at firm or sectorlevel.

4. GREECE

68

4.1.

ue to a

openness has

their shares in Greek total trade in goods

share

und 10% of GDP in 2008),services have diminished toP in 2008 (from 8½% in 2000).

SETTING THE STAGE: FOREIGN TRADECHARACTERISTICS

Although the degree of openness has been risingover the last 15 years, Greece remains a relativelyclosed economy. Measured in terms of the sum ofexport and import volumes as a share of GDP,trade openness increased significantly from closeto 43% of GDP in 1995 to almost 60% in 2008, astill relatively modest figure compared to theaverage of the euro area as a whole (around 88%of GDP in 2008). This increase reflects unevendevelopments in exports and imports. Linked withbuoyant and sustained domestic demand and asteady worsening of competitiveness (see below),import penetration rose by 10 percentage points,from around 26% of GDP in 1995 to nearly 36% in2008, while the share of total exports in GDPincreased by around 7 percentage points from 17%to 24% over the same period. As a result, theexternal balance of the Greek economydeteriorated rapidly from 1997 onwards, with thecurrent account deficit reaching 14¾% of GDP in2007 and declining somewhat to 13¾% of GDP in2008. This development was mostly dgrowing deficit of the trade in goods, whichregistered 16½% of GDP in 2008 (4½ percentagepoints more than in 1997).

Trade in goods and trade in services have followeddifferent growth patterns over recent years. Indeed,trade in goods grew moderately at around 6% inreal terms on average over the period 1995-2008,while the corresponding figure for trade in serviceswas almost double this figure. This reflects notonly the higher demand elasticities for services butalso the strong performance of the tourism industryand the sea freight transport services, which havealso been the most dynamic sectors of the Greekeconomy in recent years.

Interestingly, the increase in tradenot been driven by enhanced integration of Greecein the euro area. Although the euro area remainsthe country's most important trade partner, itsshare in total trade has diminished. Indeed, trade ingoods and services with the euro area representedless than half of total trade in 2008, compared toalmost 58% in 1995. Moreover, in the case of tradein services, the euro area accounted for just onethird of the total trade in services between 1995

and 2008. Germany and Italy, which have beentraditionally the main trade partners of Greece,have seenshrink from 35% in 1995 to around 22% 2008. Thesteady erosion of competitiveness vis-à-vis theeuro-area partners has contributed to a change inthe geographical specialisation of Greece towardsneighbours with high economic growth, such asthe Balkans and countries of south-eastern Europe.The share in total exports of goods accounted forby Bulgaria, Romania, Cyprus, Turkey, Croatiaand Former Yugoslav Republic of Macedoniagrew from just above 10% in 1995 to 24½% in2008, while, in parallel, the share of goods in totalimports from Russia, China, South Korea andJapan almost doubled over the same period.

In terms of product specialisation, the share oflow-tech and labour-intensive products remainssignificant, although declining. Products in thecategories of 'Food and live animals' and 'Crudematerials' represented almost 25% of total exportsin 1995 and almost 20% in 2008. In contrast, theshare in total exports of products in the category'Mineral fuels, lubricants and other relatedmaterial' almost doubled between 1995 and 2008from 6% to 11%, especially to countries outsidethe euro area. On the import side 'Mineral fuels,lubricants and other related materials' saw itsincrease from 7% to almost 12%, reflecting notonly higher oil prices, but also the importance ofrefining activity in Greece, which acts as the mainprovider of petroleum products to neighbouringBalkan countries. In the realm of medium-to-hightech products using highly skilled labour, thechemical industry has been the most dynamic inGreece over recent years, with the export share of'Chemical and related products' having risensignificantly, from around 5% in 1995 to morethan 13% in 2008. The share of high value-added(high-tech) exports has edged slightly higher overthe last few years, although it remains much lowerthan in the euro area.

At around 14% of GDP in 2008, exports ofservices have been much more significant thanexports of goods (at arowhile imports ofaround 7¼% of GDTravel and transport services represent almost 90%of the total exports of services. Travel serviceswere mainly exported in the form of tourism



vered around 1 percentage point overthe 2000s. Persistently high inflation appears to be

losses may also be related toimperfections in the functioning of productmarkets, as reflected by rapidly-growing mark-ups.

ansionin international markets since 2005, as revealed bytrade in goods and services and flows of portfolioinvestment and FDI. The pace of real growth inexports of goods and services exceeded 10% onaverage over the period 1995-2000, although itturned temporarily negative in 2001 and 2002 (-4¼% on average) before regaining a positive realgrowth rate of more than 6% on average between2003 and 2008. Growth in exports has beenconsistently below that of imports, especially sincethe late 1990s. Export market shares have been ona downward trend, falling from 0.22% in 1995 to0.16% in 2002 and stagnating afterwards at around

negative outcome, it isworth noting that the country seems to have lost

(69), the Internal Market Restrictiveness70 e

the goods sector, both domestically (such as theheavily regulated professional services by lawyers,accountants, etc.) and internationally. In parallel,the income convergence process has led to ademand shift towards those service activities withhigher income elasticities (e.g. private healthcareservices), thus putting further pressure on prices inthese sectors and contributing somewhat to theinflation differential with the euro area.

inflows, mainly originating from euro areacountries, although tourism from Eastern Europeand Russia has grown in the most recent years.Transport services, especially sea freight transport,are mainly directed outside the euro area,reflecting the important penetration of Greece'scommercial fleet in world trade in seatransportation.

All four indicators of the real effective exchangerate (based on the GDP deflator, the privateconsumption deflator, the export price deflator andULC-total economy) recorded an appreciatingtrend vis-à-vis the IC35 from 2000 onwards – thedegree of appreciation between 2000 and 2008based on price measures varies from around 16%(export price deflator) to 13% (GDP deflator).When considering REER vis-à-vis the rest of theeuro area, an appreciating trend is also apparent,reaching its peak in 2008. These developments areunsurprising given the persistence of the inflationdifferential between Greece and the euro area,which has ho

mainly the result of non-competitive behaviour andrigidities in product and labour markets, while theBalassa-Samuelson effect seems to be lessimportant. Summing up, most estimates of theequilibrium exchange rate suggest that the realeffective exchange rate of Greece is overvaluedwith respect to its long-term equilibrium.

The appreciation of the ULC-based REER for thetotal economy (more than 14% in 2008 since 2000vis-à-vis the IC35) results from much higher wagegrowth than in the euro area and the IC35. Labourmarket rigidities and wage-setting institutionsseem to lie behind high wage growth in Greeceand the concomitant widening gap in unit labourcosts with its main trading partners. The positiveincrease in the wage differential, which has beenespecially significant since 2002, put pressure oninflation and price competitiveness, in spite of fast-growing productivity, which has exceeded that inthe euro area. Persistently higher inflation andcompetitiveness

Greece has not fully benefited from the exp

0.17%. In spite of this

relatively little in market shares when viewedagainst the deterioration of competitiveness. Thus,Greece compares favourably with other euro areacountries, which experienced more pronouncedlosses in market shares.

Wholesale and retail trade, personal services(hotels/restaurants) and financial intermediationand business activities have been recordingsignificantly higher mark-ups since 2001,revealing a more rapid evolution of mark-ups inservices compared to the manufacturing exportsectors. Higher mark-up growth in services can bepartly attributed to limited exposure tointernational competition. Although the regulatoryenvironment has become more supportive ofproduct market competition in Greece since thelate 1990sIndex in Services (IMRIS)( ) suggests that thservices sector is less exposed to competition than

69 Product Market Regulation

(70) ECB (2006), "Competition, productivity and prices in theeuro-area services sector", Occasional paper No 44, April2006, p.43.

( ) According to the OECDdatabase

69


3¾%of GDP in 2008, from a close-to-balance position

some of these countries have beenrecording relatively high growth rates in the recentpast, the size of their markets is relatively small

a the highshare of extra-EU trade and in particular extra-

increasing over time, from 24% in 1997 to around26% in 2008 – implying a high import elasticity

evi

procomof

t, on the other hand,remained largely stable until the early 2000s at

e, with the currentaccount deficit increasing rapidly. As a result, the

4.3. SPECIAL FOCUS: TWIN DEFICITS INGREECE AND THE ROLE OF FISCAL ANDSTRUCTURAL POLICIES

The combination of high economic growth,persistent fiscal imbalances and deterioratingcompetitiveness in the last decade has worsenedthe external balance of the Greek economy, withthe current account deficit peaking at 14¾% ofGDP in 2007 before declining somewhat to 1

in the mid-1990's. The widening externalimbalance was mostly due to a growing deficit ofthe trade in goods, which registered around 17% ofGDP in 2008 (almost 6 percentage points morethan in 1995). More specifically, the performanceof merchandise exports was disappointing over thelast decade, while imports growth was strong, inline with buoyant domestic demand. Trade inservices, on the other hand, has gone in theopposite direction. The balance of net exports ofservices has improved over time reaching a surplusof more than 6% of GDP in 2008, 1 percentagepoint higher than in 1997. However, thisimprovement fell short of compensating for thedeterioration in the balance of goods.

The relatively poor export performance of goodscan also be explained by the geographic structureof external trade. Almost half of Greek exports aredirected to extra-EU countries, mainly to theBalkans, Turkey and the Mediterranean basin.Although

comp red to the euro area. In addition,

euro-area trade has increased the exposure of theeconomy to the exchange rate fluctuations of theeuro. This is particularly significant now that thecurrencies of some of Greece's main trade partnersare depreciating, thus aggravating Greek'scompetitiveness losses further.

With the share of imports of goods in GDP

only to a further gradual decline of their alreadylow share in GDP, but also to losses in marketshares.

In parallel, the balance of primary income andcurrent transfers has deteriorated over time,reaching a deficit of around 3½% of GDP in 2008,compared to a surplus of more than 4½% of GDPin 1997. This reflects a dynamic feedback betweenthe current account deficit and debt accumulation,through increasing interest rates. Surpluses on thecapital transfers accoun

with respect to domestic demand – there isdence that the economy is facing structural

difficulties in substituting imports with domesticduction and in adjusting to externalpetition. In contrast, the growth rate of exports

goods has been slower than GDP, leading not

around 1¾% of GDP per year. Nevertheless, whilecapital transfers were sufficient to offset theexternal imbalance and the net borrowing positionof the Greek economy in the late 1990's, theygradually diminished in the beginning of the newmillennium and turned negativ

net external borrowing position of the economyexceeded its historical high of 12% of GDP in2007, before declining somewhat in 2008.Whereas FDI inflows are relatively small (lessthan 1½% of GDP in 2008), the growing externalimbalance is being financed mostly throughportfolio investment and government bonds,reflecting the role of the public sector in the originof the current account deficit.

The progressive deterioration of the net externalborrowing position of the economy reflects bothrising investment and falling savings. The publicand private sectors have alternated during the lastdecade as the driving force of this deterioration. Inparticular, three different periods can bedistinguished, ending just before the currentrecession: a first period of fiscal consolidation andprivate sector dis-saving (1997-1999); a secondperiod of dis-saving in the public sector and stronginvestment activity, mainly in infrastructure (2000-2004); and a third period of fiscal adjustment andstrong private investment, mainly in dwellings,between 2005 and 2006. After 2007, however, andespecially in 2008 and 2009, fiscal consolidationcame to an end with the general government deficiton the rise once again.

More specifically:

(1) On the road to the euro, the governmentimplemented a revenue-led fiscal consolidationprogramme that cut the deficit by nearly 2½

70


of theprivate sector into deficit by 1999. As a result,

the cyclically-adjusted general governmentprimary surplus, which turned into a deficit in2003, in a context of high output growth andoutput gaps. Although part of the increase inpublic deficits financed public works and othermajor projects linked to the organisation of theOlympic Games, infrastructure investmentcontributed only marginally to the mounting publicdeficit, which reached 7½% of GDP in 2004.While the private sector improved its financialposition slightly, the growing public deficit offsetthese gains.

(3) With the current account deficit remaininghigh, the fiscal stance became restrictive again in2005. The government implemented a significantfiscal adjustment programme that cut the budgetdeficit to just below 3% of GDP in 2006. At thesame time, the cyclically-adjusted deficit wasreduced by the same amount. The structuralbalance, in turn, (i.e. the cyclically-adjusted-balance net of one-offs and other temporarymeasures) improved by 3½ percentage points ofGDP. Despite the containment of the public sectordeficit, the financing needs of the economy stillremained high and growing, reflecting furthersignificant dis-saving by the private sector due torising private investment (mainly in housing)associated with improving economic prospects anda buoyant housing market. As a result, given thelower but still present public deficits and theworsening net financial position of the privatesector, the net borrowing position of Greece vis-à-vis the rest of the world deteriorated further (seeGraph III.4.2).

percentage points of GDP. Rising privateinvestment, however, led to dis-saving by thecorporate sector and a fall in household savings,thus pushing the combined net balance

while in the mid-1990's private sector savingslargely compensated for public deficits, the publicdeficit could no longer be financed by domesticsaving in the early 2000's, thus further increasingthe external borrowing needs of the country.

(2) Fiscal consolidation came to a halt in 2000.During the period 2000-2004, fiscal policy becameexpansionary, as reflected in the downward trendof

Graph III.4.1: Current account balance (% of GDP)

-30

-20

-10

0

10

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Goods Current transfersServices Primary incomeTotal current external account

urce: Commission services.So

In 2007, the fiscal stance eased mainly due tocurrent primary expenditure slippages and, in spiteof still good economic times, the structural balancedeteriorated by a ½ percentage point of GDP. Thefiscal deterioration continued in 2008, with theheadline deficit reaching 7¾% of GDP and thestructural deficit widening by 3¼ percentagepoints of GDP. According to the authorities'estimations, the fiscal deterioration continued in2009. A further fall in private (mainly households)sector savings led to a jump in the net borrowingposition of the country to double digit levels,exceeding 12% of GDP in 2007 and in 2008. In2009 however, the deterioration in the generalgovernment deficit was the main factor behindnegative external borrowing, which reached 12¼%of GDP.

Graph III.4.2: Net lending (+) / Net borrowing (-): Sectoralbreakdown (% of GDP)

-16

-12

-8

-4

0

4

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

General government Private sector Total Economy


71


External imbalances can result from different

compe ight be the most

er

NEED FOR ADJUSTMENT (72)

factors. Available evidence suggests that inGreece, structural factors and persistent

titiveness losses msignificant. In other words, although relativelysluggish growth in Greece’s main trade partnersand strong domestic demand can largely explainthe limited net export growth until 2000, cyclicalfactors may fall short in explaining the size of thecurrent account deficit in more recent years.

The build-up of external imbalances carries with ita risk of lower medium-term growth. The patternsof sector and geographical trade specialisationshow that Greece not only exports too little, but itsexports of goods are mainly concentrated in low-technology and slow-growing demand products.Moreover, the bulk of imports is mainly made upof consumer goods, while equipment andinvestment goods account for a relatively smallshare. An additional important factor is that, whileFDI inflows are relatively small, the growingexternal imbalance is being financed mostlythrough portfolio investment and, reflecting thepublic-sector origin of the current account deficit,through government bonds.(71) As mentioned inthe previous section, the rapid rise observed inwage costs and mark-ups in excess of thesignificant growth in productivity has led to thedeterioration in competitiveness over the last tenyears, which is reflected in the sizeableappreciation of the real effective exchange rates(REER).

4.4. THE

The rapid deterioration in the lending position ofthe Greek economy mirrors a combination of bothrising investment and falling savings, including asignificant deterioration of the fiscal position overthe past several years with the public sectorabsorbing the main part of the available externalfinancing. The growing and persistent externalimbalances have led to the build-up of a high

(71) According to the Bank of Greece, foreign investors’purchases of government bonds have been the main sourceof net inflows under portfolio investment.


foreign debt, bringing with it a clear risk to theeconomy's medium-term growth prospects.Moreover, the pace of external debt accumulationin recent years is likely to be unsustainable in thelong-run and needs to be corrected by appropriatepolicies. In the context of the ongoing economiccrisis, the implied re-pricing of risk and possibleimplications for the financing of large currentaccount deficits require an adequate andcomprehensive mix of macroeconomic andstructural policies to tackle the factors underlyingthe external imbalances.

In view of Greece's weakened competitiveness in

ies that theemphasis should be put on policies aimed at

labouret rds,

towards investment in knowledge and in human

the euro area and its persistent current accountdeficit, adjustment in the context of the euro areawould be facilitated by relative price and costadjustments and a shift of resources from the non-tradable to the tradable sector.

Against this background and in view of Greece'swidening domestic and external imbalances, policyefforts will be needed to address the variousdimension of the challenge. The structural natureof external imbalances in Greece impl

tackling the rigidities in the product andmark s and promoting innovation. In other woimplementing the policy measures reflected in theupdated Stability Programme, therecommendations and invitations on structuraladjustment needs identified in the CouncilRecommendation with a view to ending theinconsistency with the broad guidelines ofeconomic policies and the strategy for growth andjobs should contribute to attenuating thepersistence of the inflation differential betweenGreece and the euro area. Moreover, althoughlabour productivity growth has been relativelyhigh, unit labour costs have been increasing at afaster pace than in Greece’s main trade partners inthe euro area, thus worsening the competitiveposition of the country. A recovery ofcompetitiveness can be supported by: improvingproduct and services market functioning to allowfor a more active role for competition in theallocation of resources; fostering wage behaviourthat takes due account of productivitydevelopments; ensuring that tax and benefitsystems make work pay; and improving thefunctioning of the public administration and publicresources management, which could be channelled

72


73

e moderation,with a view to bringing labour cost increases

Fiscal policy developments in Greece in the recentpast reflect inefficient control of publicexpenditures, in particular current primaryexpenditure, not only in periods of fiscalexpansion, but also in those of fiscal consolidation.This is evident in deviations of actual fiscaloutcomes from budgetary targets as a result of bothrevenue shortfalls and expenditure overruns. Thesesystematic slippages in the execution of the Budget

and physical capital. The public sector has animportant signalling role for wag

significantly below the euro area average.

Laws, which had an effect similar to expansionarypolicies, fed domestic demand also at times whenthe Greek economy was already growing above itspotential. The inadequacy of the budgetary stancealso contributed to inflation, thus leading to asizeable appreciation of the real effective exchangerate vis-à-vis the euro area. Given theunsustainable path of public finances in Greeceover the past years, there is a need to pursueprudent fiscal policies with a view to ensuring acredible budgetary consolidation towards abalanced position, together with measures tocontrol current primary expenditure.

5. SPAIN

74

d trade, the Spanish economysaw its openness fall by eight percentage points,

Spanisgoods. ed for 70% of total

India 0.5%. Latin America, with a share of less

of iexpres

sing in

process was boosted by integration into the EU inthe mid-eighties. In the period 1996-2003, Spanishexports reached their largest share in world trade,around 2%, thanks to both the increasing economicintegration in the EU and the depreciation ofpeseta in the early nineties. Since 2004, the shareof Spanish exports in global trade has beenweakening (1.7% in 2008), in line with thedeterioration of its competitiveness and thegrowing role of emerging economies.

A breakdown of exported goods by productcategory shows that almost half of Spanish exports

medium-quality goods. Inside thispresented around 17% of

exchange rate was about


Although the openness of the Spanish economyhas grown significantly in the last few decades, thecountry is still a relatively closed economy. Risingfrom 44% of GDP in 1995, the degree of openness(measured in terms of the sum of export andimport volumes as a % of GDP) reached 61% in2009, compared to 88% for the euro area average.The main driver of this process was imports, whichcontributed more than twice as much as exports tothe increase in openness. The behaviour of importswas the result of buoyant and sustained domesticdemand in the period 1995-2007. In 2009, giventhe collapse of worl

slightly more than the average for the euro area.

h external trade is mainly driven by trade inIn 2009, goods account

to

exports and 80% of total imports. These shareshave changed only slightly since 1995 (69% and83%, respectively). The stagnation of the exportsof services in terms of total exports reflects thesituation of the tourism industry that, after stronggrowth in the last 40 years, now suffers fromstrong competition from emerging-countrydestinations. Consequently, whereas tourismaccounted for around 63% of total exports ofservices in 1995, it contributed only 44.5% in2009. Among non-tourism services exports,business services have recently been the mostdynamic.

Geographically, around 57% of Spanish exports ofgoods went to the euro area in 2009. Morespecifically, France absorbed almost 20% ofexports, Germany nearly 11%, and Italy andPortugal between 8% and 9% each. Among thenon-euro-area EU countries, the United Kingdomappears as the major export destination with over6% share of the total. With regard to the rest of theworld, the major economies do not have anysignificant weight in Spanish exports. Thus, theUSA accounts for around 4%, China 1¼% and

Since the early seventies, the weight of Spanishexports in world trade has been increa

than 5%, has been an important destination in viewts rapid economic growth. On the other hand,orts to Africa have continued to grow rapidly

ulting in a share of more than 5.9% by 2008.

parallel with the opening up of the economy. This

(45%) are ingroup, the car industry re

tal exports in 2009, reflecting the important roleof Spain as car maker (after Germany and France).Although the most advanced technologicalindustries have a reduced presence in Spanishexternal sales (almost 10%), they seem to be themost dynamic sector in external trade.


All four indicators usually used in the calculationsof the real effective exchange rate (DPC, GDPdeflator, export price deflator, ULC-totaleconomy) exhibit an appreciating trend vis-à-visthe IC35 from 2000 to 2008 – the degree ofappreciation varies from 17% (export pricedeflator) to 24% (GDP deflator). The appreciationof the nominal effective14% over the same period. Against the rest of theeuro area, the real appreciation trend ranged fromaround 9% (DPC) to about 13% (GDP deflator),and also saw a slight correction in 2009. Indeed,most estimates of the equilibrium exchange rate,suggest that the real effective exchange rate ofSpain has been overvalued with respect to its long-term equilibrium. After a temporary depreciationin 2009, the real effective exchange rate isexpected to appreciate once again, making furthercurrent account adjustment difficult. Thetemporary depreciation owes much to cyclicalfactors, as reflected in expected negative outputgaps of above 3% between 2009 and 2011. Indeed,the underlying current account balance corrected


for the cycle is expected to improve by less thanthe actual current account balance.

Graph III.5.1: REER based on ULC (total economy, 1999=100)

90

95

100

105

110

1995 1997 1999 2001 2003 2005 2007 2009 2011f

115

120

125

EA EU27 IC35


The indicator based on ULCs in the total economy(Graph III.5.1) seems to be the most appropriate tomeasure the competitiveness performance of

rsening ofeconomic activity in 2009 has led inflation to fallsharply, reducing the differential with the euroarea.

nof internati e period extendingfrom the early nineties until the onset of the globalfinancial and economic crisis, Spain experiencedconsiderable growth in trade in goods and servicesand flows of portfolio investment and FDI. Theopenness of the economy, as defined in section 1,doubled between 1990 and 2008, while netportfolio investment more than doubled its share inGDP over the same period. However, thecontraction in world markets since late 2008 ispushing the economy's openness back towards thelevel of 2000. The pace of real growth in exportsin goods and services decelerated from on average5% between 2000 and 2007, to -7% in 2008-2009.

rket shares during 2001-2003, Spain experienced losses in the subsequentears up to 2009 (except for 2007), although it

swhen com n ofcompetitiveness. This might be explained byefforts of domestic exporters of manufactures tokeep markets by reducing mark-ups. All in all,Spain compares favourably with other large euroarea countries (France and Italy), which sufferedlarger losses in market shares. Spain partially owesthis relatively favourable result to: its low degreeof specialisation in goods, such as clothes andtextiles, which experienced strong internationalcompetition; an above (euro-area and EU) averageshare of services in total exports; and limitedexposure to the contraction in manufacturedproducts.

where, as mentioned above,mark-ups had to be limited in order to maintain

quality-enhancing processes for goods, marginal

domestic products in international markets(tradables). Despite some recent adjustment inview of the recession, Spain remains among thecountries experiencing the highest appreciationagainst other euro area countries since the creationof the euro area in 1999. These trends areunsurprising given the persistence of a positiveinflation differential between Spain and the euroarea, which appears to be mainly the result ofstructural elements. Indeed, income convergence,higher wage growth coupled with lowerproductivity growth than in the euro area, and thepresence of non-competitive behaviour and marketrigidities in some sectors seem to be key elementsbehind the persistently higher inflation in Spain,while the Balassa-Samuelson effect does notappear to be a significant factor in explaining thedifferential. From close to zero in 1999-2000,productivity growth (in terms of output per hourworked) remained almost flat at less than 1%between 2002 and 2006. Although productivitygrowth has accelerated substantially in 2009, thisseems to be a temporary factor, reflecting the highnumber of lay-offs recorded in Spain, especially inthe construction sector. While structural rigiditiesremain, the rapid and severe wo

Not surprisingly, in view of the ongoing expansioonal markets over th

From gains in export ma

yseems to have lost relatively little in market share

pared with the deterioratio

Competition is lower in less tradable services thanin manufacturing

market shares. Although competition from lowcost countries in sectors such as tourism has thepotential to adversely affect Spain's tourismindustry, so far this has not translated into lowermarket shares. The terms of trade for servicespicked up rapidly between 2001 and 2003, whilethe improvement for goods has been more gradual.The expansion of exports of services in Spain wasgreatest in the category of "Other services", whichincludes insurance, financial services, ICT andcommunication, all of which experienced rapidgrowth in recent years. On the other hand, theshare of goods in total exports has been declining.While many other euro area countries were able totake advantage of growing niche markets or

75


at this was not the case for Spain.

e restof the economy appear to have been more limitedin recent years.

xcess of its main trading partners,namely those in the euro area. Second, structural

erioration incompetitiveness, which has resulted in a steady

changes in technology and in diversificationindices suggest th

After peaking at close to 8% in the early nineties,Spain's share in world FDI inflows fell to 3% in2007. In net terms, FDI outflows have exceededinflows almost continuously since 1997. Analysissuggests that the downward trend in FDI inflowssince 2002 may be attributed to rising wage andnon-wage costs, the administrative burden fordoing business and, later on, increased competitionfrom new Member States following EUenlargement. While FDI flows played an importantrole in Spain's economic development in the 1980sand the early 1990s, positive spillovers to th

5.3. SPECIAL FOCUS: A PERMANENTCORRECTION OF THE SPANISH CURRENTACCOUNT BALANCE?

The Spanish current account deficit widenedrapidly over the last decade. From 1% of GDP in1998, which may be considered small by historicalstandards, it rose to a peak of 10% in 2007 ofGDP, moderating to 9.5% in 2008 and further tojust above 5% in 2009. This high current accountdeficit reflects the traditionally-elevated tradebalance deficit and the primary income deficit,driven by the negative net investment position ofthe country. Net outflows of primary income,linked particularly to the debt burden, andimmigrants’ transfers abroad (until 2007), havealso contributed recently to the current accountdeficit(73). Spain's current account imbalancesstem from both cyclical and structural factors.First, cyclical factors reflect the strong economicgrowth in e

factors explain why growth in exports has alwaysbeen below that of imports, particularly in the lastdecade. These structural factors are associated withpersistent inflation differentials between Spain andthe euro area, together with low productivitygrowth and the concomitant det

(73) Martinez-Mongay C. and Maza Lasierra L. A. (2009),«Competitiveness and growth in EMU : The role of theexternal sector in the adjustment of the Spanish economy »,European Commission, Economic Papers No.355, DGECFIN, January.

increase of import penetration and a wideningtrade deficit.

Graph III.5.2: Current account balance in Spain (% of GDP)

-12-10-8-6-4-20246

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

Net exports - services Net exports - goodsNet primary income Net current transfersBalance on current transactions


The widening external deficit of the Spanisheconomy has led to a significant increase in theaccumulated stock of liabilities incurred bySpanish economic agents relative to the rest of theworld. Spain's external debt position is comparableto other euro area members, but its rapid increasein the last decade may be a cause for concern.Moreover, the bulk of the long-term debt, whichrepresents over two-thirds of the external debt, hasbeen issued at variable interest rates, thusincreasing the potential exposure of borrowers torising interest rates. During the current crisis, thenon-financial private sector has faced somedifficulties in raising funds in internationalmarkets, as reflected in both prices, through higherrisk premia, and quantities, via lower creditavailability.

In spite of the strong deceleration of activity in2008, the current account deficit remained close totwo-digit levels as a percentage of GDP, thesecond largest among developed economiesfollowing the United States. However, externalimbalances are currently diminishing due inparticular to the sharp drop of imports as a result offalling domestic demand and the current accountdeficit halved in 2009 to around 5% of GDP. Thechange in credit conditions and the economicenvironment will continue to affect externalimbalances in the near future. Just as easy creditconditions fuelled the external imbalance in acontext of weak productivity growth and anoverheating economy, the now de facto tighter

76


ed to remainsubdued, by historical standards, in subsequent

ears.

Spain will also probably record slight temporaryimprovements in measured competitiveness as theresult of the change in sector composition, thecorresponding job losses in less productive sectors,especially the construction sector, and somemoderation in private sector wage growth.However, this change has more of an effect onnon-tradable activities than on tradables andimplies only a temporary improvement, which willnot be enough to structurally change the loss inprice competitiveness accumulated during the lastdecade.

The increase in borrowing needs over the lastdecade was driven by a steady worsening of thenet financial position of both households andcorporations (see Graph III.5.3), on the back of astrong fall in risk premia and an easing of financialconditions. This deterioration in private balanceswas partially offset by an increase in public sectorsavings. With the crisis, Spain is experiencing acorrection of the external imbalances, in particularin the trade deficit, which represented 2.1% ofGDP in 2009. This is a consequence of thedecrease in domestic demand and the increase insavings. In addition, the economy is going througha rebalancing in the composition of the currentaccount deficit. The correction of the currentaccount deficit is explained by the reduction in thefinancing needs of the private sector, which hasbeen only partially offset by greater indebtednesson the side of the government. The latter reflectsthe public sector's need to finance the sizeableincrease in expenditure, as a result of thediscretionary fiscal stimulus and the working ofthe automatic stabilisers, e.g. the sharp shortfalls intax revenue and increases in expenditure, forexample on unemployment benefits.

credit conditions in a recessionary context areleading to a reduction of the external deficit. Theexpected improvement over the medium term isnonetheless likely to be much more moderate.Further improvements will not be achieved via a‘denominator’ effect, as nominal GDP growth fellby about 3½% in 2009 and is project

y

Graph III.5.3: Net lending (+) / Net borrowing (-). Sectoralbreakdown (% of GDP)

-1

4

9

-16

-11

-6

1995 1997 1999 2001 2003 2005 2007 2009 2011f

corporations general governmenthouseholds and NPISH total economy


Graph III.5.4: Net financial transactions with the rest of theworld. Sectoral breakdown (% of GDP)

-16

-12

-8

-4

0

4

8

1995 1997 1999 2001 2003 2005 2007

financial corporations non-financial corporationsgeneral government households and NPISHtotal economy

(1) A negative (positive) sign indicates that the rest of theworld grants (receives) financing to (from) the counterpartsector.Source: Bank of Spain.

Given that Spanish households and most non-financial corporations are small and cannot borrowfunds directly from abroad, their borrowingpositions are covered by funds from the domesticfinancial sector, which in turn gets its funds fromexternal markets (see Graph III.5.4). The financialsector has acted as an intermediary particularlysince the creation of the euro area, distributingexternal funding to the private and non-financialsectors of the economy. The onset of theinternational credit crunch in August 2007 saw atightening of international credit conditions.Lending to households and businesses has, in turn,been scaled back rapidly along with the percentage

77


of external funding captured by the Spanish

All in ustment of the current

structuralfactors, which are associated with persistent

area averag low productivitygrowth and the concomitant deterioration incompetitiveness. The widening external deficit ofthe Spanish economy led to a significant increasein the accumulated stock of liabilities to the rest ofthe world. Several factors will shape the externaladjustment to the current crisis. As discussedabove, currently, a significant adjustment of thecurrent account is taking place through cyclicaland structural factors. Further reductions in thecurrent account deficit require the tackling ofstructural elements such as subdued productivitygrowth, eroded competitiveness and a vulnerablefinancial position of private agents due to high

financial sector.

all, a significant adjaccount is taking place due to cyclical andstructural factors. Strong contraction of domesticdemand has allowed imports to decline sufficientlyto substantially reduce the trade deficit. Given theadjustment in the construction sector, adjustment isalso structural in nature. Nevertheless, the loss inprice competitiveness accumulated during the lastdecade, due to persistent inflation differentialsbetween Spain and the euro area, together with lowproductivity growth, call for more adjustment inthe euro area through gains in relative ULC.


The Spanish current account deficit has beenwidening rapidly over the last decade, peaking at10% in 2007. Spain's current account imbalancesstem from both cyclical factors and

inflation differentials between Spain and the euroe, together with

debt levels.

In view of Spain's weakened competitiveness inthe euro area and its persistent current accountdeficit, adjustment in the context of the euro areawould be facilitated by relative price and costadjustments and a shift of resources from the non-tradable to the tradable sector.


Against this background and in view of Spain'sproductivity differential vis-à-vis the euro area andits eroded cost position, efforts are required inseveral areas to produce a sustainableimprovement in competitiveness. In this respect,measures to support the resilience of the supplyside could be beneficial in the light, inter alia, ofthe productivity gap of Spain vis-à-vis the euroarea average and an eroded cost position. The coststructure could be improved further by fosteringwage behaviour that allows for wage moderationand better aligning wages with productivity. Theproductivity gap could be narrowed through avariety of channels. Scant productivity growth inSpain during the last decade (around ½% onaverage) mirrored a relatively high allocation ofinvestment to the construction sector and somelow-productivity services. Although measuredproductivity is estimated to increase in 2009 byaround 3¼%, thus above the euro area average,this is mainly due to the sharp contraction of theabovementioned activities rather than a significantimprovement in the structural drivers of totalfactor productivity.

Enhancing productivity in a more sustainable waywould involve further investment in and enhancingthe efficiency of expenditure in research,development and innovation, as well as improvingthe efficiency of R&D expenditure are crucial forachieving productivity advances. Furtherimprovements of the education and life-longlearning systems and investment in human capitalshould also be envisaged. This may be achieved,

implementa ucation reformsin addition to upgrading the skills and increasingmobility of the labour force to promote a swifttransition into employment, and reducingsegmentation in the labour market. Reducingdualism in the labour market would involvereforming employment protection legislation witha view to reducing the large gap betweenconditions for workers on permanent versustemporary contracts and closing the gap betweenthe firing costs of permanent and temporarycontracts. Reforms in the labour market would alsoinclude increasing the strictness and strengtheningenforcement criteria for receipt of benefits,

etween the administrationof benefits and activation policies, as well as

inter alia, by ensuring the effectivetion of widespread ed

improving coordination b

modifying the regulation on opt-out clauses, as a

78


79

means of fostering wage bargainingdecentralization and facilitating wagedifferentiation. Moreover, a better allocation ofresources would be facilitated by improvingproduct market functioning through increasingcompetition in services, including professionalservices, and in network industries.

In addition, a correction of the external imbalanceswill also be facilitated by ambitious fiscalconsolidation. The fiscal stimulus has undoubtedlyplayed an important role in the adjustment of theSpanish economy to the current shock, but lookingforward, fiscal consolidation will contribute toreducing the external imbalances.

6. FRANCE

80


The French economy is among the least open inEurope and, in particular, less open than euro areacountries such as Germany or Spain. As measuredby the share of (volumes of) exports and importsof goods and services in GDP, openness stood at62% in 2008, almost 6 pps. higher than in 2000.However, at the same time, the euro area averagerose by 16 pps (to 89% - see Graph 1), boosted bythe impressive 28.7 pps increase in Germany'sopenness (to 95% in 2008). French exports may be

consisting of some hightechnology sectors (such as aeronautics and

harmacy), but with a large share of low-

ingeconomies. France's main trading partners(Germany, Italy, Spain and the UK) account foraround 50% of its exports and imports.

defined as “generalist”,

ptechnology-intensity products that are exposed tocompetition from both industrialised and emerg

Graph III.6.1: Openness of EU economies, 2008 (exports andimports as a % of GDP)

0

50

LUHUCZSKEEBEIEMTBGNLSILTROATCYDKSELVDEFIEA-16EU-27PLPTESUKFRELIT


100

150

200

250

300

350

The current account balance followed adeteriorating trend from the beginning of thedecade to 2008, when it reached a record deficit of3.3% of GDP (see Graph 2). While currenttransfers were persistently negative over the period

-2foreigngoods in 2004, after having

ce 1998.

1997 008 (due notably to the remittances ofworkers in France), the trade balance in

became negative onlybeen positive in the previous years (with theexception of 2000). The balance of trade inservices, previously one of the bright features ofthe French economy, remains positive but has also

experienced a downward trend: services intensityin total exports fell by 3¼ pps. between 1997 and2008. The current account deficit is estimated tohave narrowed significantly to 2.3% of GDP in2009 mainly as a consequence of the improvementin the terms of trade prompted by the decrease incommodity prices. Thus, even if exports areestimated to have shrunk at a double-digit rate invalue terms, imports are estimated to havedecreased even faster. In terms of exportperformance, France has lost ground compared toits European neighbours, which is evidenced bythe fact that the ratio of French exports to euro areaexports has been on a downward trend sinSimilarly, France's share of exports of goods inworld trade (including intra-EU exports) decreasedby 2.2 pps over the same period (1998-2008)whereas its main trading partners (Germany, Italy,Spain, UK), facing the same internationalenvironment, have seen their foreign trade sharesdecrease by only 1.2 pps on average. When thefinancial crisis broke out, French exports werealready in a difficult position. They fell sharply inthe fourth quarter of 2008 and in the first quarter of2009 (-6.6% and -6.7% q-o-q), in the wake of thesharp contraction of world demand. Exportsrecovered from the second quarter of 2009,growing again in the last three quarters of the year,notably thanks to the performance of theautomotive industry, which was stimulated by car-scrapping schemes put in place in other EUMember States.

Graph III.6.2: Evolution of the current account balance andits main components

-5-4-3-2-1012

1997 1999 2001 2003 2005 2007 2009 2011f

345

Net exports, goods Net exports, servicesNet income Net current transfersCurrent account as % of GDP


Since 2003, the balance of trade for thenufacturing industry has deteriorated, movingma


ributed 0.7 pp. of GDP to thisdevelopment, moving from a surplus of 0.6% of

industry. Thedeterioration in the deficit for energy products

inly oriented towards theEU15, in particular towards neighbouring

price deflator increased by only 4% from 2000 to2008, which is much less than the average increase

from a surplus of 0.8% of GDP to a deficit of 1.1%of GDP in 2008. The trade balance of transportmachinery cont

GDP to a deficit of 0.2% of GDP. Notably the poorperformance of equipment and telecom goods overthe same period added to the decline of the tradebalance for manufacturing

(mainly natural oil), which increased from 1.4% ofGDP in 2003 to 2.8% of GDP in 2008, explains theremainder of the worsening in the trade balance forgoods.

French exports are ma

countries. In comparison with its Europeanpartners, and particularly with Germany, France'sexports have been performing rather poorly in theNear and Middle East, in major industrialised non-EU countries, and especially in emerging Asia.Consequently, French exports are structurally moreoriented towards slow-growing areas. This couldplay a role in explaining the moderate pace ofexport growth, at least in the short term. Recentstudies have however shown that this factor alonefails to explain completely the differences in tradeperformance between France and its neighbours.(75)


A brief look at competitiveness data shows that theincrease of almost 14% in the real effectiveexchange rate (based on ULC) against 35industrial countries from 2000 to 2008 was wellabove the average experienced by France's maintrading partners (+8¾% on average for Germany,Spain, Italy and UK) (see Graph 4). This relativelylarge increase is linked to the dynamics of real unitlabour costs, which decreased by 1% between2000 and 2008, against -2.8% in France's maintrading partners. However, as regards pricecompetitiveness, the REER based on the export

See, for example, J.-P. Villetelle and D. Nivat, "Lesmauvaises performances du commerce extérieur de laFrance sont-elles liées à un

(75)

problème de demande?",

by much more than other euro area countries, and

the continuous deterioration ofFrench export-market shares suggests that there

As stated above, French exports are focussedlargely in the category of low and medium-high

nificantlyhigher importance of price competitiveness than

Bulletin de la Banque de France, février 2006, or M.Cochard, "Le commerce extérieur français à la dérive",Revue de l'OFCE, juillet 2008.

of 8.5% in its main trading partners during thesame period of time (see Graph 3). This suggeststhat French export firms have tried to a largeextent to offset the decline in cost competitiveness,notably through a reduction in their profit margins,

particularly Germany, Spain and Italy(76).

According to empirical analysis,(77) French exportperformance is particularly sensitive to price-competitiveness. Still, as was previouslymentioned, the loss in price competitiveness hasbeen relatively limited and cannot by itself explainthe weakness of the export performance.Consequently,

may be other factors besides price competitivenessthat adversely affect the performance of Frenchexports.

technology intensity, implying a sig

for countries positioned in high technology sectors.This, coupled with a limited degree of productdifferentiation within its medium-to-high rangeproduction, magnifies the exposure of France tointernational competition from rapidly developingcountries such as China and India. Consequently,France has become more vulnerable to competitivepressures from emerging markets than otherindustrialised countries that are closer to thetechnological frontier and have a greater degree ofproduct differentiation.(78) Although France has agood position in one high value-added segment ofhigh-tech products, namely aeronautics, excessiveconcentration on a single sector is a source ofvulnerability. The country is currently not in aposition to respond adequately to the observedlosses in cost competitiveness by shifting to theproduction of high-technology goods that have alower price elasticity of demand.

(76) See L. Fontagné and G. Gaulier, Performances àl'exportation de la France et de l'Allemagne, Rapport duConseil d'Analyse Economique, sept. 2008

(78)

(77) See, for example, J.-P. Villetelle and D. Nivat, 2006, op.cit.P. Sillard, C. L’Angevin and S. Serravalle, « Une analysestructurelle de l'évolution des exportations de la France parrapport à ses principaux concurrents », 2006.

81


Graph III.6.3: REER (vs. 35 IC) based on export price deflator(2000=100)

80859095

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

105110115120125130135

DE ES FR IT UK


Graph III.6.4: REER (vs. 35 IC) based on ULC (2000=100)

80859095

100105110115120125130

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

DE ES FR IT UK


In this context, it is worth underlining that France'sgross domestic expenditure on R&D as apercentage of GDP is just above the euro areaaverage (2.1% against 1.9% for 2007, latestavailable data), but lags behind Germany (2.5%),the US (2.6%) and Japan (3.4% in 2006).Moreover, the share in GDP of resources devotedto R&D has been on a downward trend since 1993when the ratio stood at 2.4% of GDP.

6.3. SPECIAL FOCUS: DEMOGRAPHY OF FIRMS- RECENT PROGRESS IN PROMOTING THEGROWTH OF FIRMS

The economic literature has discussed therelationship between firm size and exportsextensively, concluding that the larger the size of

to Germanexports comes from the middle range of firms,exporting between 50% and 90% of their turnover,the contribution to French exports comespredominantly from the extremes of the range, i.e.either from firms exporting between 10% and 50%of their turnover or from firms exporting more than90% of their turnover.

Second, exporting firms perform better than non-exporting firms in terms of employment, valueadded, wages, capital intensity and skills. They arealso the most productive in their sector. However,the question of the direction of causality remainsopen, in other words, whether the “selectioneffect” (i.e. trade selecting firms which havehighest productivity levels) or the “learning effect”

the firm, the higher the probability that it is anexporting firm.(79) Indeed, exporting firms have tobear fixed costs to sell their products abroad; thesecosts are related to administrative, institutional orcultural obstacles. Although France’s exportweakness seems to point to a wide range of issuessuch as low investment in research anddevelopment, insufficient competition and lowlabour market flexibility, a more specific concernis that there are only very few firms that are bigenough to sustain their position on export markets.

Three stylised facts emerge from a cross-countrystudy by Mayer and Ottaviano (2007).(80)

First, there is considerable heterogeneity amongfirms within the same sector, with large disparitiesin terms of size and productivity and hence exportperformance. In all the countries under review,only a minority of firms are exporters and a verysmall number of firms account for the bulk ofexports. In France, for example, the top 1% ofexporting firms represents almost 45% ofaggregate exports, and the top 10% account for84% of the total. Apart from these few bigexporters, a large majority of exporting firms areonly marginal participants in international trade, asthey export to a very small number of countries(mostly neighbouring countries) and their exportsrepresent a very limited share of their turnover.Whereas the largest contribution

(79) See for instance J. Wagner, “A Note on the Firm Size-Export Relationship”, Small Business Economics, 17(4),229-237, 2001.

(80) T. Mayer and G.I.P. Ottaviano, “The happy few: theinternationalisation of European firms”, Bruegel blueprintseries, 2007.

82


(i.e. firms' performance improves under the

firmwith 49 employees, for instance, recruiting an

additional laws and decrees, with resulting costs tothe tune of 4% of the total compensation ofemployees.(81) The 2008 law of modernisation ofthe economy (LME) has taken steps to reduce thefinancial impact of some of these thresholds: athree-year freeze and a four-year adjustment periodfor the financial consequences linked to crossingthe 10- and the 20-employee thresholds have beenput in place. The issue will however remainsignificant, given the quantity of existingthresholds (there are ten size thresholds in all).

Several measures were taken in 2007 and 2008with a view to improving financing conditions forSMEs: the LME limited payment delays in theprivate sector to a maximum of 60 days(previously there was no such maximum); amechanism similar to the US “Small BusinessAct” was adopted as part of the LME, which givesSMEs preferential access to public procurement(up to 15% of procurements can now be earmarkedfor SMEs); tax incentives to invest in SMEs wereput in place as part of the TEPA package

oom for improvement,

pressure from increased competition)predominates.

Third, most of the variation in French exportsrelative to other countries is due to the variation inthe number of exporters rather than to the averagevolume exported by each firm.

Thus, competitiveness in France is hampered bythe size and number of exporting firms, which arein turn influenced by several administrative andstatutory requirements. The authorities haveundertaken several reforms that could helpalleviate this problem.

As a firm grows, an additional administrativeburden is placed on it, creating an incentive to staysmall and thus hampering expansion. For a

additional employee triggers the application of 34

(2007).(82) There is r

(81) According to the Attali report (J. Attali, Rapport de laCommission pour la libération de la croissance française,Paris, XO Éditions, La Documentation française, 2008);the report was published before the law of modernisation ofthe economy entered into force.

(82) The so-called TEPA package (Loi en faveur du Travail, del’Emploi et du Pouvoir d’Achat) was adopted on 22 August2007; it comprises various tax cuts.

however, in the system of public subsidies infavour of firms. As was underlined by the OECDin its 2009 Economic Survey for France, thissystem remains particularly complicated: some6000 different types of subsidies currently coexist.

A “growth SME” (PME de croissance) status wascreated in 2007, granting tax breaks to fast-growing firms with between 20 and 250employees. More generally, a number of measuresregarding taxation were undertaken, which couldhelp improve the competitiveness of firms (mostnotably the suppression by 2011 of the annual

than on adjustment in the euro-

fixed tax and the suppression of the local corporatetax in 2010).

These measures constitute significant progress.However, there is still room for improvement, andmany hurdles hindering the growth of SMEs arestill in place.


Net trade has hampered French growth in asignificant way over the last six years. This is notdue to a single factor but is rather the symptom ofa series of weaknesses on the supply side, whichimpinge more on the competitiveness position ofthe country ratherarea context. The underperformance of Frenchexports is related to, inter alia, the deterioration ofcost competitiveness. Exporting firms havereduced their profit margins in order tocompensate for this, thereby containing the loss interms of price competitiveness. However, giventhe pressure on prices from competitors inemerging economies, even such pricing behaviourcould not limit the rapid loss of market shares.Moreover, there are limits to how much profitmargins can be squeezed. Analysis of theunderperformance of French foreign trade alsoclearly points to the medium-high technologypositioning of French exports, linked withrelatively low and decreasing expenditure onR&D, and leading to a situation of innovationfollower. Indeed, French exporters havedifficulties in differentiating their products from


83


84

rms. A number ofinitiatives have been taken in this area (see

is still room forimprovement.

In view of France's competitiveness position in theeuro area and its current account balance,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against this background, there is a need to tacklethe supply weaknesses of the economy. In order todeal with the deterioration in cost competitiveness,social partners should work together to ensurewage developments in line with productivitydevelopments, bearing in mind that the currentfiscal situation does not leave room foruncompensated tax reductions. Future increases inthe minimum wage should consider the need toensure wage differentiation at the lower end of thewage scale. The introduction of the“competitiveness clusters” in 2004 is in line withthe efforts to build a critical mass necessary to faceinternational competition; it is important that suchclusters are organised in such a way as to avoid adispersion of efforts. An in-depth simplification of

coupled with furtherefforts to strengthen higher education and lifelong

and theattractiveness of researchers' careers wereidentified by the European Commission as two

i beingaddressed by the French authorities.

exports from cheaper countries and have largelyestablished markets in countries whose growthrates are relatively low. The performance ofFrench exports is also being jeopardised by thelimited number of exporting fi

previous section), but there

all administrative obligations for companies of lessthan 250 employees could further promote thegrowth of SMEs. Additionally, as has beenunderlined by the OECD in its 2009 EconomicSurvey for France, a large-scale reform andsimplification of the system of public subsidiescould serve as a means to better promotecompetitiveness and innovation. Investing inknowledge and innovation in the framework of thestrategy for growth and jobs could help France tolimit the losses of market shares, which it has beenexperiencing over the last five years, and wouldalso foster productivity growth. Possible measuresinclude a continuation and strengthening ofongoing reforms in R&D

learning, as well as an improvement in thetechnology intensity of French exports. In thisrespect, the planned reform of the French researchand innovation framework could improve thetechnology intensity of French exports and wouldthus be a step forward, provided that it iscompensated by budgetary savings in other areas.Measures have also been taken to stimulatebusiness R&D intensity (such as the Crédit ImpôtRecherche). The organisation and functioning ofPublic Research Organisations

main ssues to be tackled; they are currently

7. ITALY

85

In value ter for less thanone third of GDP, a share broadly in line with thatof France and Spain but much lower than inGermany. Imports also represent less than onethird of GDP, below most other euro areacountries. As a consequence, the openness of theeconomy, measured in terms of the sum of exportsand imports as a share of GDP, was among thelowest in the EU in 2008, having increased by only10 percentage points over the previous decade.Growth of exports has been particularly subduedand was outpaced by that of imports, which hasbeen relatively modest, reflecting sluggish


ms, Italy's exports account

domestic demand and equipment investment.

Graph III.7.1: Terms of trade and current account balances

Panel A: Terms of trade for goods and services (1998=100)

9092949698

100102104106108

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

IT DE FR ES

Panel B: Current account balances with the rest of the world(National accounts - % of GDP)

-12-10

-8-6-4-202468

10

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

IT DE FR ES EA12


A worsening trade balance contributed to thesteady deterioration of Italy's current account,which moved from a surplus of 1.9% in 1998 to adeficit of 3% of GDP in 2008 (Graph III.7.1, PanelB). In 2009, the trade balance returned marginallypositive, thanks to improved terms of trade (GraphIII.7.1, Panel A), while the income account

worsened, dragged down by a growing net debtorposition. As a result, the current account improvedslightly. The sharp slowdown in international tradewas reflected in a decline of Italian exports, whichfell by almost 20% in the year as a whole. Acorresponding drop in imports was recorded, onthe back of the retrenchment in investment, whichdid not fully offsetting the export drag on theeconomy and thus translated into a negativecontribution of net exports to growth and a sharpcontraction in the degree of openness of the

duct category

other euro area countries, whereas extra-EU

Wiparandexptog

economy.

In the next two years, the assumed improvement ofthe global environment and, especially, ofdomestic demand in EU countries, which accountfor around 57% of Italy's total merchandiseexports, is projected to drive the recovery inexports. However, it can be expected thatrecouping the heavy losses in competitivenessaccumulated since the start of this decade will bevery difficult in the short term, and that exportgrowth will therefore remain subdued, thusdepriving the Italian economy of an importantsource of growth. As domestic demand and inparticular investment is set to recover, imports areexpected to regain strength but the still-improvingterms of trade should allow the trade balance toimprove slightly.

Italy's exports mainly consist of manufacturedgoods, with the share of services in total exportsremaining broadly stable at around 20%, in linewith the euro area average, for at least one decade.A breakdown of exports by proreveals a relative predominance of labour-intensiveproducts and low-technology goods. Little changein this specialisation pattern has been observedover the years, although there is some evidence ofa shift from low- to high-quality products (seeSection III.7.3 below). From a geographicalperspective, around 44% of Italy's exports go to

countries account for almost 43% of exports.thin the euro area, the country's main tradingtners are Germany and France. Outside, the US

the UK together absorb around 11% of totalorts. Russia, other CIS and MENA countriesether represent more than 10% of total Italian

exports, a bigger share than for the other large euroa countries. Indeed, over recare ent years, the

geography of Italian exports has shifted away


somewhat from the main developed markets,namely the US, Japan and the EU, towardsexpanding markets and oil producers,demonstrating some responsiveness to theevolution of global demand.

Graph III.7.2: Export performance

Panel A: Export performance in volume terms (1998=100)

70

80

90

100

110

120

130

601991 1993 1995 1997 1999 2001 2003 2005 2007 2009

IT DE FR ES

Panel B: Export performance in value terms (1998=100)

60

70

80

90

100

110

120

130

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

IT DE FR ES

(1) Performance relative to the rest of 35 industrial countries;double export weights.Source: Commission services.

The evolution of the external position of the Italianeconomy has been a distinguishing factor of Italy'sslow growth over the past decade.(84) The moststriking manifestation of Italy’s weak exportperformance has been the steady loss of marketshares experienced by the country since the mid-1990s. While a mature economy can be expectedto lose some market shares, Italy’s performancenevertheless compares unfavourably with otherlarge euro area countries. When measured involume terms, Italy's loss of market shares forgoods and services over 2000-2009 was close to3½% per year on average, continuing a trend thathad already started in 1996 as the lira appreciated

(84) See Bardone, L. and V. E. Reitano (2009), 'Italy in theEuro Area: the Adjustment Challenge', in Buti, M. (ed.),Italy in EMU: The Challenges of Adjustment and Growth,Palgrave MacMillan.

that yewith th rmance of Germany, whichrecorded a gain of market shares of almost 1¾%

oderate recovery in2007, the Italian export share in world markets

overy of marketshares is expected in 2010 and 2011.

However, the degree of appreciation is much larger

cosope

a

in nominal terms from the low point attained earlyar (Graph III.7.2, Panel A). This contrastse export perfo

per year over the same period, whereas France lostonly 1½% per year. When measured at currentprices (Graph III.7.2, Panel B), however, thecontraction of market shares was broadly in linewith that of France and, since 2001, slightly morecontained than when measured at constant prices,although still marked if compared with that ofGermany and other euro area countries. This gaphas widened in the last two years, showing that theweakness of Italy's relative export performance haspersisted during the crisis.

After having recorded a m

declined again in 2008 and 2009 in both constantand current prices, on the back of an erosion incost competitiveness and the plunge in globaldemand for some of the products in which Italy isspecialised, namely traditional products liketextiles and clothing, leather and footwear,furniture and wood products, as well as mechanicalengineering products. No rec


Measured by a series of standard indicators, Italy’sprice and cost competitiveness has consistentlyworsened since 2000. Indicators of the realeffective exchange rate exhibit an appreciatingtrend against both euro area and non euro areacountries from 2000 onwards. Vis-à-vis the IC35,much of the increase may be explained by theappreciation of the euro against the currencies ofnon euro area trade partners, a trend shared by alleuro area countries.

Looking at individual indicators, the appreciationof the REER based on the deflators for privateconsumption or GDP vis-à-vis the rest of the euroarea is more contained and is explained bydifferential inflation developments up to 2005.

when looking at the indicator based on unit labourts in the total economy (ULC), which shows thening up of a large competitiveness gap with

respect to Italy's euro area peers, Germany inp rticular. The gap widens even further when the

86


REER based on the export price deflator isconsidered. This could be partly due tomeasurement problems (see Section 3).

Graph III.7.3: REER based on ULC and the gross operatingsurplus in the corporate sector

Panel B: Gross operating surplus – corporations (1998=100)

195205215

95105115125135145155165175

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f2011f

185

IT DE FR ES

Panel A: REER based on ULC (1998=100)

90

95

100

105

110

115

120

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f2011f

Relative to the rest of the euro areaRelative to the rest of 35 industrial countries


The stagnation in productivity growth in Italysince the end of the 1990s is the key factor behindthe rise in the REER based on unit labour costs(Graph III.7.3, Panel A). Such stagnation, whichwas widespread in both the tradable and non-tradable sectors, went largely beyond the wagemoderation achieved since the incomes' policyagreements with the social partners of the early1990s. Low productivity growth was especiallyevident in manufacturing, the sector most exposedto international competition.

Overall, developments in the REER indicatorsreviewed above suggest the opening up ofconsiderable competitiveness gaps versus othereuro-area members, which undoubtedly shapedand is expected to continue shaping Italy’s weakexport performance. It is true, however, that thereis some uncertainty in determining the size of thisgap, as also evidenced by the estimates of theequilibrium exchange rate that are presented in the

horizontal part of this note, which indicate a morelimited overvaluation of the REER.(85) However,there is enough evidence to show that the economy

gree of competitiveness of aneconomy. Non-cost factors matter as well and an

taly,and in particular its Southern regions, moreexposed than other partners in the area to the

e

suffers from competitiveness losses that need to betackled with some urgency. In addition, grossoperating surplus developments in the corporatesector suggest that, since 1998, Italian (andGerman) firms have been experiencing lowerprofitability growth compared to those located inSpain and France (Graph III.7.3, Panel B). Thismay have hampered private investment.

Costs and prices are not the only factors thatdetermine the de

analysis of competitiveness must take into accountthe role played by diminishing barriers to trade andglobal developments (i.e. globalisation). With anexport mix that competes with, rather than beingcomplementary to, that of the emergingeconomies, Italy may have been more exposedthan other euro area countries to increasing globalcompetition. As already mentioned above andsupported by an analysis of exports according totheir technological content, Italy’s tradespecialisation pattern shows little sign of change.On the contrary, Italy appears to have actuallystrengthened its specialisation in labour-intensiveproducts, while making no progress or even losingground in the production of high-technologygoods. In this context, ISAE (2007)(86) argues thatcloser European integration may have left I

comp titive shock of globalisation.

The results of a constant market share analysisconducted by the Italian Institute for ExternalTrade (ICE, 2009)(87), which decomposes thechange in market shares in value terms between1999 and 2008 into structural effects (related to thecommodity composition and market distribution of

(85) Other econometric estimates point to equilibrium, if notslight undervaluation, of Italy's REER at the time of euroadoption. See: Alberola, E., S.G. Cervero, H. Lopez, andA. Ubide (1999), 'Global Equilibrium Exchange Rates:Euro, Dollar, “ins,” “outs,” and Other Major Currencies ina Panel Cointegration Framework'; and InternationalMonetary Fund (2007), Italy: Selected Issues, IMF Country

(86)

(87)

Report, No. 07/65, Washington.Le previsioni per l'economia italiana. L'Italianell'integrazione europea - March 2007L'Italia nell'economia internazionale. Rapporto ICE 2008-2009 – June 2009

87


with structural effects beingbroadly neutral. The competitiveness effect has

effect on each of the three countries' export

een strongly affected by the financial crisis,owing both to the deterioration in the economicoutlook and to firms' reduced self-financingcapacity and access to credit. In 2008, FDI inflowsto Italy fell by over 60%, in line with the fallrecorded in Germany but in percentage terms twicethat recorded in France.

kingmanufacturing sector, particularly in the most

aditional industries, with its share in total value-added declining from 21.7% in 1998 to 18.1% in2008. Export developments in 2006 and 2007,indicating a stabilisation and even a recovery ofmarket shares at current prices, were seen asevidence that the ongoing restructuring in thetradable sector was bearing some fruit, eventhough the recovery of Germany and strong

exports) and a competitiveness effect, seem toconfirm the importance of both effects in the caseof Italy. In particular, the competitiveness effectwas able to explain half of the loss in marketshares. The same exercise carried out on Frenchmarket shares reveals a predominant role of thecompetitiveness effect in explaining theexperienced loss,

had a clearly positive effect on German marketshares, particularly in the first half of the currentdecade, but this has been partly dampened bystructural effects. In the two year period 2007-2008, the competitiveness effect has had a negative

performance.

Finally, developments in foreign direct investment(FDI) provide further evidence of the low degreeof market integration of the Italian economy. Boththe stock and inflow of FDI from abroad remainwell below those of most other euro area countries.In 2007, the accumulated stock of inward FDIamounted to 15% of GDP, only half or less thefigure recorded in France, Spain and most othereuro area countries. Italy also underperforms interms of its capacity to invest abroad, largely dueto its corporate governance and culture thatcontribute to maintaining highly fragmentedindustry structures with a prevalence of small-sized firms. The country therefore appears to belagging behind as a potential location choice and,at the same time, Italian firms need to acceleratetheir transformation into "global players". Thecomplexity and instability of Italy's legal system,inefficiencies in public administration, inadequateinfrastructure and, in many instances, organisedcrime, could be important deterrents to FDIinflows. World flows of direct investment haveb

7.3. SPECIAL FOCUS: HAS THERE BEEN AQUALITATIVE UPGRADING OF ITALIANEXPORTS?

The combination of the steady loss of marketshares experienced by the Italian economy and thesharp deterioration in some measures of costcompetitiveness, along with fast growing exportprices, has attracted a lot of debate among Italianresearchers. Three alternative explanations forthese developments have been put forward(Bugamelli, 2007)(88): i) pricing strategies,whereby Italian firms have maximised profitmargins while sacrificing export market shares; ii)composition effects leading to an increase in theaverage quality and thus prices of exported goods;and iii) measurement errors.

The hypothesis of pricing strategies of exportersaimed at maximising profit margins at the cost oflosing market shares may have been valid for someexporters in the traditional sectors and in smallerfirms, particularly those less oriented to theinternational markets. However, protecting profitmargins is usually a short-term strategy that cannotbe sustained over the long run.

There is some evidence(89) of a restructuringprocess in the Italian manufacturing sector,whereby less efficient companies in the traditionalindustries have been forced to exit the market, witha consequent shift of production towards higherquality segments more sheltered from competitionfrom emerging economies. Competitive companieshave maintained healthy profits thanks to highquality output and specifically targeted marketsthat have provided them with some price-settingpower. This has implied an overall shrin

tr

(88) Bugamelli, Matteo (2007), "Prezzi delle Esportazioni,qualità dei prodotti e caratteristiche di impresa: un'analisisu un campione di imprese italiane", Banca d'Italia, Temidi Discussione (Working Paper) No. 634.

(89) Lanza A. and B. Quintieri (ed.) (2007), Eppur si muove:come cambia l'export italiano, Fondazione Masi.

88


demand from oil-producing countries certainly

increas verage company size

he "price" indices built up

the proposition that the

position of exports and improvements in

he picture that

ow capitalisation, some firms -

outstanding loans.

also supported these developments. Furthersupport for this explanation comes from the

e, albeit small, in arecorded in recent years and the greater frequencyof closures in sectors that are more exposed tocompetition from developing countries, as well asamong smaller and less capitalized firms. Over thelast two years, however, both manufacturingoutput and exports worsened considerably.

Measurement issues appear to be another validexplanation for the apparent puzzle. In the field oftrade statistics, making the breakdown betweenvalues and volumes is problematic in the absenceof directly measured prices. The basic informationavailable is often limited to total values and thetotal numbers of units of some groups of importedor exported products. Tfrom this information are usually referred to as"average unit value (AUV)" indices that measurethe change in the average value of heterogeneousunits. They may therefore be affected by changesin the mix of items as well as by changes in theirprices. Even after a statistical revision carried outin February 2008, the price deflator of Italianexports based on such unit values increased by acumulative 27% from 1998 to 2007, as againstaround 2½% in France and Germany. Newsample-based evidence on producer price indicesfor industrial exports (PPIX) recently released byISTAT further supportsAUV index overstates movements in export prices.Over the period 2003-2007, the average annualincrease in PPIX was lower than that recorded foraverage unit values and barely larger than thatrecorded in France and Germany. It was also lowerthan the average annual increase in the prices ofthe same goods sold in the domestic market,particularly in the case of exports to countriesoutside the euro area, probably in response to therecent appreciation of the euro. This indicates apropensity of Italian exporters to defend theirshares in foreign markets through lower profitmargins, contrary to what the AUVs suggest. If thedifference in behaviour between the PPIX and theAUV indices were attributable entirely to changesin the comquality, then the PPIX would more closelyrepresent the ideal deflator. This would implystronger growth in the volume of Italian exportsthan estimated on the basis of the AUV indices,and consequently a loss of market shares at

constant prices between 2002 and 2007 that isbroadly similar to that recorded at current prices.

However, even if there is under-estimation of someof the growth determinants for Italy, this is notsuch as to substantially modify temerges. The claimed structural improvement ofproduction in response to competitive pressurespredominantly concerns medium-large firmslocated in the Centre-North of the country, whichare most able to compete globally, while manyother firms have had to exit foreign markets andstructural weaknesses continue to weigh on the restof the economy.

In any case, at the current juncture, the pertinentquestion concerns the extent to which therestructuring process in response to competitivepressures has been affected by the crisis, as export-oriented firms are hit hard. Having heavilyinvested in opening up internationally and startingfrom a relatively lhaving taken on debt - had to cope with bothtighter financial conditions and the fall in demand.The closure of firms that would have the ability tocompete and expand when the global economyrecovers would further undermine Italy’scompetitiveness and could adversely affect thepotential growth of the Italian economy. For thisreason, the government introduced temporarymeasures to facilitate small firms' access to creditand provide some relief on


Italy's current account and trade balances with therest of the world moved progressively from surplusfor most of the nineties to deficit in recent years.Deteriorating cost competitiveness since the late1990s accompanied Italy's steady loss of marketshares and relatively weak export growth. Thestagnation in productivity growth in Italy since theend of the 1990s is a key factor behind the rise inunit labour costs and the consequent deteriorationin cost competitiveness. In addition, with an exportmix that competes with, rather than beingcomplementary to, that of the emerging

(90) The text which follows, including policy challenges, draws,inter alia, on already issued policy invitations and

ations and the strategy for growth and jobs.

recommendations under various Community instruments,such as the updated Stability Programme, the EDPrecommend

89


90

in thelabour-intensive sectors, Italy's trade has moved up

In view of Italy's competitiveness position in theeuro area and its current account balance,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against this background and in view of Italy'sproductivity growth differential vis-à-vis the euroarea, the key challenge for Italy is to quicklyrestore competitiveness on international markets.The international crisis makes it more urgent totackle the structural problems of the Italianeconomy. There is scope for better balancing wage

al level with appropriatewage adjustment at firm and/or local levels,

cluding in the public sector. While this wouldity

differential sectors and regions, thushelping to correct regional imbalances, it wouldalso sustain private investment already in the shortrun and improve incentives in the labour market.The application of the newly-formed bargainingframework from 2010 onwards is expected to havea positive effect on unit labour costs. In the longerterm, the key challenge for Italy is to ensure aswift and durable recovery in productivity growth.Competition, which so far has generatedsignificant efficiency gains in manufacturing,needs to be strengthened in important sectors suchas local public services, network industries and

that the efficiency and effectiveness ofservices provided by the public sector, including

. Thisincludes reducing the difference in the treatment of

economies, Italy may have been exposed morethan other euro area countries to increasing globalcompetition. As a partial response to thesecompetitive pressures, a restructuring process hasbeen taking place in the tradable sector in recentyears. While maintaining its specialisation

the quality ladder.

coordination at the nation

inallow wages to better reflect productiv

s across

professional services. Business activity is hinderedby red tape and shortcomings in the regulatoryframework. Despite the progress made inregulatory simplification, the costs deriving fromregulation and the administrative burden remainhigh and uneven across the country; theinefficiency of the civil justice system continues toentail high costs for firms. More generally, there isevidence

education, needs to be improved. Italy’s corporategovernance and corporate culture contribute tomaintaining highly fragmented industry structureswith a prevalence of small-sized firms, which arerelatively less conducive to investment ininnovation and research. Despite the recentincreases, employment and participation rates inItaly remain low by international standards,particularly for women, youth and older workers,and the educational attainment of the workforce isalso low by international standards. There is thus aneed to improve the functioning of the labourmarket within a flexicurity approach and with aview to raising the participation rates

temporary and permanent workers (also byguaranteeing adequate flexibility in hiring andfiring), continuing to tackle undeclared work andreinforcing activation strategies and incentives towork, while reducing the segmentation of theunemployment insurance system and introducing asystem of social safety nets for all types of workcontracts. Finally, shifting the high tax burdenaway from labour would help to recoupcompetitiveness, while a general government debtstill well above 100% of GDP weighs on fiscalsustainability and limits the scope for publicfinances to be supportive of growth and jobs.

8. CYPRUS

91

REIGN TRADE

(defined as the average share of exports

rts and imports of goods, themost important partners are Greece, Germany, the

trArabiaimporta r merchandise exports

food,

as well as temporary factors, such as the rising


Cyprus is a small, open, services-orientedeconomy, highly integrated in terms of trade andFDI both with the euro area and the EU27. Thisreinforces competition pressures on productmarkets and therefore promotes efficiency.However, the small size of the economy hampersthe range of diversification of production activitiesand leads to a high degree of trade specialisation,which in turn increases its exposure to externalshocks. The ongoing transition towards a morediversified, quality and innovation-driveneconomy is important for increasing the resilienceof the economy to competitive pressures fromlower-cost economies.

At about 115% of GDP in 2008, the degree oftrade openness is well above the average for boththe EU and the euro area as a whole. Nevertheless,it is below the average for the smaller EU MemberStates, which suggests that there is still scope forfurther integration. The EU is reinforcing itsposition as the country's main trading partner. In2008, the share of intra-EU exports in total exportsof goods was almost 70% (up from about 59% in1999, the first year for which data exist), which iscomparable to the share of intra-EU imports ofgoods in total imports.

Consistent with the orientation of the Cyprioteconomy towards the tertiary sector, the intensityof servicesand imports of services in total trade) reachedalmost 60% in 2008, the second highest in the EU.More specifically, exports of services accountedfor almost 85% of total exports. Within theservices sector, tourism, banking, financial andother business services (accounting, legal services,merchanting, shipping etc.) have held apredominant position. Export-oriented serviceshave benefited from the country’s abundantendowment of skilled labour and a goodinfrastructure, as well as its strategic geographiclocation.

The evolution of the balance of payments showslarge disparities between the trade in goods andservices. The persistently very high deficit ingoods trade and the very high surplus in services

trade reflect the shift of the Cypriot economytowards the tertiary sector. The negative tradebalance in goods (-27¼% of GDP over 2000-2008)is only partly compensated by the surplus recordedin services trade (24¼% of GDP).

From a geographical perspective, the major tradepartner of Cyprus is the EU. Among MemberStates, for both expo

UK and Italy. The Near and Middle Easterncoun ies (including Jordan, Lebanon, Israel, South

and UAE) represent the second mostnt destination fo

(about 13% of total exports). Where imports ofgoods are concerned, the second most importantprovider, after the EU Member States, is made upof a number of Asian countries (mainly China,Japan, South Korea, Thailand, India, Taiwan andSingapore), which accounted for 12¼% of totalimports in 2008.

The share of intra-industry trade in totalmanufacturing with the EU remains among thelowest among Member States. With the exceptionof pharmaceuticals (which accounted for about22½% of domestic exports in 2008), Cyprus'revealed comparative advantage is concentrated inlow- and medium-low tech sectors, namelybeverages and tobacco, non-metallic mineralproducts and clothing.


Between 2000 and 2008, Cyprus experienced asubstantial appreciation in the real effectiveexchange rate(91) vis-à-vis the IC35. In 2009, thisis expected to have continued at a slightly slowerpace, as a result of the subdued economic activityand more benign inflation conditions. During thelast nine years the degree of appreciation variedfrom 19¼% (GDP deflator) to 12¾% (export pricedeflator). In terms of the deflator of privateconsumption, the REER appreciated by about16%. This has been affected by the increase inindirect taxes, as part of the VAT harmonisationprocess of Cyprus to comply with the EU acquis,

When deflated by the deflator for private consumption, theGDP deflator, the export price deflator, and ULC-totaleconomy.

(91)


energy and commodity prices in 2008. Part ofthese competitiveness losses are also attributable tothe appreciation of the nominal effective exchangerate (Graph III.8.1), which partially reflects theappreciation of the euro, to which the Cypriotpound was pegged before euro area entry.

Graph III.8.1: REER - Cyprus vs. euro area,NEER - Cyprus vs.40 industrial countries (2000=100)

95

100

105

110

115

120

125

NEER, relative to 40 industr. countries

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

REER, (ULC - total economy) - relative to the rest of EA.


Graph III.8.2: Wages – Productivity, Cyprus vs. euro area(2000=100)

95

100

105

11

115

0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

CY - Real GDP / person employedEA - Real GDP / person employedCY - Real compensation per employee, deflator GDP: total economyEA - Real compensation per employee, deflator GDP: total economy


Against the euro area, developments in the realeffective exchange rate were relatively morebenign. The ULC-based REER appreciation overthe period was about 6%, mainly reflecting wage

ro area. Indeed, wagesin Cyprus grew: by almost 4% on average, while

the international financial crisis camewith a lag in Cyprus relative to its euro area

erage by 9% annually, while exports ofgoods grew by about 3¼%, compared with 7½%

growth above that in the eu

average productivity increased by only 1% a year,i.e. a gap of 3 percentage points compared with agap of 1¾ percentage points in the euro area. Theproductivity performance (in terms of levels) in

Cyprus has been lagging behind the euro areaaverage. However, since 2006, productivity growthhas outperformed the euro area average (GraphIII.8.2), in line with the increase of the GDPgrowth differential in favour of Cyprus. This wasespecially noticeable in 2008, as the negativeimpact of

partners.

Nevertheless, in the specific case of Cyprus, due tothe high specialisation in services exports,developments in the REER should be interpretedwith caution as they seem to have had adifferentiated impact on services versus industry.In particular, while the manufacturing sector,which represents about 8% of the economy,followed a declining trend in recent years, export-oriented services prospered partly due to a betterproductivity performance. In addition, export-oriented services, such as accounting and legalservices, are less price-sensitive as they areinfluenced more by other institutional factors suchas the country’s tax and legal frameworks.

Although due to the small size of the Cyprioteconomy, market shares are negligible byinternational standards(92), the openness of theeconomy, measured by the share of trade flows(volume) in real GDP, increased further between2000 and 2008 (from about 110% to just below115%). Over the same period, imports of goodsgrew on av

nominal GDP growth. In parallel, exports ofservices grew on average by 6½% annually duringthis period, benefiting from well-established tradelinks with the fast-growing markets of Russia andother CIS countries, as well as the Balkans, theMiddle East and North Africa. On the other hand,imports of services grew by 8% on average,largely due to an increase in the number ofCypriots travelling abroad. The increase wasparticularly pronounced in 2006-2007. Overall,between 2000 and 2008, Cyprus’ overall terms-of-trade (ToT) improved somewhat despite stagnatingToT for goods, due to gains in services, reflecting

(92) Due to the small volumes and sizes associated with a smalleconomy such as Cyprus, indicators tend to be relativelymore volatile than in the case of larger countries.Therefore, caution should be exercised in theirinterpretation.

92


l as inmodern productive and distribution processes,which impacted negatively on productivity growth.

o ntributedto the gradual decline of the Cypriot

of holiday houses (lower inflows) in conjunction

e

to200acc

0. The evolution of the Cypriot currentaccount balance shows large disparities between

ervices trade (24¼% of GDP).

the growing specialisation of the Cypriot economyin services.

During the last few years, the growth of thetourism sector has been sluggish due to increasedcompetition from, inter alia, low-costneighbouring Mediterranean countries. However,overall, the services balance remained rather stablethanks to an improved performance of otherexport-oriented services. Export-oriented servicesin particular, such as insurance, banking andfinancial services, merchanting, shipping, and ICTservices, recorded significant growth. Theharmonisation process in the run-up to EU-accession (2004) and, later, euro area membership(2008) acted as catalysts in this respect, throughthe liberalisation of various sectors of the Cyprioteconomy, leading to strengthened competition andflexibility and an induced confidence effect. Incontrast, while many other euro area countrieswere able to take advantage of growing nichemarkets or quality-enhancing processes for goods,the Cypriot manufacturing sector shrank. The mainfactors behind this gradual decline were the lack ofinvestment in R&D and in innovation, as wel

More ver, rising production costs also co

manufacturing sector. The combination of highwages and low productivity growth has led to lowprofitability the manufacturing sector, as reflectedin the downward trend in the ratio of the grossoperating surplus to value added over the past fewyears.

Net FDI inflows averaged 3% of GDP between2000 and 2008. However, the figure slumped in2008, largely due to a large one-off outflowassociated with the purchase of a Russian bank bya Cypriot financial group. Also, FDI has beennegatively affected since 2008 due to fallingexternal demand from non-residents for purchases

benefit largely from the presence of these foreign-owned enterprises. Thus, FDI flows into Cyprustend to be associated with the positive exportperformance of services. At the current economicjuncture, FDI outflows linked to the profits offoreign-owned companies are expected to declinein line with subdued economic activity and adampened profitability due to the internationaleconomic crisis.

8.3. SPECIAL FOCUS: THE STRUCTURE OF THECURRENT ACCOUNT BALANCE AND ITSFINANCING

Cyprus's current account deficit reached a recordhigh deficit of 17½% of GDP in 2008 (GraphIII.8.3). Following a close-to-balance position inthe mid-1990s, the current account balance hasdeteriorated over time and has been in the redsince 200

with the outflows associated with foreignerss lling their properties in Cyprus. A largeproportion of inward FDI also includes monetary

ws in the form of retained profitflo s (reinvestedearnings) of firms with foreign shareholding basedin Cyprus. In 2008, reinvested earnings amounted

53.5% of inward FDI, the highest share since0. Export-oriented services associated withounting, legal and other business services

net trade in goods and services. The persistentlyvery high deficit in goods trade and the very highsurplus in services reflect the shift of the Cyprioteconomy towards the tertiary sector. The negativetrade balance in goods (-27¼% of GDP over theperiod) is only partly compensated by the surplusrecorded in s

The widening of the trade deficit in the recent past(Graphs III.8.3 and III.8.4) reflects also theacceleration and the composition of GDP growth,which was exclusively driven by domesticdemand, as well as developments in commodityprices. High import elasticities led to asignificantly increasing trade deficit. Especially in2007-2008, the import elasticity increased to 1½,from an average of about 1 in the preceding years.The trade deficit was adversely affected by a fall inexcise duties on cars in 2003, followed by anadditional reduction at the end of 2006, which ledto a large increase of car imports.(93) Moreover,given Cyprus' large dependence on imported oiland foodstuffs, the trade balance has also beensignificantly affected in the last two years bytemporary factors such as the soaring oil, food andcommodity prices. The negative impact of higher

(93) The rise looks large when compared with the lower sales ofthe previous year. As consumers were anticipating the thenforthcoming reduction in excise duties, they held back carpurchases until the measure was adopted.

93


oil and food prices on import growth in 2008 wasonly partially mitigated by a positive growth ofexports of goods, largely reflecting revamped re-export activity (7¾%), after two years of negativegrowth. In parallel, the services trade surplusduring 2005-07 recorded only moderate growth,while it declined by 2¾ p.p. of GDP in 2008, dueto the negative impact of the international financialcrisis. In the coming years, the trade balance isexpected to improve, mainly due to animprovement in the balance on goods associatedwith the dampening effect on imports of mutedconsumption and investment.

Graph III.8.3: Current account balance (% of GDP)

-45-35-25-15-55

152535

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Goods Current transfersServices Primary incomeTotal current external account


Graph III.8.4: Net lending (+) /net borrowing (-) broadsectoral breakdown (% of GDP)

-20

-15

-10

-5

0

5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Private sectorGeneral governmentTotal Economy


The current account deficit also reflects aparticular country-specific feature related to thestatistical treatment of profits of firms with foreignshareholding based in the country. While these

in the financial account, whenreinvested. As a result, part of the current account

ere negatively affectedby subdued external demand for housing from

on-residents in 2008, while outflows resultedfrom sales by foreigners of their holiday propertiesin Cyprus.

Foreign capital is overwhelmingly concentrated intradable services, particularly financial services,but also increasingly in other business services likeaccounting, legal and consulting, as well as ITactivities. Beyond FDI, portfolio investment(essentially bonds, notes and money marketinstruments issued by banks and by thegovernment) provides an additional source offinancing, although it is characterised by highvolatility as it depends on the investment decisionsand strategy of private banks and financialinstitutions. Other inflows have also been sizeableespecially in 2008, essentially reflecting asignificant inflow of non-resident deposits, mainlyfrom the CIS, held in the Cypriot financial sector.Capital transfers have been very low in net terms(0.06% of GDP and 0.03% in 2007 and 2008,respectively) as inflows from the EU wereessentially offset by contributions to the EU.

profits are accounted as an outflow in the incomeaccount, which is included in the current account,they are treated as a foreign direct investment(FDI) inflow

deficit is automatically compensated by capitalinflows.

The external financing of the current accountdeficit includes a variety of instruments, which canbe classified into three categories: direct, portfolioand other investments, which are recorded in thefinancial account. In the case of Cyprus, thefinancial account posts significant surpluses,mainly due to positive net FDI inflows and, to alesser extent, to positive balances in portfolio andother investment. Net FDI inflows, whichrepresent mostly reinvested profits of firms, havecovered a substantial part of the current accountdeficit. In particular, they accounted for more than100% of the current account deficit between 2000and 2003, for 50-75% between 2004 and 2006, anda smaller share in 2007 and 2008. In 2008, thefinancial account posted a surplus of 18¼% ofGDP, out of which net FDI inflows representedonly 2% of GDP, due to a significant outflowassociated with an investment by the largestfinancial group in Russia. As mentioned in theprevious section, inflows w

n

94


The increase in the current account deficit in the

private I.8.4). On the back of a

ase inpublic sector savings, as government accounts still

from 3½% of GDP in 2007. Thus, public sectorsavings played a buffer role in meeting theincreasing financial needs of private agents.


In the specific case of a small, open, services-oriented economy like Cyprus, joining the euroarea has given a more prominent role tocompetitiveness as a channel of adjustment.Therefore, developments in productivity andwages play a crucial role. While productivity inCyprus grew at the same pace or even slightlyfaster than in the euro area over the last decade,wages grew at a significantly higher rate. As aresult, unit labour costs rose faster than in the euroarea, implying a steady loss of Cyprus'competitiveness vis-à-vis its partners. At the sametime, the current account deficit grew steadily, asthe surplus in trade in services failed to

last five years essentially reflects a steadyworsening of the net financial position of the

sector(94) (Graph IIfall in risk premia and an easing of financialconditions, the private sector saving rate(95) fellsharply. In 2008, credit(96) expanded by around18½%, compared to 22% in 2007. Credit to theprivate sector grew by almost 19¼% in 2008compared to 21¼% in 2007, with growthconcentrated in construction, real estate, renting,and business activities. In particular, about 47¼%of total lending went to non-financial corporationsand 48½% to households, with 21½% goingdirectly to house loans. Compared to 2007, lendingto non-financial corporations increased slightly,while for households, insurance corporations andpension funds, lending remained about the same.However, the deterioration in private sectorbalances was partially offset by an incre

recorded a surplus of 1% of GDP in 2008, down

(94) Due to data availability, it is not possible to discriminatebetween households and corporations.

r, ESA95, declined from 17.7%GDP in 2008.

(96) MFI loans to domestic residents by institutional sector

ff in the inflow of

stment in the context of the euro area

sustained wage growth during a period of slumpedproductivity growth. Moreover, wage moderation

spifor

(95) Gross saving - private sectoof GDP in 2003 to 1.7% of

excluding companies without physical presence.(97) The text which follows, including policy challenges, draws,

inter alia, on already issued policy invitations andrecommendations under various Community instruments,such as the updated Stability Programme, the EDPrecommendations and the strategy for growth and jobs.

counterbalance the growing deficit in merchandisetrade. And while the deficit is shrinking due tocyclical factors, it is expected to remain relativelyhigh and the trend appreciation in the real effectiveexchange rate is set to continue. The relativelyimportant specialisation of manufacturing trade inlow- and medium- technology sectors reflects thelow level of technological sophistication ofmanufacturing. The small size of the economyhampers the scope for the diversification ofproduction activities and leads to a high degree oftrade specialisation, which increases its exposureto external shocks and to competition from lower-cost economies. The country is also characterisedby constraints in term of labour supply, which arebeing exacerbated by a fall-oforeign workers flowing the deterioration in thecountry's short-term economic prospects. Asustained supply of labour would also appear to beparamount for ensuring wage moderation inCyprus.

In view of Cyprus' weakened competitiveness inthe euro area and its persistent current accountdeficit, adjuwould be facilitated by relative price and costadjustments and a shift of resources from the non-tradable to the tradable sector, including in exportsof services.

Against this background and in view of Cypruswidening domestic and large external imbalances,remedial efforts are needed in a number of areas.Restoring the link of wages to developments inproductivity is crucial to support thecompetitiveness of the Cypriot economy. In thiscontext, there is a need to ensure that labourmarket institutions do not unduly impede theefficiency of the wage-setting process. Allowingwages to reflect sector or company productivitygains would lead not only to a more competitiveposition at the sector level, but also to a moreefficient allocation of labour. In view of this, aresponsible stance is warranted by all actors in thetraditional tri-partite wage-setting negotiations.Importantly, the wage drift and indexation(COLA), which adjusts wages based on inflation inthe previous six months, could contribute to a

in the public sector, in view of its size andllover effects to the private sector, is importantoverall wage developments. A sustained supply

95


96

hat to curbing wage pressures.Nevertheless, with Cyprus’ short-term economicprospects appearing less bright, as the country is

a a lag,inflows of foreign workers are expected to subside.

competitiveness. Reforms to improve the humanes

would app e, given theweight of these activities for Cyprus. Initiatives todevelop a comprehensive research and innovationsystem, as well as improvements in the functioningof product and labour markets, could play a role infacilitating the restructuring of production towardsmore innovation-driven manufacturing and

t-term economic outlook andprospects. With government revenues projected to

of labour would also appear to be paramount forensuring wage moderation in Cyprus. Hitherto,large migratory inflows of foreign workerscontributed somew

being ffected by the international crisis with

Given the overall tight labour supply conditions,an improvement in the participation rates of femaleand older-age workers would increase laboursupply. While emphasising the importance of wagerestraint, further productivity-enhancing structuralreforms are also warranted. Redirecting resourcesto growth-enhancing areas, investing in humancapital development (e.g. via vocational,education, training and apprenticeship systems) aswell as further improving active labour marketpolicies, investing in innovation and R&D wouldenhance the economy’s growth potential and

capital of the labour force for market servicear particularly appropriat

services activities. However, given the relativelysmall size of the Cypriot industry, Cyprus couldbenefit from concentrating on a limited number ofmarket niches.

Given the country's high current account deficit,prudent fiscal policies are crucial. Public sectorsavings can play a buffer role in satisfying thefinancing needs of private agents. At the currentjuncture, this is particularly pertinent in view ofthe muted shor

decline in line with subdued economic activity anda less tax-rich composition of growth, controllingcurrent primary expenditure, which has been on acontinuous upward trend, would be paramount.Social support measures should be targeted toreach those in real need, in order to strengthensocial cohesion without jeopardising the country’sfiscal position. Efficiency in the use of publicresources should also be improved through arestructuring of public expenditures towardsgrowth-enhancing areas. In particular, publicexpenditure could become more productivethrough a reallocation towards public investmentin knowledge, human and physical capital. Thiswould increase the attractiveness of the country tobusiness activities with higher technologicalcontent and added value.

9. LUXEMBOURG

97

REIGN TRADE

open economy inntrated

s -quarters o and about two-thirds ofimports. Exports of services are chiefly directedtowards Germany (18%), the UK (13%),Switzerland (11%), as well as Belgium, France andItaly (10% each). Exports of goods are for the mostpart directed to the EU (87% in 2008), mainly to

Belgium. They areessentially made up of metal-made manufactures,


With exports of goods and services amounting to179% of GDP in 2008 and imports to 151%,Luxembourg is by far the mostthe EU-27. Foreign trade is strongly concein service , which account for more than three

f exports

Germany, France and

machinery and equipment as well as the residualcategory "other" or "diverse" manufactures.

Graph III.9.1: Luxembourg's share in total euro-area exports(in %)

a. Goods

0.42

0.44

0.46

0.48

0.50

0.52

0.38

0.40

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

goods at current prices goods at constant prices

b. Services

3

4

5

6

7

0

1

2

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

services at current prices services at constant prices


In the last few decades, trade in goods and servicesrecorded recurrent surpluses, which rose fromabout 12% of GDP in 1991 to 32½% in 2008.These surpluses were the combined result of large

and broadly stable deficits in merchandise trade(about 10% of GDP on average) and surpluses inservices that increased from about 25% of GDP inthe early 1990's to 43% in 2008. In recent years,financial and insurance services have accountedfor more than 90% of the total surplus in services.Simultaneously, the balance on net primary

negative si because ofthe surge in the number of cross-border workers,which rose from less than 25% of totalemployment in 1991 to more than 40% in 2008. Asa result, the current account surplus has remainedfairly stable since the early 1990s at about 10% ofGDP, reaching 12% in 2008.

The export performance of Luxembourg since thebeginning of the 1990's has been quite different forgoods and services. The country's share in totaleuro-area exports of services almost doubled invalue since 1995 and rose by more than one thirdin volume, decreasing only during the 2001-2003slowdown and in the current crisis (see GraphIII.9.1 a).

Exports of goods present a more complex picture:Luxembourg's share in euro area exports(including intra-EA exports) increased slightly(though with relatively large fluctuations) from1995 to 2004 (see Graph III.9.1 a). Afterwards, itdiminished until 2007 before rising significantly in2008. Up to 2003, developments in volume and invalue were quite similar. However, since then, the

exports of goods hasincreased by about 30% in five years, leading to a

income from abroad has been increasinglynce the mid-1990s, mainly

price of Luxembourg's

56.8% increase in value, compared with a 20.8%rise in volume. This increase in price compensatedfor a large part of the relative decline in volume ingoods exports from 2004 to 2007: as Graph III.9.1a shows, during that period, Luxembourg's share ineuro-area exports of goods declined significantlyin volume but barely in value.(98) Similarly, thestrong rise in goods exports recorded in 2008(7½% in value) was mainly due to a surge in prices(almost 6%), since exports only grew by 1½% involume. However, this picture could be somewhatblurred by the large increase in re-exports in recent

(98) From 2004 to 2007, in real terms, Luxembourg's share inthe EU-15 total exports of goods decreased from 0.40% to0.36%, a 10% drop with respect to the 2004 level, while invalue terms, it only declined from 0.42% to 0.41%.


MPETITIVENESS

The cost-competitiveness of Luxembourg has

2001, tfaster he EU-15 as awhole, as well as in Belgium or in France. It was

t years.

years.(99) As far as domestically-produced goodsare concerned, Luxembourg's exports performancemight thus be less favourable than exportsstatistics indicate.

9.2. INDICATORS OF CO

unquestionably deteriorated in recent years. Sincehe rise in ULC has been one and a half timein Luxembourg than in t

especially strong in manufacturing industry, whereULC increased by a cumulative 22.5% from 2000to 2008, while in the economy as a whole, theyrose by 18% over the same period. This strong risein ULC in Luxembourg's manufacturing industrymay contribute to explaining the rather subduedperformance of exports of goods in recen

Graph III.9.2: Luxembourg: real effective exchange rateindicators (2000 = 100) (IC36)

90

95

100

105

110

1995Q1

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

120

125CPI deflatedGDP

115

Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1

deflator deflatedULC deflated

Source: ECB, OECD, BCL and Commission services.

The increase in ULC was even stronger infinancial intermediation, where they surged by acumulative 28.1% from 2000 to 2008, essentiallydue to a 25.1% rise in wages.(100) However, thisdoes not seem to have had a commensurate effect

(99) Luxembourg-Findel is the 5th European airport for freightahead of e.g. Brussels, Madrid and Munich.

(100) Since 2000, the rise in ULCs was weaker in the financial

added per person employed surged by a cumulative 76.3%from 2000 to 2007). In the sub-sectors "insurance" and

orting sectors havebeen able to switch to higher-value added products

ecade. Clearly, one reason for thisdeterioration is the appreciation of the euro since

an even more unfavourable

sector than for the economy as a whole. This is due to avery strong decline in the sub-sector "intermediation andinsurance auxiliaries", where ULCs dropped by nearly onethird thanks to a very strong increase in productivity (value

on the country's performance in terms of exports ofservices. The prices of exports of services havealso surged in Luxembourg since 2000: theircumulative rise reached 25.3% from 2000 to 2008(the second strongest increase in the EU-15 afterIreland), despite a 6.3% decline over the years2001 to 2003. This suggests that theLuxembourgish services-exp

"financial intermediation", the rise in ULCs was strongerthan on average in the economy as a whole.

and/or they are able to pass through cost increasesinto their prices.

The ECB harmonised competitiveness indicator(which is a real effective exchange rate based onrelative HICPs vis-à-vis the group ofLuxembourg's 36 major trading partners (IC 36)(101) confirms the deterioration of the competitiveposition of Luxembourg since the beginning of thecurrent d

the end of 2000. However, this factor has played arole for all countries of the euro area (and also forthose whose currency is pegged to the euro) and itis probably less important for Luxembourg, sinceits exports of goods are relatively moreconcentrated inside the euro area. Moreover, as theweight of oil products in the HICP is much largerin Luxembourg than in most other Member States(due to the massive purchases of car fuel by non-residents), the HICP tends to overstate domesticinflation during periods of rising oil prices. Forthis reason, the Central Bank of Luxembourg(hereafter BCL) computes indicators using therelative GDP deflators, the relative ULCs or theLuxembourgish national CPI, which excludesconsumption by non-residents. As expected, theindicator based on the national CPI gives a lessunfavourable picture of the competitiveness ofLuxembourg during this decade than the HICP-based indicator, because the rise in the nationalCPI has been significantly smaller than that in theHICP (see Graph III.9.2). On the other hand, theindicators based on the GDP deflators and on therelative ULCs give

(101) The ECB indicators based on the GDP deflators and onULCs are compiled vis-à-vis the other 15 euro areacountries and a group of 21 trading partners, whichcomprises the 11 non-euro-area EU Member States plus the10 other most important trading partners. The ECB

15 euro area countries and a group of 41

artners.

indicators based on HICPs are additionally calculated vis-à-vis the othertrading partners, which comprises the group of 21 plus the20 other most important trading p

98


re ents inLuxembourg in recent years.pictu of competitiveness developm

As Table III.9.1 shows, the reason for the strongerrise in ULC in Luxembourg since the beginning ofthis decade is twofold: a faster rise in wages and aslower increase in productivity.

Table III.9.1: Luxembourg and neighbours: wages,productivity and unit labour costs(2001 - 2008)

(average annual %change) LU BE DE FR Euro area

Nominal compensation perhead 3.2 2.9 1.6 2.9 2.7

Real GDP per personemployed 0.8 1.0 1.5 1.0 1.0

Nominal unit labour cost 2.4 1.8 0.1 2.0 1.9


Wages, which had increased by less inLuxembourg than in the rest of the EU from 1995to 1998 and by hardly more in the strong growthyears of 1999 and 2000, decelerated less during the2001-2003 slowdown and re-accelerated morefrom 2004 to 2007. In 2008, however, theydecelerated markedly, rising by 2.6%, to becompared with 3.4% in the euro area. (see GraphIII.9.3). This faster rise in wages compared with

e stronger job creation in the faster rise in wagesin Luxembourg is thus not completely clear-cut.

The role of the stronger inflation seems lessambiguous. Since 2001 the rise in consumer priceshas been faster in Luxembourg than on average inthe euro area, while it had been slower thanaverage during the period 1995-1998. In order toimprove competitiveness, it was agreed with thesocial partners in April 2006 that the existing wage

indwoinc

the euro area since 2001 may be related to the factthat both job creation and inflation have beenstronger in Luxembourg:

Since 2001, employment has been much moredynamic than in the euro area as a whole.However, this was also the case from 1995 to1998, when wages were rising more slowly inLuxembourg than on average in the EU. Moreover,the existence of a large pool of available workersin neighbouring regions reduces tensions on thelabour market in fast growth periods. The role ofth

indexation mechanism, under which wages wereexed each time the CPI had risen by 2.5%,uld be replaced until 2009 by 2.5% wagereases at pre-determined dates (about once a

year) regardless of the actual rise in the CPI. Thismeasure has probably reduced that part of the risein wages that is due to indexation with respect towhat it would have been under the "normal"system. However, it did not prevent wages fromrising rather fast in 2006 and 2007 (by 3.1% and4.3%, respectively).

Graph III.9.3: Luxembourg and euro-area yearly % increasein wages and productivity (in %)

Nominal compensation per head

56

4

-3-2-10123

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Luxembourg Euro area Difference

Real GDP per person employed

-5-4-3-2-101234

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Luxembourg euro area Difference


On the other hand, the average increase inproductivity has been slower in Luxembourg since2000, chiefly because both during the 2001-2003slowdown and the current recession, job creation

acted with a sizeable lag to the slowdown inoutput: GDP slowed down strongly from 2000(+8.4%) to 2001 (+2.5%) but employment hardlydecelerated, still growing by 5.6% and 5.5%,respectively. Due to this massive labour hoarding,GDP per person employed dropped by 2.3% overthe period 2001-2003. However, from 2004 to2006, productivity grew faster in Luxembourg, asis generally the case during strong growth periods,the opposite being true during phases ofslowdown. Finally, something similar to the 2001episode took place on an even larger scale in 2008:real GDP stagnated, while total employment,

re

99


though decelerating strongly during the last few

fell by r with a 3.4% average

isation ofLuxembourg's industry but reinforced by an

From 2002 to 2007, the demand for productsexported by Luxembourg rose faster than averageworld demand. This was exclusively due to themetal-made manufactures, with the contributionsof all other categories of goods to this effect beingnegative or insignificant.

The geographical distribution of exports had anegative influence on their growth:Luxembourgish exports are mostly directedtowards the EU-15, especially the comparativelyslow-growing neighbour countries, withproportionally little going to the new member

owing regions like theBRICs.

months of the year, still grew by 4.8% in annualaverage. As a result, GDP per person employed

4.5%, which, togetheincrease in nominal wages, resulted in a 6.8%surge in nominal ULCs (compared with 3.4% onaverage in the euro area).

9.3. SPECIAL FOCUS: SECTORAL ANDGEOGRAPHICAL COMPOSITION OFLUXEMBOURG'S EXPORTS

A study by the Central Bank of Luxembourg(102)concludes that the loss of cost competitivenesssince the beginning of the decade has beenpartially compensated by a favourable "producteffect" resulting from the sectoral special

unfavourable geographical distribution:

states and other fast-gr

Developments in cost competitiveness had anegative effect on average but they were verydiverse across sectors. Competitiveness improvedin the sectors of "other manufactures" (i.e. notmetal-made) and transportation material, while itdeteriorated in the sector of metal-mademanufactures, where growth in exports, thoughstronger than average, was thus less dynamic thanthe rise in exports markets would have suggested.

Developments in cost competitiveness also variedaccording to the country of destination: onaverage, cost competitiveness deteriorated in the

(102) Banque centrale du Luxembourg, Compétitivité etexportations, in Bulletin 2008 / 1, pp. 82-90.

Belgian, French and UK markets but improved inGermany, other euro area countries and the newmember states. This is a quite paradoxical resultsince, as already mentioned, the loss of costcompetitiveness since 2000 has been much largercompared to Germany than to France and Belgium,while ULC have even increased marginally less inLuxembourg than in the UK.

No similar study has been found for exports ofservices. It is, however, possible that the strongperformance of services exports up to 2007,despite a very significant rise in labour costs, isdue to a kind of "product effect" similar to thatobserved in goods exports: from 2003 to 2007 thedemand for financial services, in whichLuxembourg specialises, most probably increasedfaster than the demand for most other types ofservices.

In some neighbouring countries (e.g. France), thesmall size and limited number of exporting firms,as well as the relatively low R&D expenditure ofenterprises, have been identified as factorshampering export performance. There is noevidence that these factors play a similar role inthe case of Luxembourg. Indeed, total R&Dexpenditure is comparatively low, but this is partlydue to the very low public spending on R&D(which is, however, set to increase significantlywith the development of the University ofLuxembourg). Moreover, the Luxembourgishmanufacturing sector is relatively concentrated and

ation ringustrial

intern alised: more than 90% of manufactuoutput is exported and the 4 biggest indemployers in the country belong to largeinternational groups(103), which certainly carry outa lot of research abroad(104), from which theirLuxembourgish subsidiaries or facilities canbenefit. Consequently, neither the size and numberof exporting firms nor the low amount of R&Dexpenditure inside the country seems to constitutea significant handicap for the Luxembourgishexport performance.

Arcelor-Mittal, Goodyear, Guardian Industries and Dupontde Nemours.

(103)

(104) Beside a production unit, Goodyear also has a largeresearch centre in Luxembourg.

100


101

on in cost competitiveness probablyplayed a role in the decline up to 2007 in the

into force once again. Since this likely worsening


The cost-competitiveness of Luxembourg hasdeteriorated since 2000, due to a faster rise inlabour costs than in its main trade partners. Thishas been caused both by a stronger increase inwages, despite their partial de-indexation in 2006,and by a slower rise in productivity, chiefly relatedto very large labour hoarding during the 2001-2003 slowdown and the current recession. Thedeteriorati

country's share in euro-area goods exports.However, this share rose abruptly in 2008,although the deterioration in cost competitivenesswas especially sizeable that year. On the otherhand, no similar decrease can be observed inLuxembourg's share in euro-area exports ofservices, although the rise in ULCs was evenstronger in the financial intermediation andinsurance sectors than on average in the economy.The Luxembourgish services sector seems to havebeen able to pass through cost increases into itsexport prices without resulting losses in marketshares, which, on the contrary, significantlyincreased in recent years.

The combination of the contraction in output andthe still strong employment growth recorded in2008 resulted in another strong increase in labourcosts, which rose by more than 7%. Sinceemployment is unlikely to contract as much asoutput, ULCs are expected to continue to rise bymore than in most other EU member states.Moreover, the partial de-indexation of wages isscheduled to last through 2009, after which the"classical" indexation system is supposed to come

in competitiveness will be largely due to

developments in productivity that are beyond thecontrol of the authorities and of the social partners,it might be advisable to try to influence the otherterm of the equation, namely the increase in wagesin a favourable way. The rise in real wages since2000, though not spectacular, has not beennegligible either. Moreover, income tax bracketswere recently adapted by 15% in two steps in orderto compensate for their non-indexation since 2001,leading to a sizeable in


the strategy for growth and jobs.

crease in the after-taxincome of many households (the ex ante loss of

ecently been adapted by 15% in twosteps in order to compensate for their non-indexation since 2001, a few years of wage

wagesbe war ng European Councilinsisted on the need to invest more in knowledge

recommendations under various Community instruments,such as the updated Stability Programme, the EDPrecommendations and

revenues resulting from these tax cuts has beenestimated at 0.8 percentage point of GDP in 2008and 1.2 pps in 2009).

In view of Luxembourg's strong non-pricecompetitiveness and current account positions,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against this background and in view of theimportant deterioration in cost-competitivenesswhich occurred in recent years, efforts should aimat containing the increase in wages and fosteringwage behaviour that takes due account ofproductivity developments. Given that income taxbrackets have r

adjustment, where, for instance, the rise in nominalexclusively compensates for inflation, couldranted. The 2008 Spri

and innovation. In this respect, the projectedincrease in public R&D spending related to thedevelopment of the University of Luxembourgshould be welcomed. Efforts to increase R&Dactivities in the country need to be pursued further.

10. MALTA

102


Malta is one of the most open economies in theeuro area with exports and imports combinedamounting to some 180% of GDP, in volumeterms. Malta's small size necessarily implies anarrow range of exports, which gives rise to risksstemming from a lack of diversification. This,coupled with the country's dependence on strategicimports, specifically fuel and industrial supplies,limits the economy's resilience to external shocks.However, as witnessed in the current global crisis,the ongoing transformation of the export sectortowards high value-added activities, especially inservices, may have improved resilience.

Graph III.10.1:Developments in Malta's external account,1995-2011

-30-25-20-15-10-505

101520

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10f 11f

Net exports of goods Net exports of servicesNet primary income frm r-o-w Net current transfers from r-o-wCurrent account balance


Malta has traditionally registered a trade deficit,which nonetheless has declined markedly from13.2% of GDP in 1995 to around 3% of GDP in2008, helped mostly by a steady improvement inthe services surplus, which almost doubled from8.7% of GDP in 1995 to 17.3% in 2008. In 2009,the trade balance moved into surplus for the firsttime since 2002 also thanks to lower energy prices.Looking forward, the external balance of goodsand services is expected to narrow further on theback of a notable drop in imports, reflecting themarked slowdown in domestic demand and a

growth in the volume of services exports averageda notable 4.7% annually in the period 1996-2009.These developments reflect the ever-shrinking roleof manufacturing, as traditional sectors like textilesand clothing face stiff competition from low-costproducers, an

lower oil import bill in 2009 followed by arecovery in the services balance thereafter. The

dec69%

d have occurred despite Malta's

activities s as pharmaceuticals and aircraftmaintenance. Further success was registered inattracting new services activities, most notablyICT and financial services and online gaming, andin upgrading traditional tourism exports.

A breakdown by product category shows thatelectronics account for around half of total foreignsales of goods (linked to the dominance of a singlefirm), while the remainder is spread thinly acrossother sectors, namely pharmaceuticals (9%), food3.7%), printed matter (6%), aircraft maintenance

%), textiles and clothing (4.2%) and scientificequipment (2.5%). Malta's merchandise exportsappear to enjoy a very strong comparativeadvantage in the high technology sectors. Around55% of merchandise exports are concentrated inthe high-technology category, reflecting the highshare of electronics. For services, the distributionis more even with tourism remaining the mainexport sector (25% of services exports revenue)followed by ICT and other business services(25%), online gaming (20%) and financial services(6%).


share of exports of goods in total exports haslined progressively over the years from almost

in 1995 to around 57% in 2009. Conversely,

recent inroads in attracting new manufacturinguch

((2.5

In the period 1995-2009, Malta's real effectiveexchange rate (ULC-based) registered a substantialappreciation against both euro area countries andindustrialised countries (IC35).(106) The pace ofappreciation was faster between 1995 and 2001 inrelation to the euro area while it depreciatedagainst industrialised countries, reflecting in partnominal effective exchange rate developments inthis period. Thereafter, the REER depreciated vis-à-vis the euro area but appreciated further relativeto the industrialised countries.(107) The loss in

(106) The average annual appreciation during this period variesfrom a low 1.0% for the private-consumption-deflator-based REER to a high 2.2% for the REER based on theexport price deflator.

(107) This is significant given that some 60% of Malta's totalexports are directed to non-euro-area countries.


registered animprovement as Malta progressively diversifiedinto new fast-growth activities. For goods, market

ated inelectronics and clothing, while gains were

The ratio of gross operating surplus to value added

sectoral level, the more-than-doubling of the profit

competitiveness against industrialised countriesafter 2001 was brought about by unfavourabledevelopments in Malta's ULC relative to the IC35as well as a weakening dollar.(108) For Malta,consistently higher unit labour costs, especially ina context of an appreciating exchange rate, may becritical as firms in the exposed sector are "price-takers" on the international market, implying thatany adjustment would have to come through areduction in profit margins, reduced investment orlay-offs.

Malta's share of exports of goods and servicesdeclined during the period 1995-2009, albeitmarginally. The fall is due to the performance ofgoods, whose export shares declined appreciably.Conversely, services export shares

share losses were mainly concentr

recorded in food. On the other hand, Malta'smarket share improved marginally inpharmaceuticals but declined in scientific andtelecoms equipment. In the case of services,market shares increased in financial intermediationand ICT services and substantially for personal,cultural and recreational services, mainly due tothe expansion of remote gaming in recent years.The higher export market shares in services led topositive terms-of-trade changes. A look at theexport market performance indicator suggests thatMalta has not been able to respond fully to theaccelerating global demand of its products. Theexport performance indicator has been decliningalmost uninterruptedly between 1995 and 2008,with little prospects of a reversal in the near term.

deteriorated during the period 1995-2005 forindustry as a whole. For manufacturing, afterdeclining in the second half of the 1990s, theprofitability ratio peaked in 2000 mainly on theback of the strong growth registered in theelectronics industry. Thereafter, the ratio broadlycontinued its downward trend due to bothrestructuring in anticipation of EU accession in2004 and the global economic downturn. At a sub-

For Malta, fluctuations in the exchange rate of the dollarare relevant given that it is the currency in which electronicproducts are traded.

ratio in the chemicals sector between 2000 and2005, reflecting the growth of the high value-added pharmaceutical activities, is worth noting.Conversely, during the same period theprofitability of the electronics sector fell markedly.In services, profitability was pushed down bylower gross operating surplus in tourism during theperiod 1995-2005. This was partly offset by theemerging online gaming and activities related tofinancial intermediation.

Net FDI inflows were particularly strong duringthe period 2000-2008 peaking at slightly above29% of GDP in 2006.(109) Around 45% of inwardinvestment originated in EU27 Member States in2007. In services (excluding financialintermediation, which is the sector mostly affectedby non-productive flows), the highest FDI inflowsin 2007 were registered in the transport, storageand communication sector (60%), while real estateaccounted for 22% and recreational, cultural andsporting activities reached 16% of total inflows,reflecting investment in online gaming. Over theyears, FDI has proved to be a key aspectsupporting Malta's competitiveness since itpromotes transfer of technology and expertise,while allowing for the exploitation of new marketopportunities.

10.3. SPECIAL FOCUS: DIVERSIFYING THEEXPORT SECTOR TOWARDS FAST-GROWING SECTORS

(108)

The small size and openness of the country,

vulnerable to external shocks. Continuing the

together with its narrow productive base havehistorically provided a challenge to the Malteseeconomy. Heavy reliance on external trade and alack of diversification, both in terms of productsexported and export markets, make Malta

diversification of the export sector with a focus onmore dynamic sectors is key for enhancing Malta'sresilience as evidenced by the role played by newservice activities in cushioning the impact of theglobal economic crisis.

(109) There are indications that a proportion of inward FDIincludes non-productive flows reflecting the activities of“Special Purpose Entities” or SPEs, which are mainlyfinancial holding companies, foreign-owned, andprincipally engaged in cross-border financial transactions,with little or no local activity in the Member State ofresidence.

103


dition, new services-oriented export activitiessuch as remote gaming, call centres, and moreimportantly financial services and ICT haveexpanded in recent years. The authorities' strategyto make Malta an ICT cluster in the region hastranslated into securing 'Smart City', a project thatwill involve the operation of a technology park forICT and media companies. There are indicationsthat the expansion in new services activities hasimproved Malta's economic resilience.Specifically, in 2009, as economy-wide grossvalue added contracted by 0.3%, gross value addedin both financial intermediation and remotegaming posted significant growth suggesting that,in their absence, the decline in output would havebeen much worse. Malta's strategy of FDI-ledexport diversification could potentially encounterdifficulties in the current economic situation asglobal liquidity constraints tend to favour savinginstead of funding long-term investments.(110) Inthis context, the need to press ahead with structuralreform, specifically in those aspects that improvethe business climate, becomes even more pertinent.

A look at Malta's specialisation shows that it is stillhighly concentrated in the less internationallydynamic sectors. This seems to be particularly thecase in manufacturing due to the dominance ofelectronics (slightly more than 50% ofmerchandise exports). However, the expansion ofpharmaceuticals, telecommunications andscientific instruments points to the steady, albeitincipient, progress achieved in recent years inshifting manufacturing to high-growth industries.Malta has been losing export market shares mainlyin electronics and clothing, both considered to beslow-growth sectors internationally, while gainswere recorded in food, also a less dynamic sector

In recent years, Malta has followed an FDI-leddiversification strategy relying on improving non-price competitiveness by targeting and attractinghigh-end niche operations. Manufacturing has seena shift to high value-added activities such asprinting, aircraft maintenance and genericpharmaceuticals. The tourist industry is beingtransformed from one largely reliant on thedeclining mass-market tour operators to faster-growing, high value-added individual tourism. Inad

(see Graph III.10.1). On the other hand, in high-growth sectors such as pharmaceuticals, scientificinstruments and telecoms equipment, Malta'smarket shares have either improved marginally(pharmaceuticals) or else declined (scientific andtelecoms).

Graph III.10.2:Change in Malta's exports market share, 1995-2007

Services

-1 0 1 2 3 4 5 6 7 8

Air Transport

Other Transport

Communications

Financial

Other business services

Construction

Goods

-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15

SemiconductorsMisc. manufactures

PharmaScientific equipment

FishRoad vehicles

ClothingEdible products

RubberTextiles

Industrial machineryTelecom equipment

Office machinesPower generators

Specialized industrial machinery

Source: IMF.

Malta's degree of specialisation in services hasincreased significantly over time. Despite a moreeven distribution across services sectors (comparedto that in the goods exports), tourism remains thedominant activity. Improvements in the exportperformance of total services would thus requirestrong growth in tourism. This has not been thecase: after reaching a peak in 2003, Malta's sharein global visitors has declined. However, theunderperformance of the tourism industry has beenmore than compensated for by emerging serviceactivities. In recent years, Malta has becomespecialised in high-growth sectors, with substantialmarket share increases in personal, cultural andrecreational mainly due to the expansion of remotegaming. Market share increases were also recordedin financial intermediation and ICT, two of the tophigh-growth sectors at the international level.

(110) Although they should be treated with caution due to theirhigh degree of volatility, provisional FDI data show that inthe first half of 2009, inflows declined by around 10%compared to the corresponding period of 2008.

104


The structural changes undergone by Malta and the

the siz by the new activities

ADJUSTMENT (111)

impulses. Malta has largely avoided such a pitfallto the

economic ublicinfrastructure, which should result in a highmultiplier to the local economy. At the same time,although unpopular, some reforms aimed atenhancing the quality of public finances, namelythe reduction of subsidies granted to the water andenergy providers and the liquidation of the Maltashipyards (which however had a strongly negativeimpact on the general government deficit in 2008),have been implemented.

Nevertheless, in the specific case of small andopen economies operating within the context of amonetary union, competitiveness as a channel of

h as the current crisisent role. Against the

efforts to diversify the export structure in the pastfew years have started to bear fruit, although so far

e of exports generatedremains relatively modest in comparison toMalta’s traditional exports. It appears that in thecase of manufacturing, Malta's export performancewould benefit from further shifts in the productionbase from declining to fast-growth sectors as wellas from capturing a bigger share of the growingworld demand in those new sectors withsignificant growth potential. For services, whilethere remains scope for reducing the dominance ofthe tourism sector, overall Malta seems to betargeting internationally dynamic sectors and thechallenge is to respond more forcefully to theopportunities offered by this trend.

10.4. THE NEED FOR

Although fiscal policy can play a role indampening the impact of external shocks, itseffectiveness for small and open economies likeMalta is limited because of significant importleakages that generally accompany budgetary

by focussing most of its fiscal responsedownturn on enhancing p

adjustment to shocks suctakes a more prominbackground of weak productivity gains, Malta'scompetitiveness remains vulnerable. Real wagerestraint was reversed recently following thesustained pay increases in the public sector as


provided in the current collective agreement aswell as higher salaries awarded to publichealthcare employees. As a result, in the first halfof 2009, wage inflation exceeded productivitygrowth. Looking forward, wages are expected togrow at an annual average of slightly more than2¼% in 2009-2010. Wage increases in the sizeablepublic sector (which accounts for slightly less thana quarter of total employment in Malta) may havecushioned the initial impact of the economicrecession but could act as a signal to the privatesector, thus hampering the wage adjustmentprocess. In addition, between October 2008 andmid-2009, Malta displayed a persistent inflationdifferential with the euro area, most notably as aresult of sticky food prices. Trade operators failedto pass on the lower global food prices, suggesting

elp the economy respond

lic

the existence of a dysfunction in the productmarket, such as restrictive trade practices. This isof further concern for Malta since annualautomatic cost-of-living adjustment is mandatoryand based on backward-looking pricedevelopments. Such a mechanism may give rise toprice inertia as past inflation is built into future paysettlements. As a result, wage adjustment ishindered, which could heighten the persistence ofthe adverse impact of external shocks on outputand thereby reduce the economy's resilience.Ensuring competitiveness demands furtherstructural reforms that will enhance productivityand better alignment of wage to productivitydevelopments. It is therefore desirable to promotemore price flexibility to hswiftly to such shocks.

In view of Malta's competitiveness position in theeuro area and its current account balance,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against this background and considering theimportance of the export sector to Malta's growth,policy efforts should aim to ensure that labourmarket institutions do not unduly hamper theefficiency of the wage-setting process. This maybe achieved through, inter alia, sustaining wagemoderation by promoting wage restraint in thepublic sector and preventing excessive pubsector pay increases from spilling over to theprivate sector, while ensuring that wage growthreflects productivity developments and reducinginflation persistence. There is also a need to bolster

105


106

DI, which represents the main source oftechnology transfer, and further reducing the sizeof government. In addition, improving non-price

ed by

productivity. Looking forward, the near-termprospects for productivity appear weak. Therefore,productivity should be boosted by strengtheningcompetition in product markets, redirectingresources to growth-enhancing areas, investing inhuman capital development and facilitating furtherinward F

competitiveness should continue to be pursu

further reorienting the export sector towards highvalue-added and fast-growing goods and services.In the area of the labour market, there is a need toimprove incentives to work, particularly forwomen and older workers, inter alia by: takingfurther action on the tax and benefit systems tomake declared work more attractive and toenhancing lifelong learning, while stepping upefforts to increase educational levels and reducethe number of early school leavers.

11. NETHERLANDS

107

ports and imports


The Netherlands is one of the most openeconomies in the euro area. Trade openness in theNetherlands (measured as the sum of imports andexports relative to GDP) increased steadily from74% of GDP in 1980 to 161% in 2008 (comparedto the euro area average of 89% in 2008). Theshares of both exports and imports in GDP havebeen increasing at a rather similar pace in the lastfew decades with the former rising from 37.3% in1980 to 84.1% in 2008 and the latter from 37% in1980 to 76.8% in 2008. Due to the globaleconomic and financial crises, however, tradeopenness declined in 2009 for the first time inalmost thirty years as both exports and imports fellby more than GDP.

The share of Dutch exports and imports of goodsand services in world trade has remained relativelystable over the past few decades. The Dutchmarket share in world examounted to 3.7% and 3.3%, respectively, in 2008.

Graph III.11.1:Relative export performance of theNetherlands (net exports of goods andservices as a percentage of GDP)

-151996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-10

-5

0

5

10

DE EL ES FR IT NL EA-16

Commission services.Source:

The trade balance recorded a positive 8½% ofGDP in 2008, considerably higher than the euroarea average (see Graph III.11.1). Dutch exports ofgoods accounted for 82% of total exports in 2008.A significant part of this consists of re-exports(47% in 2008), which can in large part beexplained by the country's strategic geographicalposition, especially vis-à-vis Germany, which

enables the Netherlands to function as a majortransit country, particularly through the part ofRotterdam. Most re-exported goods originate inAsia, and are primarily oriented towards the EU.

d goodsgoing to th hing 78%.The country's main export partners are Germany(24.2%), Belgium (12.6%), United Kingdom(9.1%), France (8.1%) and Italy (4.7%). Incontrast, just half of total imports originate fromthe EU. The relative importance of exports ofgoods has increased somewhat over the past fewdecades, while the share of services in total exportshas declined from around 23% in 1980 to 18% in2008, which is slightly below the current euro-areaaverage (20%).

A breakdown of exported goods by categoryindicates that exports are mainly in the categories"machinery and transport equipment" (30%),"chemicals and related products" (17%), and"mineral fuels and lubricants" (16%). Re-exportsaccount for around two thirds of the total exportsof machinery and transport equipment andprimarily consist of electrical equipment andelectronics. The high share of exports of mineralfuels and lubricants can be explained by the factthat the Netherlands is both a producer and anexporter of gas (total net exports of gas amounted

n 2008), an importer ofned oil products (through

Unsurprisingly, the total share of exportee EU is relatively high, reac

to around 1.6% of GDP ioil and an exporter of refithe port of Rotterdam).

Net exports of services were negative between1995 and 2003 before turning positive in 2004(due to an increase in the balance of licenceroyalties, transport and tourism). The total share ofexported services going to the European Union is58%, whereas around 9% of exported services aredestined for the US. Exports of services thereforeseem to be more extra-EU-oriented than goodsexports. The main exported services are in thecategories "other business services" (33%),including e.g. legal services, accountancy andmanagement advice, commercial services,architect and engineering services, and "transportservices" (24%). Financial services amounted to amere 1½ % of total exported services in 2008.

The Netherlands is a structural net direct investorabroad, as the net Foreign Direct Investmentbalance was mainly negative in past years. Only in


s.Due to the subsequent nationalisation in 2008, the

EER (based on unitlabour costs, the GDP deflator, the deflator of

section 3). Competitivenessbased on the other REER deflators show a less

re-exports, which are scarcely affected byunfavourable domestic unit-labour-cost

proaro

Othof

itiveness, due forexample to quality improvements, or falling profitmargins. Starting with the latter, the much more

on theexport price deflator suggests that Dutch exporters

al effective exchange rates versus IC 35

2007 did the Netherlands record a positive net FDIbalance of over 11% of GDP, which can beexplained by the take-over of ABN-AMRO by aconsortium of Spanish, British and Belgian bank

total net FDI turned negative once again (-3% ofGDP).


Cost and price competitiveness may be assessed bylooking at developments in the real effectiveexchange rate (REER). The R

private consumption and the export price deflator)vis-à-vis the euro area appreciated from 1997 to2002 and has stabilised since then. The REER vis-à-vis a group of 35 industrialised countries (IC35)shows an appreciating trend from 2000 onwards,pointing to decreasing competitiveness, which wasonly briefly interrupted in 2005. Specifically, thelargest competitiveness losses were recorded withthe REER based on unit labour costs, whichincreased by 14% vis-à-vis IC35 over the period2000-2008 (see also

pronounced deterioration, especially that using theexport price deflator, which appreciated by 9% vis-à-vis IC35 in the period 2000-2008. Despite theappreciation of the REER vis-à-vis the IC35(whichever deflator one takes), the market share ofDutch exports increased from 3.5% in 2000 to3.7% in 2008. This trend is also apparent in theexport market performance indicator, which hasbeen showing gains in market share over severalyears except for 2006.

The high market share of exports is distorted bythe fast growth of re-exports. The latter posted anannual average growth rate during 2000-2008 of11%, whereas domestically produced exports grewby only 2% on average. The loss ofcompetitiveness of domestically-produced goodsand services was thus offset by the dynamism of

cost competitiveness could stem from animprovement in non-price compet

developments. The added value of domesticallyduced exports is, however, estimated to beund six times higher than that of re-exports.

er reasons for the relatively stable performanceDutch exports in spite of the deterioration of

limited deterioration in the REER based

may have reduced their profit margins to maintaintheir competitiveness. Factors other than cost andprice developments may also play a role. First,geographical specialisation can play an importantrole in export performance: if for example exportsare primarily oriented towards fast growingmarkets, this will, ceteris paribus, improve exportperformance. Second, sectoral specialisation caninfluence trade performance: if demand is high forcertain products (e.g., in highly research-intensivegoods) and competition remains low, this can havea positive effect on export performance. Finally,other non-price competitiveness developmentssuch as technological competitiveness can also beimportant. Technological competitivenessincreases export performance, not only by leadingto more innovation, but also by increasingefficiency and reducing costs.

Graph III.11.2:Re(2000=100)

90

95

100

105

110

115

1995 1997 1999 2001 2003 2005 2007

Real effective exchange rates, based on unit labour costsReal effective exchage rates, based on GDP deflatorReal effective exchange rates, based on private consumption deflatorReal effective exchange rates, based on exports of goods and services


Dutch exports are primarily oriented to other euroarea countries, whose import growth has beenrelatively limited in comparison with growth inworld trade. In addition, the share of extra-EUexports directed to fast-growing markets such asBrazil, Russia, India and China (BRIC- countries)is relatively low (around 15%). Thus, geographical

posof

specialisation does not seem to have a veryitive effect on the relative export performance

the Netherlands.

108


ge, which iscalculated as the share of a given goods category

chnology intensity of manufactured goods, theNetherlands excelled in all but medium-to-low-technology goods until 2006, but showed a markeddeterioration in 2007, especially for high-technology goods. This development mightjeopardize competitiveness since high-technologygoods are more difficult to imitate than medium-to-low-technology goods.

In the latest EU Innovation scoreboard, theNetherlands is classified as an innovation followerand scores just above the EU average. OverallR&D intensity was 1.7% of GDP in 2007, downslightly from 1.8% of GDP in 2001. Privateinvestment in R&D is relatively modest at around1% of GDP (well below the Dutch target of 2%)and is mainly concentrated in a few multinationalcompanies. The relatively low private R&D mightpartly be the result of the strong service focus ofthe Dutch economy as a whole. However,compared to other countries (DE, BE, SE, FI),R&D investment in services also lags behind in theNetherlands.

11.3. SPECIAL FOCUS: WAGE DEVELOPMENTSAND UNIT LABOUR COSTS

Unit labour costs increased steadily between 1995and 2003, as shown in Graph III.11.3. This was theresult of the strength of the Dutch economy in thesecond half of the 1990s, which created vigorouslabour demand growth. Increasing demand and atightening labour market exerted upward pressureon wages around the turn of the century. Followingan agreement in autumn 2003 between thegovernment and social partners to moderate wages

Revealed Comparative Advantage (RCA) providesan indication of the relative advantage ordisadvantage of the Netherlands in a certain field.It is measured using the classic Balassa index ofrevealed comparative advanta

in the country's total exports, relative to the exportshare of that goods category for the worldaggregate. If the RCA is higher than 1, this meansthat the Netherlands has a comparative advantagein this field. The RCA based on factor intensityshows that the Netherlands performs well in "easyto imitate research-intensive" goods and "Rawmaterial intensive" exports, where the latter seemsto be explained by exports of domestically-produced gas. Looking at the RCA based onte

in 2004 and 2005, unit labour costs remainedbroadly stable until 2006, when they started to risesharply again, although at a similar pace to thecountry's main trading partners.

Graph III.11.3:Relative unit labour costs and wagedevelopments in the Netherlands

Nominal unit labour costs; total economy(national currency (2000=100))

100105110115120125130135

9095

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

BE DE FR NL

Nominal compensation per employee; total economy(national currency; annual percentage change)

0

1

2

3

4

5

6

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

BE DE FR NL


Looking at the period 2000 to 2008, unit labourcosts rose by around 20% in the Netherlands,which is somewhat above the 17½ % increases inFrance and Belgium, but markedly above the 3%increase in Germany over the same period. Thiswidening gap vis-à-vis Germany is particularlyimportant given the fact that Germany is the maintrading partner of the Netherlands. Unit labourcosts consist of two components: productivity andcompensation of employees. Observed differencesin unit labour costs result mainly from differencesin compensation of employees and far less fromdifferences in productivity. Over the period 2000-2008, nominal compensation per employee rose by34% in the Netherlands compared to 25% inFrance and Belgium and only 14% in Germany(see Graph III.11.3). Since it is difficult to increaseproductivity through the implementation of newpolicy measures, at least in the short run, policymakers tend to plead for wage moderation when

109


competitiveness needs to be improved, as

compe etherlands in 2005.

nominal unit labour

high trade surplus in

experienced in 2003 when the above-mentionedautumn agreement was reached and led to a

tiveness gain of the N

Wage behaviour affects not only competitiveness,but also public finances. For the Netherlands, thiseffect is very important, as social benefits aredirectly linked to wage developments. Lower wagegrowth not only has a positive effect on publicfinances through the government wage bill, but italso automatically leads to lower social benefits.These combined effects dominate the negativeeffect from lower income tax.

Against this background, wage moderation waspresented as one of the pillars of the exit strategyfor the high current deficit levels by the Dutchgovernment in their third stimulus package inMarch 2009. The incidence of wage moderationwill depend largely on the social partners(112), butit can be expected that some wage moderation willtake place due to the rapid loosening of the labourmarket. Since wage agreements tend to be set forone year or more, their effects are expected to holdfor 2010 and 2011.

Due to the severe recession,costs increased in 2009 by around 5%, above theeuro area average of around 4%. This is the resultof the combined effect of a lagged labour marketresponse to the crisis, resulting in lowerproductivity, and the still relatively strong wagegrowth. As unemployment is set to increasesharply in 2010 and the effect of wage moderationis expected to hold notably in 2011, unit labourcosts are predicted to stabilise in 2010 and todecrease in 2011. Due to the strong increase innominal unit labour costs, thethe Netherlands fell by around 1 pp. in 2009,although it still remained in considerable surplus(7¼ % of GDP) partly as a result of the downwardpressure on imports from the expected muteddomestic demand. In 2010 and 2011, a recovery inthe trade balance is foreseen as domestic demand

(112) In The Netherlands, collective wage contracts arenegotiated between labour unions and employers'organisations. Collective wage contracts typically refer to asingle firm or an industry. Moreover, regular discussionsbetween social partners take place within the framework ofthe Labour Foundation (STAR) and the Social EconomicCouncil (SER) and between social partners and thegovernment.

remains weak and the rising trend in unit labourcosts is expected to be reversed.


made theNetherlands particularly vulnerable to the sharpdrop in world trade as a result of the globaleconomic crisis. The significantly positive tradebalance in 2008 indicated that the Netherlands hada relatively favourable competitive position. Thisresulted partly from a stable and even slightlyincreasing market share in world exports over pastyears, although this came mainly from a stronggrowth performance of re-exports, which have arelatively low added value. Looking more closelyat competitiveness indicators, it emerges thatDutch cost competitiveness has been deterioratingsince 2000. This is also the case, though the

possibly indicating diminishingprofit margins. From a euro area perspective, this

ss in competitiveness in past years can be seen asexternal

ances.

Growth of nominal compensation per employee inthe Netherlands has been relatively high comparedto its main trading partners and is the main reasonfor the loss in cost competitiveness over the pastfew years. The policy of wage moderationconducted in 2004 and 2005 largely brought costcompetitiveness back in line with the country'smain trading partners. The government hasannounced its intention to pursue a renewed policyof wage moderation. While this may havefavourable effects on employment in tradable

ure on real disposable income,which is the main driver behind private

The openness of the economy

deterioration is more limited, for pricecompetitiveness,

locontributing to an adjustment ofimbal

sectors and public finances, it may result in somedownward press

consumption. Regarding productivity, a weaknesshas been identified in the levels of both public andprivate R&D expenditures. The Dutch governmenthas responded to these challenges by a set ofinitiatives such as the Innovation Platform and theinnovation voucher scheme. Results, however,have remained modest thus far.


110


111

ble downwardpressure on R&D investment resulting from thedifficult economic circumstances. In addition,

linewith productivity developments. In the area of the

In view of the Netherland's competitiveness in theeuro area and its current account surplus,adjustment in the context of the euro area would befacilitated by a particular focus on strengtheningthe sources of domestic demand.

Against this background and in view of therelatively high increase in unit labour costs abovethe euro area average in 2009, policy effortsshould aim at maintaining cost competitiveness byattenuating the rise in relative unit labour costs. Atthe same time, wage moderation alone is not apromising long-term strategy, given its dampeningimpact on domestic demand. A further increase inR&D spending and innovation should lead tohigher productivity growth (and therefore lower

unit labour costs) and would help to shift Dutchexports towards more high-technology-intensiveproducts where competition is more limited. It isimportant that the reform efforts are continued inorder to counterbalance possi

there is a need to ensure that wages evolve in

labour market, possible structural reforms include:simplifying the dismissal system to make it morepredictable as well as increasing labour supplythrough a reduction of disincentives to take-upwork and to work longer, especially with respect towomen, the elderly, and disadvantaged groups.

12. AUSTRIA

112


Austria's good overall economic performanceduring the last one and a half decades was to alarge extent due to favourable developments in thecountry's exports. On average, net exportscontributed close to ¾ of a percentage point peryear to GDP growth. Austria's foreign trade ischaracterised by three main features. First, there isa close link with the German economy, which wasfurther reinforced by Austria's accession to the EUin 1995. Second, Austria benefited more than otherWestern European countries from the opening-up

ral-Eastern and South-Eastern Europe (CESEE) in the course of thenlargement of the European Union in 2004 and

ally earned asizable net surplus in cross-border services mainlydue to its tourism sector. The surplus in the tradebalance is a more recent phenomenon, which hascome about as a consequence of dynamic growthin the transition economies in Austria'sneighbourhood and improved costcompetitiveness, but also due to a relativelyrestrained domestic demand.

While total exports constituted 35% of GDP in1995, they reached more than 62% of GDP at theend of 2007, but fell almost 54% in 2009. Between1995 and 2008, the share of exports of services in

ile that of goodsor imports, a similar but

started to decline in thefourth quarter 2008 and dropped dramatically in

swung into again. However due tostrong net earnings on services trade, the externalbalance of goods and services stayed in surplus,albeit substantially reduced.

Graph III.12.1:Total exports by region (billion €)

of the markets of Cent

e2007. Third, Austria has tradition

GDP increased by 50%, whexports almost doubled. Fsomewhat less dynamic pattern can be observed.As a consequence, the overall trade balanceimproved steadily over this period, turning to asurplus from 1998 onwards.

Since 1995, the degree of openness (total exportsplus imports in volume terms as a % of GDP) hasincreased by 45 pps, reaching 118% in 2007(compared with 93% for Germany and 88% for theeuro area average), and Austria managed toincrease its market share in world exports. As aconsequence of the global financial and economiccrisis, international trade collapsed, leading to adecrease in openness in 2009. The value ofAustrian goods exports

2009 (almost -18%). As the drop in imports wasless pronounced, the trade balance for goods

deficit once

20

40

80

100

120

140

160

180 R.o.w.BRIC countriesUSARest of EU-27Other neighbours

01995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

60

Germany

Source: Oesterreichische Nationalbank (OeNB), Balance ofPayments Statistics.

Graph III.12.2:Total imports by region (billion €)

40

80

100

120

140

160

180 R.o.w.BRIC countriesUSARest of EU-27Other neighboursGermany

0

20

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

60

Source: Oesterreichische Nationalbank (OeNB), Balance ofPayments Statistics.

In terms of geographical structure, Austria'sforeign trade is largely concentrated on its eightdirect neighbouring countries, which absorbedmore than 55% of exports and supplied more than63% of imports in 2008 (Graphs III.12.1 andIII.12.2). Germany clearly dominates as adestination for Austrian exports, accounting for32%dimovehasyea

of all exports, even if this reliance hasinished somewhat (from 41.6% in 1995). Withr 39% in 2008, the imports share of Germanyremained almost unchanged over the last 15

rs. The high figures reflect the tight links in the


companies, notably in the automotive andelectronics industry. With around 40% ofovernight stays, German tourists remain dominantin Austrian services exports. The slightdiversification of trade away from Germany is dueto the dynamic increase in exports to the new EUMember States of Central and South Eastern

and Eastern Europe.(114) With a share of 7.5%,

odsimports.

exports are dominated bywhich m an 40% of the total value of

in which Austria is specialised, wereaffected most by the slump of world trade in 2008and 2009.

sto

supply chains of (South) German and Austrian

Europe in recent years. These economies nowaccount for 17.5% of total exports, reflecting a

a's role as a hub for Centralcertain revival of Austri

Italy is Austria’s second largest trading partner,followed by the US and Switzerland (both around4%). Trade with China currently amounts to only1% of exports suggesting a potential for furtherdevelopment. In this regard, Austria is held back,however, by the preponderance of small andmedium-size enterprises and the absence of largemulti-national companies. This also explains whyAustria's trade is still concentrated onneighbouring countries, as entering overseasmarkets (like e. g. China or India) generallyexceeds the capacity of small companies.Conversely, China has strengthened its position inthe Austrian market in recent years. With a shareof 4.2%, China (together with Switzerland) is thethird most important origin for Austria’s go

In terms of product categories, Austrian goodsmachines and vehicles,

ake up more thexports, followed by processed materials (almost25%), notably of iron and steel. Taken together,these two categories (SITC 5 – 6) make up 65% ofall Austrian goods exports. In 2009, the exportvalue of these product categories declined by 30%(passenger car exports: -45%). Thiscountry−product−mix has rendered the Austrianeconomy more vulnerable to the current crisis, asAustria's major export markets, and the productcategories

Outward and inward foreign direct investmentcks increased strongly in the last decade

For further details, see Ragacs C., Vondra K., "Austria’sExports to Eastern Europe: Facts and Forecasts - LikelyImpact of Slowing Exports on Growth in Austria",Oesterreichische Nationalbank (OeNB), Monetary Policyand the Econ

(114)

omy, Q1/2009, pp 29-43.

(outward stock by 590% and inward stock by400%) and the excess of inward FDI over outwardstocks shrank from 57% to 5%. Compared with theEU average, however, the Austrian economy stillappears less open in this regard.


depend on theexternal competitiveness of goods and services

nt account surplus of over

ess

As a small, highly open economy, growthprospects in Austria crucially

produced. The close ties to the German economyhave led to Austrian wage-setting being closelyaligned with developments in its most importanttrading partner. Therefore, Austria's competitiveperformance over the last decade and a half hasparalleled that of Germany - with the notabledifference that Austria's domestic demand provedmore robust, as it did not have to bear the costs ofreunification.

Graph III.12.3 presents evidence of how Austria'sperformance shadowed both Germany's high wageagreements in the early nineties and wagemoderation since 1995. However, in the last fewyears, wages grew relatively faster in Austria asproductivity growth was stronger and a shortage ofskilled labour became an issue for manufacturingfirms. Like Germany, Austria also saw aturnaround in its current account balance. From adeficit of around 3% of GDP in the mid-1990s,Austria moved to a curre3½% in 2008 (Graph III.12.4). The surplus thenedged down in 2009 in the wake of the crisis.

In relation to the rest of the euro area, fourindicators of the real effective exchange rate (thosebased on the deflator of private consumption, theGDP deflator, the export price deflator and ULCfor the total economy) show a partly mixed picture(Graph III.12.5). Until the first few years of thenew millennium, an effective depreciation wasobserved followed by a period of a more or lstable REER up to 2008. The most significantdepreciation took place in the REER based onULC, in line with the subdued growth of wages inAustria and average productivity increases abovethe euro area level in the last decade. Since 1995,real output per employee has risen by about ½ pp.faster in Austria on average than in the euro area.

113


Graph III.12.3:Nominal compensation per employee inmanufacturing (annual % change- until 1995West Germany)

-4.5

-3.0

-1.5

0.0

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

1.5

3.0

4.5

6.0

7.5

9.0

DE AT


Graph III.12.4:Current account in % of GDP

-4

-2

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011f

0

4

6

8

2

DE AT


Explaining the increase in the REER based onexport prices since 2002 is not straightforward.Given that the rise in relative export prices hasbeen accompanied by a minor gain of marketshares and an improvement in the relative labour

rima

x

cost position, thus does not point to a loss incompetitiveness. However, as terms of tradeworsened, the rise in relative export prices may bethe result of an increase in intermediate inputp ces. Whether the rise in relative export prices

y also be linked to an increase in exports ofher quality products and/or a rise in Austhig rian

e porters' profit margins is not clear based on theavailable evidence.(115)

It should be noted that the reliability of the export pricedeflator for Austria suffers

Graph III.12.5:Real effective exchange rates compared withrest of euro area

95

100

105

110

115

120

1995 1997 1999 2001 2003 2005 2007 2009 2011f

private consumption deflatorGDP deflatorexports price deflatorULC


Graph III.12.6:: Real effective exchange rates comparedwith 35 trading partners

(115)from (i) the difficulty of

95

100

105

1995 1997 1999 2001 2003 2005 2007 2009 2011f

110

120private consumption deflatorGDP deflator

115 exports price deflatorULC


With regard to the IC35 benchmark (GraphIII.12.6), the picture is slightly different. Here,three REER indicators, apart from that based onULC, show a loss in competitiveness, in line withthe nominal appreciation of the euro. However, inspite of the strong euro, the REER based on ULCremained more or less unchanged between 2000and 2008, bearing witness to Austria's much lessdynamic wage developments compared with otherindustrialised countries.

measuring quality changes; (ii) Austrian export priceindices are partly adapted from German trade data fitted tothe Austrian trade basket; and (iii) underreporting is likelyto have increased since 2002, which coincides with thesignificant deviation of the export price deflator from theother deflators.

114


severe, economic activity fell sharply in 2009,

ut as government policy measures were shieldingthe labour market, the decrease in employment wasless pronounced. As a consequence, productivitydropped sharply, while unit labour costs rose.However, the increase in ULC is overstated tosome extent as part of wage costs for employees inshort-time work is borne by the government.

12.3. SPECIAL FOCUS: AUSTRIAN FDI IN THECENTRAL AND EASTERN EUROPEANCOUNTRIES

An important element of Austria's tradeperformance is due to the opening up of Centraland Eastern Europe, which affected the Austrianeconomy more than most other Western Europeancountries. Based on model simulations, the fall ofthe iron curtain and EU Eastern enlargement hadpositive effects on exports and growth as well as(but to a lesser extent) on employment, whereasreal wages per capita and inflation were heldback.(116)

he loss of competiveness based on the ULCindicator for the total economy for the period 2009onwards is due to two effects. On the one hand,wage settlements negotiated in autumn 2008 for2009 took into account the higher rate of inflationand the high productivity growth of the previousyears. On the other hand, due to therecessionb

(116) For further details see: Bayerl, N., Fritz, O., Hierländer, R.,Streicher, G., "Exports, Services and Value Added - ANational, International and Regional Analysis for Austria",FIW Studie Nr. 008/2008; Breuss F., "Ostöffnung, EU-Mitgliedschaft, Euro-Teilnahme und EU-Erweiterung,Wirtschaftliche Auswirkungen auf Österreich", WIFOWorking Papers 270/2006; Breuss F., "Erfahrungen mit derfünften EU-Erweiterung", WIFO-Monatsberichte, 12/2007,S. 933-950.

avia (Table III.12.1). Almost one-third ofhe Austrian FDI stock has been invested in theew EU-10 states, with the biggest shares in

Romania, the Czech Republic, Hungary andPoland and 17% in CESEE-9 countries (seefootnote b in Table III.12.1 for a definition). Ofeven greater importance (71%) is Central andSouth Eastern Europe in terms of the number ofpersons employed by Austrian FDI. Austria'sstrong position as an investor in this region is alsoemphasised by the market shares of Austrian FDI(Table III.12.1, column 3 and 4). In five countries,Austrian companies are the most importantinvestors.

As shown in Table III.12.2, Austria's outwardforeign direct investment is to a large extentconcentrated in the services sector (74%), mostnotably in the banking and insurance industry andreal estate, renting etc. which make up one-thirdand more than one-fourth of total outward FDI.Although the production sector roughly accountsfor only one-fourth of the FDI outward stock, 55%of those persons working for Austrian directinvestors abroad are employed in this sector.

While Austria has lost some of its first-moveradvantage, Austrian enterprises still benefitstrongly from their presence in the CESEE region.The apparent profitability (measured as return onequity) of these investments in the EU-10 andCESEE-9 is quite high, exceeding 15% on investedcapital in 2006, compared with only 5.8% for

Trade figures as presented in Section 1, however,underestimate the importance of the economicrelationship with Central and Eastern Europeancountries, as Austrian firms have developed intomajor foreign investors in the new EU MemberStates, as well as in the successor states of formerYugosltn

Table III.12.1: Austria's outward FDI position in CESEE in 2007(1) (2) (3) (4)

EU-10 a) 33. 71 32. 9

(1) (2) (3) (4)SEE-9CE b) 17.4 17.0

oatia 10.5 10.2 34.2 1snia-Herzegovina 1.6 1.5 34.2 1rbia 1.3 1.2

Slovenia 2.1 2.1 44.7 1Romania 9.2 8.9 21.4 1Bulgaria 6.6 6.4 20.2 1 SSlovak Republic 4.3 4.2 14.2 3 FYHungary 7.4 7.2 13.0 3 UkCzech Republic 7.6 7.4 10.7 3 MoPoland 3.5 3.4 3.6 9 Alb

CrBo

e 15.6 2ROM 0.2 0.2 9.4 4raine 1.7 1.7 6.8 4ntenegro 0.2 0.2 7.1 5ania 0.0 0.0 2.3 6

(1) Austrian outward FDI in Billion € (2) Share in % of Total Austrian FDI stock (3) Share of Global FDI Stock (4) Global Rank a)EU-10: Bulgaria, Estonia, Latvia, Lithuania, Poland, Czech Repub9: Albania, Belarus, Bosnia Herzegovina, Croatia, FYROM, MoldavSource: OeNB, FIW, WIFO.

lic, Rumania, Slovak Republic, Slovenia, Hungary b) CESEE-ia, Russia, Serbia Montenegro, Ukraine

115


Austrian outward FDI in the EU-15.(117) An

Accord rnative measure of

international comparison is hampered by the non-availability of a breakdown of data by region.

ing to an alteprofitability – total income from outward foreigninvestment according to balance of paymentstatistics as a percentage of the end-of-the-yearoutward FDI stocks – outward FDI activities ofAustrian firms (8.6%) were more profitable thancomparable activities of the EU 15 (6.7%).

The main motive to invest abroad appears to bemarket entry to increase sales (market seeking), inparticular for companies in the services sector. Formanufacturing firms the reduction in productioncosts (efficiency seeking) is also of someimportance, but market-seeking motives clearlydominate.(118)

Table III.12.2: Sector structure of Austrian outward FDI - allcountries in 2007

in € bn in %

102.58 100.0 Services26.93 26.2 Trade and repair4.49 4.4 Banking, Insurance

20.27 19.8 Real estate, renting, IT, R&D2.17 2.1 Other services

Source: OeNB.

Empirical evidence on the costs and benefits,which the Austrian economy might have drawnfrom FDI in its Eastern neighbours, is scarce.Falk and Wolfmayr (2009) find that foreignactivities do not have a negative impact on theemployment and turnover of domestic activities ofthe parent company. Their analysis of Austrianmultinational companies reveals a small positiverelation between employment change in the parentcompany and employment change in all foreignaffiliates.(119)

Following the financial and economic crisis,investment projects in CESEE are expected to

(117) See: Sieber S. "Grenzüberschreitende Direktinvestitionenin und aus Österreich" in: FIW (2008), ÖsterreichsAußenwirtschaft 2008, Vienna December 2008; OeNB,Statistiken, Direct Investment 2007, September 2009.

(118) OeNB, Statistiken, Direct Investment 2007, September2009, Table X.

(119) For further details see: Falk M., Wolfmayr Y., "HomeMarket Effects of Outward FDI: Evidence Based onAmadeus Firm-Level Data" in: Tondl G., "The EU andEmerging Markets", European Community StudiesAssociation of Austria, ECSA Austria Publication SeriesVol. 12, Vienna March 2009.

yield (much) lower returns as well as to bear ahigher associated risk. As a result, the strongincrease in outward FDI flows, as witnessed byAustrian companies in the region in recent years,lost much of its dynamism in 2008 and almostcame to a halt in 2009. Furthermore, asinternational financial investors' risk aversion toCESEE countries rose sharply, the strongengagement of Austrian banks in this area changedinto a critical international reassessment. Austrian

aswell as in th ediaries forAustrian firms investing in CESEE, are (also inabsolute terms) the largest foreign lenders toCESEE. Reflecting expectations of an increase incredit defaults and a decrease in the return onequity for the FDI stocks held by Austrian banks,share values of the latter dropped sharply and riskpremia on their credit-default swaps went up.However, as indicated by stress tests carried out byAustrian financial market surveillance authorities,the Austrian financial sector is still in a solidposition.


External competitiveness is of the utmostimportance for the growth prospects of a small,highly open economy like Austria. With adepreciating real effective exchange rate and asolid current account surplus for almost ten years,Austria's competitive performance over the lastdecade and a half has paralleled that of Germany -with the notable difference that Austria's domestic

, as it did not have tobear the cost of reunification. This is unsurprising

banks directly, and via their CESEE subsidiarieseir role as financial interm

demand proved more robust

since close ties to the German economy have led toAustrian wage-setting being closely aligned withdevelopments in its most important trading partner.More recently, the dramatic fall in externaldemand that took place in 2008 and 2009 had asevere impact on export-led growth in Austria.Being highly concentrated on machines, vehiclesand processed materials, Austrian exports wereparticularly hard hit by the global downturn. In2009, unit labour costs increased for two reasons.On the one hand, wage settlements negotiated in


116


117

uctivity growthof the previous years. On the other hand, due to the

n2009, but ment policy measures wereshielding the labour market, the decrease inemployment was less pronounced. As aconsequence, productivity fell sharply.Government policy measures to shield the labourmarket can only be a temporary strategy whichneeds to be supplemented by productivity-enhancing reforms. Should Austria succeed inraising productivity and potential growth morestrongly, wages would be allowed to show a moredynamic behaviour, thereby helping to sustaindomestic demand. Overall, the main medium- tolong-term challenges for Austria to maintaincompetitiveness and growth in global markets willbe to keep up with technological progress.

ular focus on strengtheningthe sources of domestic demand.

s houldcontinue to enhance structural competitiveness by

autumn 2008 for 2009 were based on the higherrate of inflation and the high prod

severe recession, economic activity fell sharply ias govern

In view of Austria's strong competitiveness in theeuro area and its current account surplus,adjustment in the context of the euro area would befacilitated by a partic

Again t this background Austrian efforts s

shifting output production to higher value-addedgoods and services. This may be achieved through,inter alia, strengthening the translation of researchresults into innovation and production of goodsand services of the highest quality segments. Thisinvolves productive investment in physical andhuman capital such as supporting R&Dexpenditures, in particular for small and mediumsized enterprises, and improving the educationsystem at all levels, in particular at the tertiarylevel.

13. PORTUGAL

118

REIGN TRADE

Since the beginning of the current decade, theopenness of the Portuguese economy has been on aslight upward trend, yet below the correspondingaverages for the euro area (EA) and EU countries.In 2008, the sum of Portuguese exports andimports was 84% of GDP, against around 88% ofGDP for the latter two area averages. Thiscontrasts with the patterns observed in the previousdecade, when Portugal's trade openness wassomewhat above the EA and EU averages andreflects weaker growth of both exports andimports. As regards openness to FDI, the sum ofinflows and outflows averaged some 3% of GDPbetween 2001 and 2007, with inflows roughlybalancing outflows over this period.

Growth in Portugal's exports of goods and serviceshas been relatively contained and below the EAand EU averages for most years of the currentdecade apart from 2006 and 2007. Overall, for thedecade up to 2008, exports volumes grew incumulative terms by less than 33%, compared with40% for the EA average (Graph III.13.1, leftpanel). Imports expanded by less than exports over

rose by slightly less than26% up to 2008, against 40% for the EA country

Acountries. In addition, the weight of exports of

Amongst these, Spain has clearly been the most

27%


this period: total imports

average (Graph III.13.1, right panel). This was aconsequence of sluggish demand in Portugal inthese years after the demand buoyancy of the latenineties.

Exports of goods account for around ¾ ofPortugal's total exports. This export structure ismarginally tilted more towards services than theaverage for the EU and, especially, the E

services in Portugal's total exports has beenincreasing in a slow but relatively steady way,while the sluggishness of goods trade seems tounderlie Portugal's weaker export performance(Graph III.13.2). Concerning geographicalmarkets, Portugal’s trade has been concentrated ina small number of the EU's largest markets; intotal, trade with the rest of the EU accounts foralmost ¾ of Portugal's exports and imports.

and France with 14% and 13%, respectively. Thegeographical distribution of services exports isrelatively similar, although the UK has maintainedits traditional role as a major client for suchexports. An increasing presence in the newmarkets of the recently-acceded Member Statesand in countries outside the EU has been observedduring this decade.

Graph III.13.1:Trade performances in Portugal, euro area

important destination for goods exports (almostof the total in 2008), followed by Germany

and EU averages (2000=100)

Exports of goods and services

60708090

100110120130140150

1995 1997 1999 2001 2003 2005 2007 2009 2011f

Portugal EU-27 Euro Area

Imports of goods and services

60708090

1995 1997 1999 2001 2003 2005 2007 2009 2011f

100110120130140150



The current international crisis has particularlyhurt Portugal's trade activity. In 2008, exportvoltheyeaalrimreflesphal

gooserand

umes diminished by ½% under the effects ofslump in world trade in the final part of the

r. However, exports were cooling visiblyeady since early 2008. At the same time,ports retained some dynamism in 2008,ecting an upswing in domestic demand,ecially in equipment investment. In the firstf of 2009, imports and more particularly exports

fell sharply. As in many other economies, trade inds is clearly adjusting more than trade in

vices. For 2009 as a whole, exports of goodsservices fell by around 11½% in volume terms


and imports by over 9%, both slightly lower thanthe averages for the EA countries.

Graph III.13.2:Export performances: goods versus services(2000=100)

Exports of goods

60708090

100110120130140150

1995 1997 1999 2001 2003 2005 2007 2009 2011f


Exports of services

120130140150

607080

110

1995 1997 1999 2001 2003 2005 2007 2009 2011f

90100



The external sector has on average provided aneutral contribution to GDP growth over thecurrent decade, yet with visible differences overtime. For instance, contributions were positive inthe earlier years of the decade, thanks to importretrenchment and to strong export growth in 2006,whereas the contribution was negative in 2004-

result of poor exportperformance and some import resilience. In 2009,

ENESS

o a possible halt in the trenddeterioration in cost competitiveness losses in

2005 and in 2008 as a

the contribution of external trade is estimated tohave been essentially neutral to GDP growth.

The balance of goods has recorded deficitsaveraging some 10% of GDP in the currentdecade, after 9¼% in the second half of thenineties. In 2008 alone, the deficit reached 12% ofGDP reflecting the gap between growth in exportsand imports in volume terms and hikes incommodity prices. In 2009, against the backdropof the crisis, it narrowed only slightly to 10% ofGDP. By contrast, the services balance has postedslightly growing surpluses averaging 1¾% of GDP

since 2000 and reaching 2½% of GDP in recentyears due to a retrenchment of imports in the early2000s' as well as an expansion of exports after themiddle of the decade.

13.2. INDICATORS OF COMPETITIV

Various indicators of the real effective exchangerate (REER) – namely those based on the deflatorfor private consumption, the export price deflatorand unit labour costs growth (ULC) – haveexhibited an upward trend vis-à-vis the rest of theEA and especially against a broader group of 35industrialised economies (IC35) since at least themid 1990s (Graph III.13.3). The degree ofappreciation is more evident in terms of ULC forthe overall economy, which have grown by 20 ppsin excess of the EA average since 1995. In the firsthalf of the present decade, the rate of growth ofboth productivity and wages slowed downconsiderably, but ULC still continued to growsomewhat more rapidly than in the country'strading partners.

Most indicators point t

relation to the EA around 2006, with variousmeasures of the REER being roughly stablethereafter.(121) Yet this has not been the caserelative to IC35 as the real appreciation hascontinued in the range of 10-15% since the year2000, mainly due to the euro's appreciation. Inaddition, the current crisis seems to be leading tothe re-emergence of Portugal's labour cost growthdifferential vis-à-vis the rest of the EA.Furthermore, estimates of the equilibriumexchange rate suggest that Portugal's real effectiveexchange rate has been overvalued with respect to

(121) These figures have to treated with some caution to theextent that compensation of employees for the wholeeconomy reflects two different phases of compensation ofgovernment employees: up to 2005, compensation of thelatter was growing well above the rest of the economy (i.e.essentially, the private sector) whereas the oppositeoccurred in some later years. Furthermore, over most ofthis decade, the strong growth in government personnelspending was more related to government deficit-coveringpayments to the public employees' pension scheme than topublic wages and employment – even if they do not affectthe wage costs of the private sector. In addition, it is worthbearing in mind that while for most of the EA productivitygrowth is measured on a full-time-equivalents basis, in thecase of Portugal it is based on number of persons.

119


e rates vs. the euro

equilibria benchmarks by one of the largestmargins in the EA.

Graph III.13.3:Real effective exchangarea and IC35 (2000=100)

REER: based on labour costs changes

859095

100105110115

1995 1997 1999 2001 2003 2005 2007 2009 2011f

120

REER based on ULC relative to the EAREER based on ULC relative to IC35REER based on unit wage costs in manufacturing relative to EAREER based on unit wage cost in manufacturing relative to IC35

REER: based on price changes

859095

100105110115120

1995 1997 1999 2001 2003 2005 2007 2009 2011f

REER based on private consumption deflator relative to EAREER based on private consumption deflator relative to IC35REER based on exports deflator relative to EAREER based on export deflator relative to IC35


A picture of adverse competitivenessdevelopments is also provided by the evolution ofexport market shares. Indeed, Portugal’s share inglobal goods exports followed a clear downwardpath, declining from 0.44% in 1995 to 0.36% in2008, which is a more pronounced loss than for theaverage of all EA countries. Portugal's weight inEA exports declined more or less continuously inthe nineties and again sharply in 2004 and 2005.

In addition to adverse cost developments vis-à-visindustrialised countries, other aspects appear tohave hampered the performance of the externalsector in past years. Notably, Portuguese exportsof goods have relied to a considerable extent on

122

labour-intensive products ─ well in excess of theeuro area average ─ in which emerging economiestend to have a strong comparative advantagethanks to their low labour costs.( ) Whilst

It can be argued that competition from emergingeconomies is not fully captured by some standard cost-based competitiveness indicators to the extent that: fi

(122)

rst,

ereby limiting the growth in demand.

BALANCE

considerable differences vis-à-vis the EA persist,Portugal’s goods export sector has undergoneconsiderable restructuring and convergencetowards the average EA pattern in recent years,with a marked decline in the importance of labour-intensive exports. Such a fall was closely linked tothe dynamics of trade in textiles and clothing,where exports have fallen by an annual averagerate of 1% since the early nineties, leading to adecline of their weight in goods exports fromalmost 30% in 1996 to around 10% in 2008.(123) Infact, excluding these goods, Portugal’s exportsperformance was comparable to that of the rest ofthe EA. Nonetheless, during the crisis, thisspecialisation does not seem to have been anaggravating factor. In fact, there is some evidencethat exports of various labour-intensives types ofgoods declined less than total exports, possibly dueto more inelastic demand. At the same time, tradehas been concentrated on a small number of EUmarkets, where growth has been below the worldaverage, th

13.3. SPECIAL FOCUS: THE EXTERNAL BALANCEBEYOND THE BALANCE OF GOODS ANDSERVICES ─ THE IMPORTANCE OFTRANSFERS AND PRIMARY INCOME INPORTUGAL'S EXTERNAL

For many years, Portugal has recorded sizeableexternal deficits. In the present decade, the currentaccount deficit has averaged 9½% of GDP(compared to 6% of GDP in the late nineties) andwas at 10½% of GDP in 2009. A striking feature isthe recording of large deficits in this decadedespite sluggish demand, as economic activity has

only recently have some of these countries becomeintegrated into world trade; second, real effective exchangerates vis-à-vis industrial economies exclude, by definition,emerging economies; third, standard indicators are basedon growth rates rather then levels of wages and prices; and,finally, the structure of trade may differ between tradepartners. For a more detailed discussion on this matter see,e.g. di Mauro, F. and Forster, K. (2008), Globalisation andthe competitiveness of the euro-area. ECB OccasionalPaper Series, No. 97.

(123) In addition, intra-sector adjustments seem to have alsotaken place as reflected in gains in terms of trade insidesome sectors, especially in more labour-intensive sectorssuch as textiles, clothing and footwear (Cardoso, F. andSoares Esteves, P. (2008), What is behind the recentevolution of Portuguese terms of trade? Bank of Portugal,Working paper, No. 5/2008).

120


uro area do not differ substantially from earlierones, e.g. throughout the early and mid nineties.Fourth, still more striking has been the downwardtrend in the surpluses on current transfers since theearly nineties and the rising importance of primaryincome deficits since the late nineties, both ofwhich have aggravated external borrowing needs.

Graph III.13.4:A long-term view of Portugal's external

been expanding by a meagre ½% per year. Theobjective of this section is to shed light on someitems of Portugal's external balance other than thetrade balance (goods and services) – transfers andprimary income balances – and their roles in theevolution of the overall external balance.

An analysis of Portugal's external imbalances andits components over the past five decades (GraphIII.13.4) gives rise to a number of observations.First, Portugal's external imbalances have beenpersisting for a long time. Second, for a number ofdecades, large trade deficits have registered closeto double-digit figures. Third, the trade deficitsthat have been recorded after the creation of thee

account (% of GDP)

-25

-20

-15

-10

-5

0

5

10

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010f

Trade balance (G & S) Current transfersPrimary income Net capital transfersTotal current external account Total external balance


Portugal has historically recorded a large surplusin transfers, which has considerably offset thetrade deficits since the late 1960s. Graph III.13.4shows the importance of current transfers, whichreached an average of 7½% of GDP in the 1970sand 1980s, largely owing to migrants’ remittances,in a situation that was somewhat unusual amongthe current EA countries. However, the gradualdecline in the importance of remittances has led toa downward trend in the current transfers’ surplus,which may have resulted from a change in thedifferential between asset remuneration in Portugal

2008. This increase reflects theremuneration paid on the rising (net) stock ofexternal liabilities, which has been growingcontinuously and surpassed 110% of GDP in 2009(from 4% of GDP in 1995 and 41% of GDP in2000). These developments reflect past externaldeficits which, for more than a decade, have beenfinanced by portfolio and other investments.Roughly ¾ of the primary income outflowsconstitute remuneration of portfolio and otherinvestments whereas the remaining ¼ isremuneration of FDI.

To sum up, major changes have occurred in thetransfers and primary income balances for morethan a decade, which have contributed to the highexternal deficits. Notably, current transfers haveoffset a gradually smaller share of the chronicallylarge trade deficit, whereas the recourse to externalliabilities has become more important. The need toservice the stock of external liabilities has led to acertain degree of inertia. Going forward, whereasimproving competitiveness, i.e. strengthening theability to successfully compete in world markets, isnecessary to improve the trade balance and toboost GDP, it may not be mapped ontocommensurate falls in the external deficit to theextent that the burden of servicing growingliabilities will also rise, thereby offsetting a

and abroad, as well as from changes in migrationflows in recent decades. In addition, capitaltransfers – comprising mainly EU transfers – havebeen significant and the highest in the EA (onaverage, almost 2% of GDP since mid-1980s).Overall, capital transfers have been more stablethan their current counterparts.(124)

Another aspect of the evolution of Portugal'sexternal account over the past 15 years is thegrowing deficit in the primary income balance,which has become a major component of theoverall external deficit. In the current decade, thisdeficit has averaged 2¾% of GDP, reaching 4% ofGDP in

(124) The large capital inflows in the case of Portugal favoursuse of the broader concept of external deficit, instead of thenarrower current account, at least as far as externalfinancing needs are concerned. At the same time, on thebasis of the evidence on the historically high trade deficitcounterbalanced by large transfers, a more fundamentalquestion could be raised on the appropriateness of therelation between the level of Portuguese and foreign prices– i.e. the exchange rate – at the time of adopting the eurowith a view aligning spending and income or savings(excluding transfers from abroad) and investment.

121


possible correction of the trade balance. In

extern .

stment path will depend on several

ectors, where competition

addition, gross national income will fall behindGDP by a growing margin due to the growing

al debt service burden


Portugal's external imbalances remain large andthe current crisis has led only to a small narrowingof these imbalances. Even if the Portugueseeconomy has fared slightly better than the EA as awhole in terms of the initial impacts of the crisis,adjustment needs continue to be rather sizeable.The adjufactors, both external, hence largely exogenous,and internal and consequently reflecting domesticconditions and policy options. Concerning theformer, despite the effects of the uncertainty ofexternal demand on export performance, it cannotbe ignored that the increase in and the persistenceof external deficits have been made possible byrather benign financial conditions. In fact, thenear- and medium-term path for the large savings-investment gap will crucially depend also on thefinancial conditions that prevail from now on. Theremainder of this section highlights internalaspects of the current situation and of the neededadjustment.

Portugal's competitiveness position still reflectspast adverse developments. Not only have costsand prices grown in excess of those of tradingpartners, but exports performance has beenhampered by a still relatively high dependence onlabour-intensive export sis fierce, and have suffered also from a highconcentration in EA markets that have grown byless than the world average. More recently, thesepatterns have been changing somewhat, with costsand prices developments better aligned with therest of the EA, a further move away from labour-intensive exports, and a stronger presence in fast-growing markets. Yet the gaps that need to bebridged remain large.

Besides chronic high trade deficits, the externaldeficit has been reflecting a downward trend in the


for growth and jobs.

ating considerable friction in theprocess of narrowing the overall deficit. Whereas

area mem ve clearly averted thedisruptive correction of external imbalances, theeconomic and financial crises, by highlighting thedifficulties that may derive for borrowers fromchanges in financing conditions, have emphasisedthe need to address these issues. From a longer-term perspective, the narrowing of the externalimbalance will depend upon sustained gains incompetitiveness and the subsequent correction ofthe persistent deficit in the balance on goods andservices.

In view of Portugal's weakened competitiveness inthe euro area and its persistent current account

ontext of the euro areawould be facilitated by relative price and cost

he lifelong learning system,and enhancing access to training andqualifications, in order to increase the labourforce's average skills level) and physical capital.Prices and costs moderation is also needed. Unitlabour costs may also be contained by improvinglabour market functioning, wage moderation and

rlab

recommendations under various Community instruments,such as the updated Stability Programme, the EDPrecommendations and the strategy

current transfers' surplus and an upward trend inthe primary income deficit. At the same time, thecontinued high external deficits have led to theaccumulation of external liabilities that have nowreached 110% of GDP. This is a non-negligibleelement to take into account as the servicing ofthese liabilities will continue to absorb a large andrising share of income over the medium term,thereby cre

the deeper financial markets facilitated by eurobership ha

deficit, adjustment in the c

adjustments and a shift of resources from the non-tradable to the tradable sector.

Against this background, efforts should aim atproducing sustained gains in competitiveness,leading to a correction of the long-lasting deficit inthe balance on goods and services. GivenPortugal's differentials in productivity vis-à-vis theeuro area, this should be achieved by liftingproductivity growth in a sustained way, which willsupport competitiveness in international markets aswell as boost potential GDP growth. Productivitymay be enhanced in a sustained manner through,inter alia, fostering further structural changetowards higher valued-added activities, andinvestment in human (e.g. by improving theeducation system and t

fostering wage behaviour that takes due account ofp oductivity developments. In the area of the

our market, possible structural reforms include:

122


123

isationof employment protection legislation, in order toimplementing recent reforms on the modern

avoid increasing duality in the labour marketbetween conditions for permanent versustemporary contracts; improving the effectivenessand efficiency of public employment services andmoving ahead with the proposal to reform activelabour market policies, including a better link withtraining programmes. There is also a need toimprove product market functioning (e.g. networkindustries, services, regulated services) and thebusiness environment and reduce administrativeburdens with a view to allowing a more active rolefor competition in the allocation of resources aswell as containing price pressures and facilitating

structural adjustment. In addition, domesticspending moderation is important for containingexternal imbalances by dampening imports, asstructural changes on the supply side often taketime to bear fruit. In this respect, the governmentsector can help in bridging the gap betweendomestic savings and investment by reducing itsown large borrowing needs, i.e. by pursuing fiscalconsolidation over the medium term. Moreover,due attention to aspects such as the impact ofgovernment revenue and expenditure patterns onpotential GDP and the efficiency and effectivenessof the public sector can strengthen the economy’sfundamentals and help boost potential GDPgrowth.

14. SLOVENIA

124

nce 2002,when a surplus of 1.2% was registered,

trade in

mports.

ovenia's biggest exporter.


The degree of openness of the Slovenian economyincreased significantly over the last few years, withboth exports and imports rising in tandem. Fromalmost 100% in 1995, exports and importscombined rose to some 150% of real GDP in 2008,with a marked acceleration since accession to theEU in 2004. Against the backdrop of the globaldownturn, openness fell steeply in 2009 withimports falling even more significantly thanexports.

The trade balance (goods and services) had beenon a gradually worsening trajectory si

culminating in a deficit of 3% of GDP in 2008.This reflects different trends in the evolution of

goods and services. While the freemovement of services within the EU and strongeconomic growth in Slovenia's main tradingpartners helped to nearly double the services tradesurplus between 2002 and 2008, there was a six-fold increase of the goods trade deficit over thesame period.(126) This pattern has been drasticallyaltered by the economic crisis. Preliminary balanceof payments data for 2009 point to an overall tradesurplus of 1.5% resulting from both improvedterms of trade and a steep fall in iAccording to the Commission services' autumn2009 forecast, the trade balance is expected toregister a surplus again in 2010, reflecting fasterexport growth this time.

In 2008, machinery and transport equipmentaccounted for around 41% of total goods exports.Road vehicles represent the most importantsubcategory, largely driven by a single carmanufacturing company owned by a Frenchmanufacturer, which is SlThe relative importance of such products forSlovenia's exports has increased over time. Theshare of chemicals and related products increasedless markedly, to 14%, with medical andpharmaceutical goods - which is the mosttechnology-intensive industry in Slovenia - beingthe most important product group in this category.

The share of goods in Slovenia's total exports (inconstant 2000 prices) has remained broadly stablesince 1998 at slightly above the euro area averageof 80%. Touri

(126) This was caused by a slightly higher average growth rate ofa somewhat

sm accounts for the largest share

imports than exports, in conjunction withhigher initial level of imports.

(42% in 2007) of services exports, but has grownless rapidly in recent years than transport services(29% share) and other services (the remaining29%).(127)

Graph III.14.1:Evolution of the current account balance (% ofGDP)

-12

-8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

0

4

-4

Goods ServicesIncome Current transfersCurrent account balance


Despite the increasing importance of othermarkets, EU countries continue to absorb themajor part of Slovenian exports, accounting forover two thirds of all goods exports in 2008.

exports going to the euro area fell from 61% in

(RA orts

maIta

ma

However, within the EU there has been a markedshift in the importance of different markets. Inparticular, the share of Slovenian merchandise

2000 to 53% in 2008. Over the same period, theimportance of the recently-acceded Member States

MS) as a destination for Slovenian expincreased from 8% to 14%. The major export

rkets in the EU are Germany (almost 19%) andly (12%). Outside the EU, the Western Balkanion, especially Croatia, and some otherreg Eastern

European countries are also important exportrkets for Slovenia.

The weight of transport services is also due to Slovenia'sfavourable geographical location and role in transit trade("Rotterdam eff

(127)

ect").


except those for privateconsumption and exports with respect to the euro


Over the period 2000-2008, Slovenia's realeffective exchange rate (for all four deflators) sawsome appreciation vis-à-vis both the euro area and35 main trading partners (IC35). Vis-à-vis the euroarea, the appreciation was most marked whendeflating by the GDP deflator or by nominal unitlabour costs for the total economy, whereas vis-à-vis the IC35, the measure based on the privateconsumption deflator showed the strongestappreciation. The loss in competitiveness vis-à-visthe IC35 cannot be explained by developments inthe nominal effective exchange rate, whichdepreciated by almost 9% between 2000 and 2004.Slovenia's nominal unit labour costs increased by22% over the 2000-2008 period, faster than in theEU and the euro area.(128) For 2009, the pictureregarding the real effective exchange rate is lessuniform, with most deflators continuing to indicatemodest appreciation,

area.

Graph III.14.2:Real effective exchange rate (based on ULCin the total economy)

95

100

105

110

115

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

IC35 RoEA


In contrast to the overall economy, themanufacturing sector's competitive situation sawan improvement over the years 2000-2008, asreflected in a depreciation vis-à-vis the euro areaof around 5.5% of the real effective exchange ratebased on nominal unit labour costs. This waspartly driven by improved productivity. Indeed, the

(128) Most other RAMS (Poland and Malta are exceptions)registered faster wage growth than Slovenia over thisperiod. Most also experienced a more pronouncedappreciation of their real effective exchange rate.

4 pp difference between average productivitygrowth recorded in the tradables sector (mainlymanufacturing) and the non-tradables sector(mainly services) in 1998-2007 was notproportionately reflected in wage developments asthe average differential in nominal wage growth

e period.This typical Balassa-Samuelson catching-up effect

the high-technology sector, despite the recent buoyant

only amounted to 0.8 pp. over the sam

is estimated to have contributed 0.6 pp. on averageto the inflation differential with the euro area overthe last decade and points to the importance ofaligning sectoral wage and productivitydevelopments for preserving competitiveness.(129)Against the background of the pick-up in inflationin Slovenia in 2007 and 2008, almost all measuresof the real exchange rate registered a markedappreciation in 2008.

From 2000 to 2008, Slovenian export marketshares increased in all but one year, leading to acumulative 30% gain in shares. Market sharesreceived a particular boost in 2007, the year ofeuro area accession. The terms of trade forSlovenia's external trade in both goods andservices deteriorated slightly over the period 2000-2008 but appear to have rebounded by around 4%in 2009, helped by falling commodity prices.

Calculations of the revealed comparativeadvantage (RCA) index – broken down accordingto the technology intensity of manufacturing trade– indicate that over the last decade Sloveniadeveloped a comparative advantage in exportingmedium-technology products, namely roadvehicles. By contrast, Slovenia continues to have amarked comparative disadvantage in

performance of the pharmaceutical sector. At thesame time, Slovenia's formerly pronouncedcomparative advantage in low-tech manufacturinghas almost been eliminated over the last decade.This may partly be explained by labour costdevelopments. This picture is broadly confirmedby the RCA for merchandise trade broken downaccording to factor intensity, where Slovenia'scomparative advantage in manufactured labour-intensive goods, although still marked, has been onthe decrease.

See Bank of Slovenia, Price Stability Report, October2008, p. 20.

(129)

125


ed less than 1% of GDP, compared toaround 4.5% for the RAMS. Recent surveys

ingrestrictions and insufficient competition) are the

In 2007, Slovenia became the first of the RAMS to

e Slovenian economy in this new environmentwith a special focus on safeguardingcompetitiveness in the euro area.

The structure of the economy is a key factor forcompetitiveness developments. Slovenia'seconomy continues to rely heavily on its industrialbase. Industry represented almost 30% of grossvalue added (GVA) in 2009 and is therefore ofmuch higher importance than in the euro area,where this share was below 22%. Within the groupof the RAMS, the weight of the manufacturingsector in GVA is higher only in the CzechRepublic and Slovakia.

At the same time, Slovenia's comparativeadvantage is not in the production of high-techgoods, which accounted for 17% of goods exportsin 2007, well below the corresponding share in theEU.(131) The country’s comparative advantage, notonly vis-à-vis the euro area but also compared toabout half of the other RAMS is clearly in

Despite its advanced economic development, goodtransport system and strategic geographicalposition, foreign direct investment inflows to theeconomy have been rather limited when comparedto the other RAMS. Inward FDI flows to Sloveniaaveraged around 3% of GDP over the period 2002-2008, compared to 6.5% of GDP on average forthe RAMS. Net FDI over the same periodaverag

indicate that, in addition to the small size of thedomestic market and high labour costs, structuraland policy weaknesses (such as high taxes,payment delays, an inefficient judicial system, lackof properly skilled labour force, rigid fir

main factors discouraging FDI inflows.(130)

14.3. SPECIAL FOCUS: PRESERVINGCOMPETITIVENESS IN THE EURO AREA

adopt the euro. While the country had been livingwith a stable exchange rate since June 2004,membership of the euro area represented a regimechange. This section analyses some of the factorswhich are crucial for enhancing the resilience ofth

(130) See IMAD Development Report 2009, p. 20.(131) See IMAD Development Report 2009, p. 79.

e economy. Asoil and food prices moderated after their 2008

ownin 2010, to 1.3%, before rebounding again in 2011

3.5%.

Recent wage developments have led to amisalignment of wage and productivity growth.While real unit labour costs had been falling

producing labour-intensive goods.(132) Thisunderlines the importance of wage and pricedevelopments if this comparative advantage is tobe maintained.

After improvements in the run-up to euro areaentry, recent developments have eroded Slovenia'scost advantage. From a low of 2.5% in 2006, HICProse to a high of 5.5% in 2008. External shocks toenergy and food prices combined with domesticdemand pressures and limited competition in partsof the retail sector were such that price increasespropagated rapidly through the entir

peaks and the economy moved into recession,inflation fell back to 0.9% in 2009, whileremaining above the euro area average.(133)

Average wage growth also displayed a decreasingtrend before euro area entry, followed by anacceleration in 2007 and 2008 when wagenegotiations resulted in nearly full indexation ofboth public and private sector wages to previousyear inflation. Wage restraint in the public sectorhas been followed by a period of acceleratedgrowth.(134) In 2009, average wage growth wasstill rather dynamic, at 3.3%. The Commissionservices' autumn forecast predicts a slowing d

to

(132) In 2007, such goods accounted for 12.6% of Slovenianmerchandise exports, compared to the RAMS' average of11.4%. See IMAD Development Report 2009, p. 79.

(133) Since 2004 HICP inflation in Slovenia has exceeded that inthe euro area, with the differential increasing from 0.5 ppon average in the period before the introduction of the euroto more than 2 pps afterwards. This differential hasdecreased since the start of the economic crisis.

(134) This has resulted from the agreement in July 2007 of a newpay system aiming to eliminate existing pay differencesamong the various professions in the public sector by 2010.Public sector employees were scheduled to receive fourwage increments, amounting to a total increase of 13% inaverage pay or 1.1% of 2008 GDP (IMAD, SlovenianEconomic Mirror, June 2008, p. 18). The most significantpay increases were planned for workers in sectors such asculture, social security and healthcare, while it is expectedthat workers in education will experience the lowest wageincrease given their more generous wage rises in the past.The first two instalments were paid out in September 2008(backdated to May 2008) and January 2009. The third andfourth instalments should be paid out in October 2010 andOctober 2011.

126


between 2001 and 2007 (on average by almost 1%

The in artly reflected strong

broad-

per year), this trend was reversed by a small rise in2008 followed by a more substantial rise in 2009.

itial improvements pproductivity growth. As might be expected giventhe different starting levels, real productivity perhour worked increased much faster in Sloveniathan in the euro area but slower than in most otherRAMS. The recent deterioration in real unit labourcosts is due to wage growth in excess of labourproductivity growth. Since future productivityincreases depend on current investment, it isimportant to note that gross fixed capital formationgrowth has been very high in recent years inSlovenia with an average annual growth rate ofmore than 8% over the period 2005-2008, 5 pps.above that in the euro area. In contrast to someother Member States, the increase wasbased, with a marked rise in equipment and non-housing construction investment rather than just inresidential investment.

Graph III.14.3:Wage and productivity developments

-4

-2

0

2

4

6

8

10

12

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

GDP per person employed % ch. Wages and Salaries % ch.


These productivity trends underline the importanceof non-price competitiveness factors. R&D andinnovation is one such factor, as is the ability ofthe business sector to capitalise on new marketopportunities afforded by changes in competitiveadvantage and relative prices. The absorptioncapacity of EU funds is a further importantelement. The capacity of the economy tosuccessfully make such adjustments, e.g. in theform of a technological upgrading of the Slovenianproduction structure leading to a new exportpattern, therefore appears central to raisingcompetitiveness over the longer term. As FDIinflows to Slovenia continue to be low, there is

scope for increasing their role in the productivity-increasing transfer of knowledge by furtherimproving the conditions for attracting investmentfrom foreign enterprises.


Up to 2007, Slovenia’s macroeconomicperformance was robust and did not point toemerging imbalances. Soon after, however, asignificant inflation differential with the euro areaopened up, also reflecting emerging overheatingpressures. With wages adjusting to inflation andproductivity growth slowing, the trade deficitpeaked at 3% of GDP in 2008. Costcompetitiveness deteriorated against both othereuro area countries and a wider group of

rading partners. The acceleration inprices was also reflected in deterioration of price-ased competitiveness indicators. The global crisis

myquite hard. Real GDP shrank by around 10%between 2008Q4 and 2009Q1 before returning tomodest positive growth in (quarter-on-quarter) inthe second quarter of last year. In 2009, Slovenia isestimated to have posted one of the worst falls inreal GDP in the euro area. In addition, some of therecent stimulus measures focused on safeguardingemployment could delay the needed structuralchanges in the labour market and hamper thereallocation of workers to more competitivesectors, if not phased-out in a timely way and ifnot accompanied, where necessary, by activationand training policies that favour job reallocation

abour force.

The surplus on the trade balance in 2009 (from aby anmore

industrialised t

bhas been hitting the very open Slovenian econo

and the re-skilling of the l

deficit position in the past 6 years) is drivenimprovement in the terms of trade and asignificant contraction of imports than of exports(due to falling domestic demand). However, ifdomestic demand regains strength as the economyrecovers, the current improvement in the tradebalance could prove to be unsustainable. If leftunchecked, recent wage and productivitydevelopments could entail a serious deteriorationof Slovenia's competitive position in the euro area.


127


128

ng thestructural features underlying these challenges.

Against this background and since the country'scomparative advantage vis-à-vis the euro area liesin the production of labour-intensive goods,Slovenian competitiveness could be improvedthrough a wage-setting mechanism that preventswage growth from exceeding productivity growth.

Structural reforms should be implemented tocounter labour market segmentation and encourageinvestment in human capital. Possible reformsinclude: reviewing the employment protectionlegislation to reduce asymmetries between non-

n system and increasing the labour supplyand employment of older workers.

Other countries' experiences show that a lengthyand painful adjustment process may then benecessary to regain competitiveness. If, however,the risks to competitiveness are adequately andpromptly addressed, the country could rely on itsoutward orientation and underutilised productivecapacity to benefit from the global upswing andcomplete the catching-up process with the euroarea.

In view of Slovenia's competitiveness positionwithin the euro area and its past significant currentaccount deficit, adjustment in the context of theeuro area would be facilitated by addressi

standard and standard employment in particular forstudent workers; increasing the coverage ofunemployment benefits, while also furtherincreasing financial incentives to work; enhancingthe efficiency and effectiveness of the publicemployment services; extending the coverage ofactivation strategies and improving their targeting,especially concerning older workers and the long-term unemployed; strengthening the link betweenthe educational system and labour market tosupport employability of the young; revising thepensio

There is also a need to foster a higher technology-intensity of manufacturing, via efforts to attractFDI and stimulate R&D activities, which wouldhelp support the development of new comparativeadvantages and a more favourable external tradingpattern. Furthermore, in view of the wideninggovernment deficit and rising debt level (albeitfrom a low starting point), in conjunction with thelong-term sustainability challenge, structuralreforms in public finances (aimed at curbing theinherent dynamics of social transfers and thepublic sector wage bill on a permanent basis) couldmake room for more productive spending (such aspublic investment) and raise potential growth.

15. SLOVAKIA

129

15.1.

akia is the country with the. This

reflects the very large expansion of trade in goodsover the last decade. The structure of merchandisetrade has changed significantly over time, with astrong concentration in the car and transportindustry that now accounts for almost a quarter ofSlovak exports. The import structure is dominatedby machinery and electric equipment goods usedin the car and energy sectors (43 percent of totalimports), and energy products (13 percent of totalimports). Turning to the characteristics of tradelinkages, the importance of intra-industry trade ishigh relative to other recently-acceded MemberStates (RAMS) – with the standard Grubel-Lloyd

anding at 60 percent in 2008 – especiallyother EU countries.

7% of imports are from

SETTING THE STAGE: FOREIGN TRADECHARACTERISTICS

The Slovak economy is one of the most openeconomies in the EU. The share of exports andimports in GDP has been increasing markedlysince the mid-nineties reaching 188% of GDP in2008 in volume terms. The main drivers have beencloser economic integration with the EU, an initialimportant cost-competitiveness advantage, gradualimprovements in the quality of Slovak productsand, up to 2008, the rapid expansion of world tradeand external demand addressed to Slovakia. Thetrade balance has improved markedly since the endof the nineties, from a deficit of around 10% ofGDP in 1998 to 2% of GDP in 2008.

With an average share of services in total exportsand imports of about 10% in 2008 – down from21% in 1995 – Slovlowest intensity of trade in services in the EU

index stin trade relationships with

The geographic distribution of Slovakia's externaltrade has experienced significant changes over thelast 10 years. In the late nineties, the CzechRepublic was still the main trading partner ofSlovakia (in 1997 about a quarter of Slovakia'sexports were directed to the Czech Republic). Thisshare has gradually diminished, to less than 15% in2008, with a corresponding increase of exports tothe euro area countries. As for many othercountries in the region, the geographical structureof imports is more diversified than that of exports:while over 85% of Slovak exports are directed tothe EU countries, which is the largest proportionacross the RAMS, only 6

other EU countries (nearly 20% of imports arefrom Asian countries).

Graph III.15.1:Regional composition of exports in 1997

22.1%

23.7%

25.5%

3.5%

25.3%

Germany

EA w/o Germany

Russia

Czech Republic

RoW

Source: Slovstat.

Graph III.15.2:Regional composition of exports in 2008

23.7%

3.5%

25.3%

Germany

Russia

RoW

22.1%

Germany

Czech Republic

25.5%EA w/o



After participating in the ERM II betweenNovember 2005 and December 2008, Slovakiajoined the euro area on January 1, 2009. Prior toERM II membership, a managed float regime hadbeen in operation since October 1998.

Slovakia has had one of the fastest appreciatingcurrencies in the EU over the recent period. Thisreflects a sizeable appreciation of the nominal

200effective exchange rate (43% over the ten years to

8) and a positive inflation differential betweenvakia and most of its neighbouring countries.Slo


eflator ofprivate consumption), the difference reflecting

ecial focus below).

The size of the REER appreciation between 2000and 2008 varies from 45% (based on the exportprice deflator) to 67% (based on the d

developments in terms of trade, including exportsmark-ups. At the same time, since the second halfof the nineties, the current account has beenconstantly in deficit, in part reflecting negativeprimary income flows due to the repatriation ofprofits. Taking these elements into account theseelements, estimates of Slovakia's equilibriumREER based on a benchmark "equilibrium" currentaccount point to an overvaluation of the order of5% in 2008 (see sp

Graph III.15.3:Effective exchange rates (2000=100)

60

80

100

120

140

1995 1998 2001 2004 2007 2010f

160

180

200REER (IC35, DPC)

REER (IC35, exp.price defl.)REER (IC35, ULCs)

NEER (IC35)


Graph III.15.4:Current account balance (% of GDP)

-12-10

-8-6-4

-20

24

1995 1998 2001 2004 2007 2010f

Net exports goods Net exports servicesNet primary income Net current transfersCurrent account balance


Slovakia's export market share in world trade hasmore than doubled since 1995, reaching 0.4% in2008. The export market share in euro areacountries has also increased significantly, from

point to a gradual shiftin the structure of Slovakia's export to highervalue-added products.

The large FDI inflows to Slovakia have been animportant source of technology transfer for itseconomy, which has supported a rapid increase inlabour productivity (the third strongest in the EUover the five years up to 2008). After a period ofslow increase in the 1990s, FDI inflows boomedover 2000-2008 and represented almost 50% ofannual GDP in cumulative terms in 2008. Afavourable geographical location, relatively lowlabour costs and taxes, the existence of variousschemes in support of FDI, importantimprovements in the overall economic andbusiness climate over the period and, after 2004,EU accession, largely explain the attractiveness ofSlovakia for foreign investors. FDI inflows areconcentrated in the energy (production anddistribution), car manufacturing and financialsectors, and come mostly from other EU countries,notably the Netherlands and Austria.

0.2% in 1995 to almost 0.8% in 2008. The keydrivers of these increases have been similar tothose mentioned above regarding the rapidexpansion of Slovakia's external trade, i.e. agreater economic integration, an initial significantcost-competitiveness advantage, and continuousimprovements in the quality of exported products(see below). However, the pace of gains in marketshares has slowed down over time, suggesting anerosion of Slovakia's competitiveness, consistentwith developments in the real effective exchangerate.

The revealed comparative advantage (RCA) index,broken down according to technology intensity ofgoods exports, indicates that Slovakia hasdeveloped a comparative advantage in medium-to-high technology goods and ICT industries. Thispicture is broadly in line with an analysis of RCAbased on factor intensity, which indicates thatSlovakia has a comparative advantage in capital-intensive goods and a disadvantage in raw-material-intensive goods. With respect to R&Dintensive goods, Slovakia is relatively strong in theeasy-to-imitate category of research-intensivegoods and less competitive in the difficult-to-imitate category. These indicators are consistentwith changes in the exports composition discussedin the previous section and

130


15.3. SPECIAL FOCUS: HAS SLOVAKIA LOST ITS

In Jan was the first of the

EDGE DURING THE CRISIS?

uary 2009, SlovakiaVisegrád Four countries – the Czech Republic,Hungary, Poland and Slovakia – to adopt the euro.The exchange rate was thus fixed after a prolongedperiod of appreciation of the Slovak koruna. Theacquired stability of the currency has hadimportant benefits in the midst of the crisis, as itprotected Slovakia against potential pressures onits exchange rate. It will also have importantbenefits in the longer run, including through lowertransaction costs, better price transparency and theelimination of exchange rate uncertainty, whichwill all support potential growth. However,following the substantial depreciation in a numberof Slovakia's competitors, the question arises as towhether recent exchange rate developments willaffect Slovakia's external competitiveness andexternal position.

Graph III.15.5:Monthly REER vs. IC35 (HICP,1999=100)

100Jan 05 Oct 05 Jul 06 Apr 07 Jan 08 Oct 08 Jul 09

PL


140

160

180

200

220

SK

CZ

120HU

Since the summer of 2008, the currencies ofSlovakia's neighbouring countries haveexperienced sizeable nominal depreciations, bothin nominal and in real effective terms. The Polish,Czech and Hungarian currencies, respectively lost18, 3 and 13 percent against the euro over the yearto September 2009. As a result, and despite thegrowing importance of euro area countries inSlovakia's external trade, the real effectiveexchange rate of Slovakia has continued toappreciate during the crisis – broadly following the

trast with

It is relevant to assess how these developmentshave affected external flows over the recent period.In the first half of 2009, Slovakia's exportsplummeted by more than 25 percent compared tothe same period a year earlier, which is similar todevelopments in other countries. At the same time,the severe contraction of investment andinventories – driven, for the largest part, by a sharpincrease in private sector savings – resulted in aneven larger contraction of imports, and the currentaccount balance swung from a non-negligibledeficit to a small surplus in the second quarter of2009. Even if this improvement was accompaniedby a sharp fall in net FDI, which was negative inthe first half of 2009, and a decline of other capitalinflows, the external position of Slovakia does notseem to have suffered excessively from nominalexchange rate developments.

same trend as before – in con

flo

development ernal flows and the realexchange rate. The overvaluation of the SlovakREER relative to equilibrium, if sustained, maytranslate into a sizeable deterioration in Slovakia'sexternal position. On the other hand, it is possiblethat the nominal depreciation in the neighbouringcountries will be partly or even fully reversed inthe months ahead, limiting the REER appreciationin Slovakia (such a movement is already underway). In this scenario, the current account balancemay well remain in surplus, or in deficit but atreadily financeable levels.

JUSTMENT (136)

developments in the neighbouring countries withating exchange rates.

It will, however, be important to carefully monitors in ext

15.4. THE NEED FOR AD

Slovakia's economy has been strongly affected bythe current global downturn. The economycontracted by over 5% yoy in the first half of 2009and exports have plunged by over 25% on a yearon year basis. Following Slovakia's entry in theeuro area in January 2009, the large nominaldepreciations in the neighbouring countries vis-à-vis the euro have implied a further significantappreciation of Slovakia's REER in the first half of2009. The very fluid environment and largemargins of uncertainties surrounding equilibriumREER estimates make it difficult to conclude that a

(136) The text which follows, including policy challenges, draws,inter alia, on already issued policy invitations andrecommendations under various Community instruments,such as the updated Stability Programme, the EDP

tegy for growth and jobs.recommendations and the stra

131


132

tiveness position inthe euro area and its current account deficit,

efacilitated by addressing the structural featuresunderlying these challenges.

Against the background of Slovakia's potentialfurther deterioration of competitiveness due toappreciation of the real exchange rate, addressingexternal imbalances and competitiveness problemswill require wage moderation and careful designand implementation of macroeconomic andstructural policies. Regarding structural policies, itis crucial that Slovakia gives a further impulse to

es,promote sufficient wage differentiation, and

htto be accompanied by reforms that enhance thequality and efficiency of public finances. Forinstance, reallocation of resources towardseducation and R&D and increasing the quality ofpublic procurements would enhance the growthprospects of the economy, while facilitating thetransition to new types of economic activities. Theproject-oriented support to R&D activities, whichSlovakia has undertaken during the crisis, is a stepin the right direction and should be continued afterthe crisis. Regarding macroeconomic policies, it isimportant that fiscal and incomes policies avoidfuelling imbalances and support moderatedevelopments in unit labour costs relative to thecountry's trading partners.

significant weakening of Slovakia's externalcompetitiveness has taken place during the crisis,but this possibility cannot be excluded.

While in the past policies to restorecompetitiveness and rebalance external accountscould rely on the exchange rate instrument, in thecontext of monetary union, in which the exchangerate reflects the economic circumstances of theeuro area as a whole, Slovakia's externalimbalances will have to be tackled throughdomestic control of relative prices and costs vis-à-vis competitors and improvements in non-pricecompetitiveness.

In view of Slovakia's competi

adjustment in the context of the euro area would b

its reform program to support productivity gainsand improvements in the non-pricecompetitiveness of its products. Reform prioritiesinclude enhancement of the business environmentand market functioning, and reduction ofadministrative burdens. Labour market functioningwould benefit from improved public employmentservices and development of an active ageingstrategy. Increasing the employment rate,especially for younger and older workers, wouldalso require stronger efforts to develop lifelonglearning, address persisting skill mismatch

safeguard income security. These measures oug

16. FINLAND

133

p of the 1990s recession. The

r (Graph III.16.2). Correspondingly,the breakdown of trade by technology and factor

intensiv


While Finland is a small and open economy with ahighly specialised manufacturing structure and astrong export base, its openness to trade (exportsplus imports as a share of GDP) is only slightlyhigher than the euro area average. Importpenetration in particular is lower than the average.It appears that the peripheral and remotegeographical location of the country might beweighing on trade potential to some extent.Nonetheless, among the euro area countries,Finland had built up one of the highest surpluses intrade in goods in the first decade of euro-areamembership. A considerable surplus in trade hadbeen achieved ever since the export-led recoveryfrom the deep slumcurrent account turned promptly into a sizeablesurplus, peaking at over 8% of GDP at thebeginning of the 2000s, but diminishing steadilyover the following years to reach 3½ % of GDP in2008(137) (Graph III.16.1). The current globalcrisis has hit Finnish exports particularly heavily.Over 2009, the decline in Finnish exports was thesharpest among the euro area countries (-24% y-o-y in Finland in volume terms vs -13% for the euroarea average). Nevertheless, while the currentaccount surplus will shrink substantially, it is notforecast to turn into a deficit over the current crisisgiven its strong starting position.

Finnish exports are specialised to a high degree,reflecting the concentrated industry structure of thecountry. The dominant sectors of metalengineering, electronics, and wood and paperindustries account for 70% of total exports. In thesecond half of the 1990s, Finnish exportperformance was boosted by the rapid rise of theICT manufacturing sector, led by the so-calledNokia cluste

intensity shows a marked shift over the past decadetowards higher technology and thereby less labour-

e manufacturing. Over the last few years,the pick-up of growth in the metal engineeringindustry (i.e. machine building, shipyards) hascompensated for the more subdued growth in ICT.

(137) The sizeable discrepancy between the current account andtrade balances before the year 2000 reflects net incometransfers.

he strongest within theEU. About 10 % of Finnish exports go to Russia

e to Russia enters

The wood and paper industry has been steadilylosing its prominence in exports. Finnish tradelinks with the rapidly emerging economies in Asiaand with Russia are among t

(to some degree transit tradFinnish statistics due to various storagearrangements) and about 10% to Asia. Amongstthe euro area countries, Finland has the highestshare of trade with countries outside the euro area.In 2007(138) about 70% of Finnish exports wentoutside the euro area, whereas the average amongthe euro area countries was about 50%. While thisallows the country to benefit from the growth ofglobal markets, it has also rendered Finland morevulnerable to the recent sudden appreciation of theeuro against other major currencies.

Graph III.16.1:Trade balance and current account balance(% of GDP)

0

1

2

3

4

5

6

7

8

1995 1997 1999 2001 2003 2005 2007 2009 2011f

10

9

trade balance current account balance


The Finnish economy is more heavily reliant onindustrial production than most of the other euroarea countries. In 2008, manufacturing industryaccounted for 33% of gross value added, while theeuro area average was 22%. Conversely, theservice sector is smaller in Finland. The strongmanufacturing base also explains the high surplusin trade in goods, while the balance of trade inservices has been in deficit over the past decade.

s started toservices trade

Whereas the surplus in goods haweaken in recent years, the deficit inhas decreased and turned into surplus in 2007,reflecting the pick up in service exports. The shareof services in exports has risen from 14% in 2000to 21% in 2008. This is partly related to the

(138) Data for 2008 not available.


GDP. Even though FDIinflows have slightly surpassed outflows in recent

higher than the inward stock.

Graph III.16.2:Change in export structure (% share of total)

internationalisation of Finnish companies, wherebythe manufacturing component is increasinglyrelocated to lower-cost locations while other, moresophisticated, business functions usually remain inFinland. In effect, the internationalisation ofcompanies has resulted in weaker exports of goodswhich are, however, partly compensated for bystronger exports of services (for example in theform of business-to-business services).Nevertheless, compared with the EU average,Finnish companies appear to be less globalised todate, as measured by both inward and outward FDIstock as a percentage of

years, the outward FDI stock is about one quarter

01997 1998 1999 2000 2001 2002

102030405060708090

100

2003 2004 2005 2006 2007 2008

Electronics Paper Metal Engineering Other

Source: Statistics Finland.


From a historical perspective, the exceptionallysevere economic recession at the beginning of the1990s proved to be a dividing line for thestructural performance of the Finnish economy.The Finnish economy was characterised in the1980s by a credit and asset price boom, highinflation, deteriorating competitiveness and severalperiods of mounting current account deficits,followed by currency devaluation cycles. It endedwith the bursting of a housing bubble and afinancial crisis, coinciding with the collapse of the

exchange rates imply that the Finnish real effectiveexchange rate (REER) i

Soviet Union, which was one of Finland's principalex arkets. This was followed by a complete

dec

s somewhat undervalued inrelation to the other euro area countries, but this

port mturnaround in the economy in the subsequent two

ades. Estimates of deviations from equilibrium

difference is narrowing. The commonly usedcompetitiveness indicators for the REER (GraphIII.16.3, also presented in the statistical annex)support this result, indicating that Finland hasgained in cost competitiveness vis-à-vis the euroarea over the past decade, but lost competitivenessrelative to the other major world economies,especially during the current global crisis, mainlyreflecting the euro's appreciation.

Graph III.16.3:Real effective exchange rates (2000 = 100)

vs. euro area

110

100

105

85

90

1995 1997 1999 2001 2003 2005 2007 2009

95

REER (DPC) REER (GDP defl.)REER (export pr. defl.) REER (ULC tot. econ.)

vs. 35 IC

100

105

110

115

120

125

90

95

1995 1997 1999 2001 2003 2005 2007 2009

REER (DPC) REER (GDP defl.)REER (export pr. defl.) REER (ULC tot. econ.)


The export-price-based real effective exchangerate (REER export price deflator) indicates thestrongest gain in competitiveness. This is heavilyinfluenced by the export structure of Finland,where the dominant ICT manufacturing sector isfacing a continuous decline in prices on the worldmarket. In effect, the rapid productivity gains inthe ICT sector are passed on to consumers in theform of lower prices. These trends in the ICT

tersector also largely explain the strongly negative

ms-of-trade indicator.

134


redthe EU with comparative price levels about a

uarter higher than the EU-27 average, surpassedly by Denmark and Sweden. The increase of

competition from the EU Single Market played animportant role in the subsequent downwardconvergence of Finnish prices. However, asizeable price gap with the euro area average stillremains, possibly indicating a lack of competitivepressures.

After a decade of broadly stable developments, theunit-labour-cost-based REER shows a loss ofcompetitiveness over 2008-2009 in relation to theeuro area average. This stems primarily from theoutcome of the most recent wage settlement round.Over the past decade, the centralised wageagreements maintained wage growth in line withaggregate productivity advances. However, themulti-annual wage agreements concluded in 2007provided for exceptionally high wage growth overthe next 2-3 years, reaching 5½% in 2008 andslightly less in 2009 and 2010. This is 1½percentage points higher than on average overrecent years. Short-term statistics indicate thatnominal wage growth amounted to 4½% in thefirst half of 2009. Downward wage flexibilityappears to be limited in Finland even during amajor recession. Since the jump in wages iscoinciding with a sudden loss in output, the rate ofgrowth in unit labour costs appears exceptionallyhigh and also adds to domestic inflationarypressures.

16.3. SPECIAL FOCUS: FACTORS BEHIND THEVULNERABILITY OF EXPORTS

In spite of balanced macroeconomic growth overthe past years and the seemingly good aggregatecompetitiveness position of the Finnish economyat the onset of the global crisis, Finnish exportshave been highly vulnerable to the crisis. This can

lobalmanufacturing overcapacity, it can be expected

at demand for investment goods will revive onlyafter demand for consumer goods has recovered.Major segments of Finnish industry are thereforenot directly responsive to stimulus measures. Aminor part of the total decline in exports can beexplained by the reduction of transit-like trade toRussia. Transit goods occasionally enter Finnishtrade statistics due to some transport and storagearrangements. Over the first half of 2009, the valueof Finnish exports to Russia dropped by 50% andimports by 45%, the steepest decline amongstFinland's main trading partners.

The values of the currencies of some of Finland'smajor trading partners and competitor countries,most notably Sweden, have depreciated sharplyover the past year. While this hardly can be amajor factor in explaining the 2009 difference inexport performance, the weakening of the Swedishkrona is putting Finnish exports at a disadvantageon the Swedish domestic market and is also puttingpressure on the international price competitivenessof major industry branches in Finland. Theindustrial specialisation of Swedish and Finnishcompanies is often similar and production can besubstituted between the two countries. It appearsthat, for example, the globalised Nordic forestcompanies have reacted to production costdifferences between the two countries by reducingtheir overall production share in Finland andretaining it in Sweden. Over the first half of 2009,forest industry exports declined by over 30% inFinland compared with less than 10% in Sweden.

Structural long-term factors

The aggregate ULC measures may hide sectoraldivergences in competitiveness in the highlyspecialised and concentrated Finnish exportindustries. In Finland, wage developments are notstrongly linked with productivity developments

The inflation-based REER measures (DPC, GDPdeflator) also show a gain in competitiveness vis-à-vis the euro area, which is however reversedfrom 2007 onwards. This reflects the relativelysubdued inflation developments over the pastdecade and the recent pick-up of inflation to abovethe euro area average due to a sudden jump inwage growth. However, while the average inflationrate is low, Finnish price levels are neverthelessamong the highest in the euro area. Finland ente

qon

be explained by both short-term direct effects ofthe crisis and also some underlying long-termstructural factors that are not directly linked to thecollapse in global demand.

Short-term transitory factors

The heavy specialisation of Finnish industry ininvestment goods is proving to be an unfavourablefeature during a major global crisis. Due to g

th

135


across industries.(139) Therefore, ULCdevelopments do not properly reflect productivitydifferences, showing large discrepancies betweenthe high- and low- growth industries. Especially inthe late 1990s, the good aggregate performancewas driven notably by the boom in the ICTindustry, while in the other major industrybranches ULC growth exceeded the averagegrowth rate (Graph III.16.4). In effect, these wagedevelopments have provided cost advantages forindustries with high productivity growth whileimposing a heavier cost burden on branches withlow productivity growth.

Graph III.16.4:Nominal unit labour costs, industry breakdown

0

20

40

60

80

100

120

140

160

1991 1992 19931994 19951996 1997 19981999 20002001 2002 20032004 2005

Total manufacturing Pulp, paper ChemicalMachinery ICT


However, even industry branches that havebenefited from notable reductions in unit labourcosts, like the ICT industry, are vulnerable toglobal production shifts. It appears that many othercompetitiveness factors are often importantunderlying determinants of industry branchperformance. In recent years, the slowing growthin the Finnish ICT sector can be explained by thematuration and globalisation of thetelecommunications equipment production, asemerging economies increasingly enter this sector.Overall, the more labour-intensive production hasbeen relocated to cheaper locations. On the otherhand, high value-added industry functions, likeR&D, and capital and skill intensivemanufacturing have been largely maintained in thecountry. Finland benefits in this respect from its

(139) For a more thorough analysis of the Finish wage settingsystem, see Maiväli, M. and Lubenets, N. (2007),"Managed vs free wage-setting in Finland and Estonia",European Commission, Country Focus No. 10, October2007.

excellent education system, which provides forhighly-skilled labour.

The export potential of the important Finnish woodand paper industry has also weakened over anextended period of time. Nevertheless, even if thissector's share in exports has declined substantiallyover the past 15 years, it still is very important fornet exports, as the import content of the productionis low. Besides the more immediatecompetitiveness loss vis-à-vis Sweden,fundamentally cheaper forestry productiontechnology is developing in areas with warmerclimates in Asia and South America. Additionally,the Finnish forest industry has been suffering fromdisturbances to wood supply caused by theintroduction of round-wood export duties inRussia.


Over the past decade, Finland built up significantcurrent account surpluses, which provide a bufferagainst a temporary loss of competitiveness.However, the recent exceptionally sharp drop inexport production has coincided with anacceleration in wage growth, mirrored in a rapidrise in unit labour costs in 2008-2009. Moreover,due to its industry structure, Finnish exports arelikely to rebound later than in many other euroarea countries after the expected recovery of globaldemand takes hold.

In view of Finland's competitiveness position inthe euro area and its current account balance,adjustment in the context of the euro area would befacilitated by addressing the structural challengesunderlying long-term export market performance.

Against the background of a rapid rise in unitlabour costs in 2008-2009 and the heterogeneity insectoral productivity developments and prospects,policy efforts should aim at bringing wage growthback in line with productivity advances in theupcoming wage agreements. The current wage


136


137

formation system implies that those industrybranches, which show below-average productivitygrowth (possibly affected by adverse globalfactors), have come under additional pressure dueto relatively higher growth in unit labour costs andvarious non-price factors. It would therefore beimportant to increase the responsiveness of thewage formation system to sectoral productivitydevelopments, a tendency that has already startedto materialise in the more recent wage rounds.

It would be important to take measures to increaselabour supply in the longer term, includingmeasures to make work pay, in order to counter thenegative effects on the labour market from theageing of the population and a related decline inthe working age population. Given its structure,Finnish industry is relatively energy intensive. Itsgrowth and productivity potential will thereforealso depend on meeting the climate changechallenges and improving energy efficiency.

Annexes

ANNEXStatistical Appendix

Table A.1: BELGIUM - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 4.8 4.2 3.3 3.7 0.2 2.0 0.9Trade balance - goods & services 3.9 2.9 3.9 3.9 0.9 2.8 1.5Trade balance - goods 3.8 2.1 2.1 1.6 -1.6 -1.1 -0.7Trade balance - services 0.1 0.8 1.8 2.3 2.4 3.8 2.2Net foreign assets 20.9 73.2 25.6 33.3 48.6 #N/A #N/AExport market perf. G & S (% change) -2.6 0.0 -1.5 -0.5 0.3 0.7 -0.4REER (DPC) index 2000=100vs 35 industrial countries 114.0 100.0 106.9 110.3 113.4 114.1 113.0vs rest of euro area 103.9 100.0 99.7 101.5 102.6 102.6 102.9REER (GDP deflator) index 2000=100vs 35 industrial countries 115.3 100.0 106.7 108.1 109.6 110.4 109.5vs rest of euro area 104.7 100.0 100.2 100.7 100.4 100.3 100.6REER (exp. price defl.) index 2000=100vs 35 industrial countries 110.5 100.0 109.1 111.0 113.4 112.0 110.9vs rest of euro area 103.1 100.0 103.7 104.6 106.4 104.2 104.3REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 115.9 100.0 106.8 109.1 112.0 114.9 114.0vs rest of euro area 104.2 100.0 99.8 101.5 102.2 103.0 103.5Terms of trade (index 2000=100):Goods & services 103.6 100.0 99.8 99.4 97.2 99.6 99.5Goods 104.6 100.0 99.3 99.3 96.8 98.7 98.4Services 99.6 100.0 102.2 99.9 98.7 99.9 99.9Openness:a1. Exports (constant prices) 64.5 78.2 84.3 87.5 87.9 80.9 81.5a2. Imports (constant prices) 62.8 75.3 80.0 82.9 84.5 77.6 77.7a3. Exports and imports (constant prices) 127.3 153.6 164.4 170.3 172.4 158.4 159.3b. Net foreign direct investment (FDI) #N/A #N/A 0.5 2.7 -3.5 #N/A #N/Ac. FDI intensity #N/A #N/A 8.9 13.4 #N/A #N/A #N/Ad. Net portfolio investment #N/A #N/A -11.7 -8.9 10.0 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 98.2 100.0 102.2 102.7 100.8 97.3 98.8b. Gross operating surplus as a % of GVA 41.8 41.5 42.7 43.4 42.5 40.7 41.6c. Employee wage bill as a % of GVA 56.9 57.2 56.5 56.3 57.2 59.2 58.3d. (NDP - TCE) as a % of NKS 12.7 13.0 12.9 13.0 12.3 10.6 10.8Economic structure (% of GVA):Agriculture (ISIC A_B) 1.4 1.4 1.1 1.1 1.1 1.1 #N/AIndustry (ISIC C_E) 21.4 22.1 20.7 20.5 20.2 18.9 #N/ABuilding (ISIC F) 5.1 5.0 5.0 5.2 5.1 5.1 #N/AMarket Services (ISIC G_K) 49.1 49.1 51.3 52.0 52.3 52.4 #N/AOther Services (ISIC L_P) 23.1 22.5 21.9 21.2 21.2 22.3 #N/AShare of services in total tradeExports 17.7 19.6 18.8 19.5 20.1 19.8 19.6Imports 17.9 19.2 17.9 17.8 17.8 17.7 17.71. RCA for all exports (vs World):raw-material-intensive 0.9 0.8 0.8 0.8 #N/A #N/A #N/Alabour-intensive 1.2 1.3 1.1 1.1 #N/A #N/A #N/Acapital-intensive 1.6 1.4 1.3 1.3 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.6 0.6 0.6 0.6 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.9 1.1 1.4 1.4 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.0 1.2 1.0 1.0 #N/A #N/A #N/Amedium-to-low-technology goods 1.4 1.1 1.2 0.9 #N/A #N/A #N/Amedium-to-high-technology goods 1.2 1.3 1.3 1.3 #N/A #N/A #N/Ahigh-technology goods 0.3 0.4 0.3 0.3 #N/A #N/A #N/A- ICT 0.3 0.4 0.3 0.3 #N/A #N/A #N/A

Footnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

140

Annexes

Table A.2: GERMANY - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -1.2 -1.6 5.2 7.9 6.6 5.0 3.8Trade balance - goods & services 0.5 0.4 5.3 7.1 6.2 4.6 3.7Trade balance - goods 2.5 3.0 7.1 8.2 7.3 5.6 4.7Trade balance - services -2.0 -2.7 -1.8 -1.1 -1.0 -1.0 -1.0Net foreign assets 2.1 0.3 13.5 19.3 20.9 #N/A #N/AExport market perf. G & S (% change) -1.7 1.2 1.3 1.6 2.3 -1.3 0.7REER (DPC) index 2000=100vs 35 industrial countries 122.7 100.0 105.6 105.9 106.7 107.5 104.9vs rest of euro area 110.6 100.0 95.8 93.8 92.8 93.0 92.4REER (GDP deflator) index 2000=100vs 35 industrial countries 126.1 100.0 102.1 101.5 102.1 103.4 101.2vs rest of euro area 113.8 100.0 93.0 90.8 90.0 90.4 89.9REER (exp. price defl.) index 2000=100vs 35 industrial countries 117.7 100.0 102.6 101.0 99.1 100.1 98.2vs rest of euro area 109.1 100.0 95.4 92.2 89.6 89.6 89.1REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 124.9 100.0 100.7 97.3 97.7 101.4 98.3vs rest of euro area 110.4 100.0 90.6 86.0 84.5 85.9 84.5Terms of trade (index 2000=100):Goods & services 105.9 100.0 101.1 100.2 99.4 103.1 103.0Goods 104.0 100.0 102.6 101.4 100.3 106.1 105.7Services 113.9 100.0 96.8 97.2 98.0 93.4 94.5Openness:a1. Exports (constant prices) 24.0 33.4 43.8 50.3 51.1 46.1 46.8a2. Imports (constant prices) 24.9 33.0 38.6 42.8 44.1 42.2 42.6a3. Exports and imports (constant prices) 48.8 66.4 82.3 93.1 95.1 88.4 89.4b. Net foreign direct investment (FDI) -1.1 7.5 -1.0 -3.7 -3.7 #N/A #N/Ac. FDI intensity 1.9 6.7 2.0 3.3 #N/A #N/A #N/Ad. Net portfolio investment 1.4 -7.4 -1.3 6.3 1.8 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 99.6 100.0 103.7 107.5 106.8 102.9 105.5b. Gross operating surplus as a % of GVA 40.3 40.1 43.1 44.5 44.0 42.5 43.8c. Employee wage bill as a % of GVA 59.7 59.4 55.9 54.2 54.7 56.9 55.6d. (NDP - TCE) as a % of NKS 10.3 10.3 11.0 12.0 11.8 10.4 10.8Economic structure (% of GVA):Agriculture (ISIC A_B) 1.2 1.3 1.3 1.1 1.2 1.2 #N/AIndustry (ISIC C_E) 25.2 25.1 25.6 25.9 25.6 22.4 #N/ABuilding (ISIC F) 6.7 5.2 3.9 3.7 3.8 4.0 #N/AMarket Services (ISIC G_K) 43.8 45.7 46.7 47.3 47.4 48.8 #N/AOther Services (ISIC L_P) 23.2 22.8 22.6 22.0 22.1 23.6 #N/AShare of services in total tradeExports 12.9 13.4 13.5 13.6 13.5 15.7 15.5Imports 23.2 21.7 19.5 18.3 17.7 18.5 18.01. RCA for all exports (vs World):raw-material-intensive 0.4 0.4 0.4 0.4 #N/A #N/A #N/Alabour-intensive 0.8 0.8 0.8 0.8 #N/A #N/A #N/Acapital-intensive 1.4 1.6 1.5 1.5 #N/A #N/A #N/Adifficult-to-imitate research-intensive 1.3 1.3 1.3 1.3 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.9 0.9 0.9 0.9 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 0.6 0.6 0.6 0.6 #N/A #N/A #N/Amedium-to-low-technology goods 1.1 1.2 1.0 0.9 #N/A #N/A #N/Amedium-to-high-technology goods 1.4 1.4 1.4 1.3 #N/A #N/A #N/Ahigh-technology goods 0.6 0.6 0.7 0.7 #N/A #N/A #N/A- ICT 0.5 0.5 0.5 0.5 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

141


)Table A.3: IRELAND - Indicators related to competitiveness (% of GDP unless otherwise indicatedIndicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 2.8 -0.4 -3.3 -5.3 -5.1 -3.1 -1.8Trade balance - goods & services 11.7 13.5 11.9 10.2 10.4 15.8 18.0Trade balance - goods 17.8 26.2 17.2 10.4 13.1 20.5 22.5Trade balance - services -6.1 -12.8 -5.3 -0.2 -2.7 -4.8 -4.5Net foreign assets -28.0 -8.1 -21.5 -17.8 #N/A #N/A #N/AExport market perf. G & S (% change) 12.0 8.3 -1.0 4.9 -1.3 10.4 -1.1REER (DPC) index 2000=100vs 35 industrial countries 101.1 100.0 121.4 122.8 127.9 126.0 121.9vs rest of euro area 86.2 100.0 107.6 105.7 106.1 104.1 102.3REER (GDP deflator) index 2000=100vs 35 industrial countries 95.8 100.0 119.7 123.3 123.6 120.0 116.3vs rest of euro area 81.0 100.0 107.2 108.0 104.4 100.7 98.8REER (exp. price defl.) index 2000=100vs 35 industrial countries 98.5 100.0 106.5 105.9 104.7 110.1 106.9vs rest of euro area 87.5 100.0 96.8 94.1 91.7 95.8 94.3REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 109.8 100.0 122.6 130.6 142.4 137.1 130.3vs rest of euro area 91.7 100.0 109.1 114.5 119.8 112.7 108.6Terms of trade (index 2000=100):Goods & services 100.4 100.0 99.0 95.5 94.3 94.7 94.7Goods 101.0 100.0 101.1 94.3 91.7 92.3 90.8Services 99.6 100.0 107.8 109.0 109.9 109.6 111.4Openness:a1. Exports (constant prices) 68.8 98.3 97.9 100.0 102.0 106.6 109.4a2. Imports (constant prices) 58.5 84.8 82.8 83.5 84.2 83.3 83.6a3. Exports and imports (constant prices) 127.3 183.1 180.7 183.4 186.3 190.0 193.0b. Net foreign direct investment (FDI) 0.9 22.6 -22.8 1.4 -12.6 #N/A #N/Ac. FDI intensity #N/A 16.1 -4.3 9.8 #N/A #N/A #N/Ad. Net portfolio investment -0.4 -5.1 32.5 -3.8 -21.6 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 86.6 100.0 100.2 97.9 89.6 89.2 92.3b. Gross operating surplus as a % of GVA 49.0 55.2 54.1 53.7 52.5 53.6 55.6c. Employee wage bill as a % of GVA 50.4 44.7 46.2 46.7 50.4 49.9 48.1d. (NDP - TCE) as a % of NKS 14.3 19.9 19.6 19.4 16.6 14.8 14.9Economic structure (% of GVA):Agriculture (ISIC A_B) 4.7 3.2 2.2 1.8 1.8 #N/A #N/AIndustry (ISIC C_E) 29.8 34.3 34.0 35.3 35.8 #N/A #N/ABuilding (ISIC F) 6.7 7.5 7.8 7.5 6.7 #N/A #N/AMarket Services (ISIC G_K) 36.0 39.2 42.0 42.4 43.1 #N/A #N/AOther Services (ISIC L_P) 23.3 15.9 13.8 13.3 13.3 #N/A #N/AShare of services in total tradeExports 13.2 21.9 30.5 35.1 35.0 35.2 35.1Imports 24.9 40.4 45.7 46.1 49.9 55.1 56.51. RCA for all exports (vs World):raw-material-intensive 1.2 0.5 0.4 0.5 #N/A #N/A #N/Alabour-intensive 0.8 0.6 0.5 0.5 #N/A #N/A #N/Acapital-intensive 0.3 0.3 0.5 0.4 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.5 0.5 0.6 0.5 #N/A #N/A #N/Aeasy-to-imitate research-intensive 2.6 3.3 3.3 3.5 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.3 0.7 0.6 0.7 #N/A #N/A #N/Amedium-to-low-technology goods 0.6 0.4 0.3 0.4 #N/A #N/A #N/Amedium-to-high-technology goods 0.7 1.1 1.3 1.4 #N/A #N/A #N/Ahigh-technology goods 1.5 1.5 1.4 1.4 #N/A #N/A #N/A- ICT 1.8 1.8 1.6 1.8 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.4: GREECE - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -0.8 -12.0 -11.0 -14.7 -13.8 -8.8 -8.0Trade balance - goods & services -6.5 -13.5 -9.2 -11.1 -10.2 -4.8 -3.6Trade balance - goods -10.9 -19.4 -16.3 -17.7 -16.6 -11.0 -10.3Trade balance - services 4.3 5.9 7.1 6.6 6.4 6.2 6.8Net foreign assets -0.3 -44.5 -82.1 -100.5 -88.4 #N/A #N/AExport market perf. G & S (% change) -4.8 1.8 -4.4 -1.3 2.8 3.0 1.2REER (DPC) index 2000=100vs 35 industrial countries 101.0 100.0 109.4 111.9 114.6 117.3 115.6vs rest of euro area 91.5 100.0 103.3 105.4 106.6 107.9 108.2REER (GDP deflator) index 2000=100vs 35 industrial countries 102.9 100.0 109.3 110.7 113.0 115.1 113.5vs rest of euro area 92.7 100.0 104.4 106.3 107.7 108.0 108.3REER (exp. price defl.) index 2000=100vs 35 industrial countries 99.2 100.0 113.6 114.6 115.5 120.2 118.9vs rest of euro area 92.4 100.0 109.4 110.6 111.9 114.6 114.9REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 102.1 100.0 111.9 112.6 114.6 115.6 115.2vs rest of euro area 90.8 100.0 105.3 107.3 107.8 106.2 107.8Terms of trade (index 2000=100):Goods & services 101.2 100.0 104.0 103.4 103.0 108.3 108.0Goods 98.7 100.0 97.7 98.9 96.7 103.0 102.1Services 105.6 100.0 116.3 113.4 116.7 116.7 117.4Openness:a1. Exports (constant prices) 16.7 24.9 23.1 23.5 24.0 21.4 22.1a2. Imports (constant prices) 25.7 38.4 33.9 36.2 35.6 28.7 27.9a3. Exports and imports (constant prices) 42.4 63.2 57.0 59.8 59.6 50.1 49.9b. Net foreign direct investment (FDI) 0.8 -0.8 -0.3 -1.1 0.6 #N/A #N/Ac. FDI intensity #N/A 1.3 0.4 1.2 #N/A #N/A #N/Ad. Net portfolio investment #N/A #N/A 3.7 7.9 7.1 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 99.4 100.0 100.7 102.6 102.2 101.2 101.7b. Gross operating surplus as a % of GVA 63.8 62.0 61.4 61.8 61.3 61.4 61.6c. Employee wage bill as a % of GVA 35.9 37.6 38.7 39.1 39.3 39.2 38.9d. (NDP - TCE) as a % of NKS 14.5 15.0 15.2 15.7 15.6 15.1 14.9Economic structure (% of GVA):Agriculture (ISIC A_B) 7.8 6.6 4.9 3.9 3.9 #N/A #N/AIndustry (ISIC C_E) 14.3 13.9 13.4 13.0 13.6 #N/A #N/ABuilding (ISIC F) 6.6 7.0 6.8 7.3 4.7 #N/A #N/AMarket Services (ISIC G_K) 47.8 50.7 54.1 54.4 55.1 #N/A #N/AOther Services (ISIC L_P) 23.5 21.7 20.8 21.3 22.0 #N/A #N/AShare of services in total tradeExports 40.2 57.9 57.8 57.2 57.3 58.8 58.9Imports 10.6 22.1 21.3 21.2 24.1 25.4 25.61. RCA for all exports (vs World):raw-material-intensive 2.0 1.9 1.5 1.6 #N/A #N/A #N/Alabour-intensive 1.8 1.7 1.5 1.3 #N/A #N/A #N/Acapital-intensive 1.0 1.0 1.1 1.1 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.3 0.3 0.5 0.5 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.2 0.5 0.7 0.7 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 2.2 1.9 2.0 1.6 #N/A #N/A #N/Amedium-to-low-technology goods 1.6 2.1 1.5 1.6 #N/A #N/A #N/Amedium-to-high-technology goods 0.3 0.5 0.7 0.6 #N/A #N/A #N/Ahigh-technology goods 0.2 0.3 0.3 0.2 #N/A #N/A #N/A- ICT 0.2 0.3 0.3 0.3 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

143


Table A.5: SPAIN - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -0.2 -4.0 -7.5 -10.0 -9.5 -5.1 -4.6Trade balance - goods & services 0.0 -3.1 -5.3 -6.8 -5.9 -2.1 -0.4Trade balance - goods -3.1 -6.3 -7.5 -8.6 -7.9 -4.2 -3.2Trade balance - services 3.1 3.2 2.2 1.8 2.1 2.1 2.8Net foreign assets -21.7 -31.6 -56.0 -77.9 -78.9 #N/A #N/AExport market perf. G & S (% change) 2.0 -1.0 -3.0 1.5 -1.9 0.2 -0.6REER (DPC) index 2000=100vs 35 industrial countries 105.0 100.0 113.3 117.6 120.8 121.1 119.1vs rest of euro area 95.5 100.0 106.3 109.0 110.0 109.5 109.2REER (GDP deflator) index 2000=100vs 35 industrial countries 104.1 100.0 117.1 121.8 124.2 124.1 122.0vs rest of euro area 94.4 100.0 110.8 114.4 114.8 113.5 112.9REER (exp. price defl.) index 2000=100vs 35 industrial countries 100.3 100.0 111.2 114.5 115.4 116.9 115.6vs rest of euro area 93.6 100.0 106.2 108.4 108.8 109.1 109.2REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 105.9 100.0 112.3 118.0 121.9 119.9 119.7vs rest of euro area 95.1 100.0 105.6 110.6 112.0 108.0 109.3Terms of trade (index 2000=100):Goods & services 100.9 100.0 106.2 107.0 105.2 109.7 110.0Goods 101.0 100.0 104.1 104.8 102.4 106.9 106.3Services 102.9 100.0 107.4 108.1 108.0 108.2 110.7Openness:a1. Exports (constant prices) 21.9 29.0 29.1 30.7 30.2 27.7 28.3a2. Imports (constant prices) 22.1 32.2 37.3 41.2 38.8 33.0 32.4a3. Exports and imports (constant prices) 43.9 61.2 66.3 71.9 69.0 60.8 60.7b. Net foreign direct investment (FDI) 0.6 -3.2 -1.5 -4.8 -0.6 #N/A #N/Ac. FDI intensity 0.9 8.4 3.0 6.4 #N/A #N/A #N/Ad. Net portfolio investment 3.4 -0.2 4.6 8.6 0.3 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 97.2 100.0 106.2 106.5 104.4 104.2 104.1b. Gross operating surplus as a % of GVA 46.2 44.8 46.6 46.9 47.0 47.4 46.5c. Employee wage bill as a % of GVA 53.0 54.7 52.9 53.1 52.9 52.4 53.2d. (NDP - TCE) as a % of NKS 12.9 12.7 12.2 11.7 11.0 11.1 10.5Economic structure (% of GVA):Agriculture (ISIC A_B) 3.8 4.4 3.3 3.3 3.2 #N/A #N/AIndustry (ISIC C_E) 20.4 20.9 19.2 18.3 17.8 #N/A #N/ABuilding (ISIC F) 8.1 8.3 9.5 9.4 9.2 #N/A #N/AMarket Services (ISIC G_K) 46.0 45.6 46.5 47.3 47.9 #N/A #N/AOther Services (ISIC L_P) 21.8 20.8 21.3 21.2 21.9 #N/A #N/AShare of services in total tradeExports 30.8 31.5 29.9 29.5 30.0 30.1 29.9Imports 17.1 18.4 18.5 18.7 19.3 20.1 20.21. RCA for all exports (vs World):raw-material-intensive 1.0 1.0 0.9 0.9 #N/A #N/A #N/Alabour-intensive 0.9 1.0 1.0 1.0 #N/A #N/A #N/Acapital-intensive 2.0 2.1 1.9 1.8 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.6 0.7 0.8 0.7 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.5 0.5 0.6 0.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.0 1.0 1.1 1.1 #N/A #N/A #N/Amedium-to-low-technology goods 1.1 1.2 1.1 0.9 #N/A #N/A #N/Amedium-to-high-technology goods 1.3 1.3 1.3 1.2 #N/A #N/A #N/Ahigh-technology goods 0.4 0.3 0.3 0.4 #N/A #N/A #N/A- ICT 0.4 0.3 0.3 0.3 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.6: FRANCE - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 0.5 1.1 -1.8 -2.3 -3.3 -2.3 -2.2Trade balance - goods & services 1.1 0.9 -0.9 -1.9 -2.5 -1.2 -1.1Trade balance - goods 0.8 -0.2 -1.3 -2.0 -2.7 -1.5 -1.4Trade balance - services 0.4 1.1 0.4 0.2 0.2 0.3 0.3Net foreign assets 7.1 9.6 8.0 14.3 -4.2 #N/A #N/AExport market perf. G & S (% change) 0.7 1.3 -2.9 -2.4 -0.6 2.3 1.3REER (DPC) index 2000=100vs 35 industrial countries 116.0 100.0 106.1 108.0 110.0 110.7 109.1vs rest of euro area 103.9 100.0 97.3 97.1 97.1 97.3 97.4REER (GDP deflator) index 2000=100vs 35 industrial countries 114.6 100.0 106.6 109.0 111.3 112.8 111.7vs rest of euro area 102.1 100.0 98.6 99.4 99.8 100.6 100.9REER (exp. price defl.) index 2000=100vs 35 industrial countries 111.5 100.0 102.3 103.1 103.9 104.5 103.6vs rest of euro area 102.8 100.0 95.7 95.2 95.5 95.2 95.7REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 115.0 100.0 109.5 112.1 113.8 113.0 111.4vs rest of euro area 101.1 100.0 100.8 102.3 101.6 98.9 98.9Terms of trade (index 2000=100):Goods & services 100.7 100.0 101.4 101.4 100.3 105.8 105.8Goods 102.4 100.0 100.5 101.3 99.5 106.2 106.2Services 94.3 100.0 103.8 99.9 101.9 101.3 101.5Openness:a1. Exports (constant prices) 22.0 28.6 29.0 29.8 29.6 27.0 27.4a2. Imports (constant prices) 21.1 27.7 30.4 32.3 32.5 30.0 30.3a3. Exports and imports (constant prices) 43.1 56.2 59.4 62.1 62.1 57.0 57.7b. Net foreign direct investment (FDI) 0.5 -10.0 -1.4 -2.5 -3.6 #N/A #N/Ac. FDI intensity 1.3 8.2 4.7 7.4 #N/A #N/A #N/Ad. Net portfolio investment 0.4 2.8 -0.8 -6.4 4.6 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 98.4 100.0 100.1 101.2 100.9 101.2 103.0b. Gross operating surplus as a % of GVA 38.5 38.5 38.2 39.2 39.2 39.4 40.4c. Employee wage bill as a % of GVA 58.0 57.9 58.0 57.5 57.5 57.3 56.6d. (NDP - TCE) as a % of NKS 11.6 12.0 11.5 11.5 11.0 10.5 10.6Economic structure (% of GVA):Agriculture (ISIC A_B) 2.9 2.8 2.6 2.4 2.4 #N/A #N/AIndustry (ISIC C_E) 17.4 17.7 17.6 16.9 16.4 #N/A #N/ABuilding (ISIC F) 6.0 5.2 5.0 5.1 5.1 #N/A #N/AMarket Services (ISIC G_K) 47.6 50.1 51.1 52.3 52.6 #N/A #N/AOther Services (ISIC L_P) 26.3 24.2 23.7 23.1 23.2 #N/A #N/AShare of services in total tradeExports 20.0 20.5 18.3 18.2 17.9 19.6 19.7Imports 18.2 17.2 16.8 16.1 15.8 16.7 16.91. RCA for all exports (vs World):raw-material-intensive 0.8 0.6 0.6 0.7 #N/A #N/A #N/Alabour-intensive 0.8 0.8 0.9 0.9 #N/A #N/A #N/Acapital-intensive 1.4 1.5 1.6 1.4 #N/A #N/A #N/Adifficult-to-imitate research-intensive 1.0 1.0 1.1 1.2 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.9 1.0 0.9 0.8 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.0 0.9 1.0 1.0 #N/A #N/A #N/Amedium-to-low-technology goods 0.9 0.9 0.9 0.8 #N/A #N/A #N/Amedium-to-high-technology goods 1.1 1.2 1.2 1.2 #N/A #N/A #N/Ahigh-technology goods 0.9 0.9 0.8 0.9 #N/A #N/A #N/A- ICT 0.6 0.6 0.5 0.4 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

145


Table A.7: ITALY - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 2.1 -0.1 -1.2 -1.8 -3.1 -3.2 -2.4Trade balance - goods & services 3.8 0.9 -0.1 -0.2 -0.6 -0.4 -0.2Trade balance - goods 3.4 0.9 0.0 0.2 -0.1 0.1 0.3Trade balance - services 0.4 0.1 -0.1 -0.4 -0.4 -0.5 -0.5Net foreign assets -4.8 11.0 -2.3 1.2 #N/A #N/A #N/AExport market perf. G & S (% change) 4.2 0.0 -5.3 -1.4 -4.8 -7.3 -0.2REER (DPC) index 2000=100vs 35 industrial countries 94.0 100.0 112.1 114.9 117.1 117.4 116.4vs rest of euro area 83.1 100.0 103.3 104.1 104.5 104.3 105.2REER (GDP deflator) index 2000=100vs 35 industrial countries 93.0 100.0 111.6 113.1 115.4 117.2 116.6vs rest of euro area 81.8 100.0 103.9 104.1 104.8 105.9 106.9REER (exp. price defl.) index 2000=100vs 35 industrial countries 92.7 100.0 116.1 122.9 126.4 131.0 130.6vs rest of euro area 84.4 100.0 109.7 115.2 118.5 121.9 123.3REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 97.8 100.0 117.2 120.0 123.6 126.9 126.4vs rest of euro area 85.0 100.0 108.3 110.2 111.6 112.4 113.9Terms of trade (index 2000=100):Goods & services 100.8 100.0 102.0 100.5 98.9 104.8 105.6Goods 99.9 100.0 101.0 99.1 96.3 103.5 104.0Services 103.2 100.0 106.6 106.3 109.8 110.4 112.5Openness:a1. Exports (constant prices) 24.4 27.1 26.8 28.8 28.0 23.9 24.1a2. Imports (constant prices) 20.9 26.1 27.4 29.1 28.2 25.4 25.7a3. Exports and imports (constant prices) 45.3 53.2 54.2 57.9 56.2 49.3 49.8b. Net foreign direct investment (FDI) -0.2 0.1 -1.2 -2.4 -1.2 #N/A #N/Ac. FDI intensity 0.5 1.2 1.7 3.1 #N/A #N/A #N/Ad. Net portfolio investment 3.1 -2.2 3.0 1.2 7.6 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 94.5 100.0 98.3 98.7 97.0 94.7 96.0b. Gross operating surplus as a % of GVA 53.4 52.8 51.3 50.8 50.4 49.7 50.3c. Employee wage bill as a % of GVA 45.8 43.9 45.3 45.7 46.6 47.7 47.2d. (NDP - TCE) as a % of NKS 15.3 16.1 14.5 14.4 13.5 12.2 12.4Economic structure (% of GVA):Agriculture (ISIC A_B) 2.8 2.8 2.6 2.5 2.5 2.6 #N/AIndustry (ISIC C_E) 24.2 23.4 21.8 22.1 21.6 19.4 #N/ABuilding (ISIC F) 5.2 5.0 5.5 5.4 5.3 5.3 #N/AMarket Services (ISIC G_K) 47.0 48.7 49.7 49.9 50.2 51.1 #N/AOther Services (ISIC L_P) 20.9 20.1 20.4 20.1 20.3 21.5 #N/AShare of services in total tradeExports 19.8 19.1 18.8 19.0 19.1 20.4 20.4Imports 21.9 19.5 20.0 21.5 22.5 23.6 23.51. RCA for all exports (vs World):raw-material-intensive 0.4 0.4 0.5 0.5 #N/A #N/A #N/Alabour-intensive 1.8 1.9 1.8 1.7 #N/A #N/A #N/Acapital-intensive 0.9 1.0 1.0 1.0 #N/A #N/A #N/Adifficult-to-imitate research-intensive 1.1 1.1 1.3 1.3 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.6 0.6 0.6 0.5 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.3 1.4 1.3 1.4 #N/A #N/A #N/Amedium-to-low-technology goods 1.1 1.1 1.3 1.0 #N/A #N/A #N/Amedium-to-high-technology goods 1.1 1.1 1.1 1.1 #N/A #N/A #N/Ahigh-technology goods 0.4 0.3 0.3 0.3 #N/A #N/A #N/A- ICT 0.4 0.3 0.2 0.2 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.8: CYPRUS - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -1.7 -4.9 -5.9 -11.7 -17.7 -11.4 -8.8Trade balance - goods & services -0.1 0.8 -2.6 -6.3 -11.5 -6.2 -5.1Trade balance - goods -22.5 -26.9 -25.0 -29.7 -32.2 -23.8 -23.2Trade balance - services 22.5 27.7 22.5 23.4 20.7 17.5 18.1Net foreign assets -32.9 -44.3 3.7 15.8 #N/A #N/A #N/AExport market perf. G & S (% change) 8.2 -1.6 -0.8 1.4 -2.6 -1.0 0.5REER (DPC) index 2000=100vs 35 industrial countries 106.7 100.0 110.1 111.4 116.0 118.8 119.7vs rest of euro area 92.2 100.0 101.4 101.7 102.9 103.8 106.1REER (GDP deflator) index 2000=100vs 35 industrial countries 104.8 100.0 111.2 114.0 119.2 122.8 123.8vs rest of euro area 89.9 100.0 103.6 105.8 107.9 109.1 111.4REER (exp. price defl.) index 2000=100vs 35 industrial countries 94.6 100.0 109.8 111.6 112.7 117.8 119.1vs rest of euro area 85.7 100.0 103.1 104.1 104.3 107.7 110.1REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 106.3 100.0 118.0 115.6 117.6 118.8 119.5vs rest of euro area 90.3 100.0 109.4 107.2 105.9 104.3 106.4Terms of trade (index 2000=100):Goods & services 99.7 100.0 100.8 103.4 102.6 108.5 108.9Goods 100.3 100.0 92.8 97.5 95.1 100.3 100.0Services 101.0 100.0 106.2 109.3 108.2 108.4 109.9Openness:a1. Exports (constant prices) 51.0 55.4 52.5 52.6 49.8 42.6 42.9a2. Imports (constant prices) 50.9 54.5 55.7 61.6 64.1 54.3 53.5a3. Exports and imports (constant prices) 101.9 109.9 108.2 114.2 113.9 96.9 96.3b. Net foreign direct investment (FDI) #N/A #N/A 3.7 4.5 0.5 #N/A #N/Ac. FDI intensity #N/A 5.5 5.1 7.9 #N/A #N/A #N/Ad. Net portfolio investment #N/A #N/A -0.9 -2.0 -73.7 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 97.1 100.0 96.4 102.1 104.2 104.4 106.1b. Gross operating surplus as a % of GVA 50.3 50.7 44.1 43.3 44.2 46.2 46.2c. Employee wage bill as a % of GVA 47.4 46.1 50.0 49.2 49.7 49.9 49.3d. (NDP - TCE) as a % of NKS #N/A #N/A #N/A #N/A #N/A #N/A #N/AEconomic structure (% of GVA):Agriculture (ISIC A_B) 4.6 3.6 2.9 2.3 2.2 #N/A #N/AIndustry (ISIC C_E) 14.2 12.2 11.2 10.2 10.2 #N/A #N/ABuilding (ISIC F) 8.8 6.8 7.5 7.8 7.9 #N/A #N/AMarket Services (ISIC G_K) 49.6 55.0 56.0 58.2 58.2 #N/A #N/AOther Services (ISIC L_P) 22.5 22.3 22.2 21.4 21.5 #N/A #N/AShare of services in total tradeExports 74.6 81.5 80.0 84.9 84.0 83.5 83.6Imports 29.3 31.9 34.1 34.2 32.3 32.6 32.91. RCA for all exports (vs World):raw-material-intensive 1.3 1.2 1.4 1.8 #N/A #N/A #N/Alabour-intensive 1.2 1.0 0.6 0.7 #N/A #N/A #N/Acapital-intensive 2.0 2.7 1.0 1.0 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.3 0.2 0.3 0.5 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.5 0.4 1.8 0.9 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 2.7 2.8 1.1 1.1 #N/A #N/A #N/Amedium-to-low-technology goods 0.5 0.6 0.4 1.0 #N/A #N/A #N/Amedium-to-high-technology goods 0.5 0.7 0.8 1.0 #N/A #N/A #N/Ahigh-technology goods 0.3 0.1 1.7 0.9 #N/A #N/A #N/A- ICT 0.3 0.1 1.9 1.2 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

147


Table A.9: LUXEMBOURG - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 12.1 13.2 11.0 9.7 5.5 9.4 11.2Trade balance - goods & services 21.2 21.0 25.4 33.5 32.5 31.1 32.1Trade balance - goods -8.9 -12.5 -11.9 -8.6 -10.5 -8.4 -8.6Trade balance - services 30.1 33.5 37.3 42.1 43.0 39.6 40.6Net foreign assets #N/A #N/A #N/A #N/A #N/A #N/A #N/AExport market perf. G & S (% change) #N/A #N/A #N/A #N/A #N/A #N/A #N/AREER (DPC) index 2000=100vs 35 industrial countries #N/A #N/A #N/A #N/A #N/A #N/A #N/Avs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/AREER (GDP deflator) index 2000=100vs 35 industrial countries #N/A #N/A #N/A #N/A #N/A #N/A #N/Avs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/AREER (exp. price defl.) index 2000=100vs 35 industrial countries #N/A #N/A #N/A #N/A #N/A #N/A #N/Avs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/AREER (ULC tot. econ.) index 2000=100vs 35 industrial countries #N/A #N/A #N/A #N/A #N/A #N/A #N/Avs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/ATerms of trade (index 2000=100):Goods & services 103.9 100.0 103.5 105.8 107.6 107.6 108.0Goods 109.4 100.0 101.8 107.6 107.8 108.4 108.4Services 110.2 100.0 104.4 103.4 107.0 107.7 107.7Openness:a1. Exports (constant prices) 124.0 150.0 166.2 182.3 185.0 172.7 174.0a2. Imports (constant prices) 103.2 129.0 143.9 156.4 161.6 148.4 149.6a3. Exports and imports (constant prices) 227.2 279.0 310.0 338.7 346.6 321.1 323.6b. Net foreign direct investment (FDI) #N/A #N/A -22.4 -127.4 -54.5 #N/A #N/Ac. FDI intensity #N/A #N/A 320.2 435.5 #N/A #N/A #N/Ad. Net portfolio investment #N/A #N/A 129.6 261.2 59.5 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 97.1 100.0 101.2 108.1 106.3 99.1 102.9b. Gross operating surplus as a % of GVA 47.3 46.5 47.3 50.5 50.2 46.0 48.2c. Employee wage bill as a % of GVA 52.0 51.8 51.5 48.1 48.9 52.4 50.5d. (NDP - TCE) as a % of NKS 21.0 23.3 22.1 24.0 22.4 18.8 19.2Economic structure (% of GVA):Agriculture (ISIC A_B) 1.0 0.7 0.4 0.3 0.3 #N/A #N/AIndustry (ISIC C_E) 13.1 12.6 11.4 10.5 10.0 #N/A #N/ABuilding (ISIC F) 6.3 5.7 6.1 5.7 5.8 #N/A #N/AMarket Services (ISIC G_K) 62.6 65.5 66.6 69.0 69.1 #N/A #N/AOther Services (ISIC L_P) 16.9 15.4 15.5 14.5 14.8 #N/A #N/AShare of services in total tradeExports 68.4 72.6 75.0 77.8 77.8 79.6 79.8Imports 49.2 58.5 61.7 65.8 65.2 67.8 67.81. RCA for all exports (vs World):raw-material-intensive 0.3 0.3 0.3 0.3 #N/A #N/A #N/Alabour-intensive 1.3 1.2 1.5 1.4 #N/A #N/A #N/Acapital-intensive 2.4 2.4 2.3 2.5 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.7 0.7 0.6 0.6 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.4 0.7 0.6 0.5 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 0.6 0.8 1.0 0.9 #N/A #N/A #N/Amedium-to-low-technology goods 3.0 2.5 2.4 2.0 #N/A #N/A #N/Amedium-to-high-technology goods 0.5 0.6 0.7 0.6 #N/A #N/A #N/Ahigh-technology goods 0.4 0.6 0.4 0.5 #N/A #N/A #N/A- ICT 0.4 0.6 0.4 0.5 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.10: MALTA - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -10.6 -12.5 -8.8 -6.9 -5.6 -2.5 -2.8Trade balance - goods & services -13.2 -10.7 -5.4 -2.0 -3.0 2.6 -1.2Trade balance - goods -21.9 -19.4 -18.9 -18.0 -19.4 -13.5 -15.3Trade balance - services 8.7 8.8 13.5 16.0 16.5 16.1 14.1Net foreign assets 21.1 -1.2 22.9 -16.3 #N/A #N/A #N/AExport market perf. G & S (% change) #N/A -5.7 -5.3 -1.1 -7.8 10.7 -1.2REER (DPC) index 2000=100vs 35 industrial countries 103.6 100.0 107.1 111.4 114.3 113.2 112.1vs rest of euro area 89.2 100.0 94.0 94.0 94.3 94.7 95.3REER (GDP deflator) index 2000=100vs 35 industrial countries 102.7 100.0 109.9 116.3 119.0 118.5 118.6vs rest of euro area 88.2 100.0 97.1 99.2 99.3 100.2 101.5REER (exp. price defl.) index 2000=100vs 35 industrial countries 83.4 100.0 100.1 115.6 115.7 110.6 109.2vs rest of euro area 74.4 100.0 90.3 101.4 100.5 96.2 96.2REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 104.7 100.0 115.3 119.2 123.6 122.2 123.4vs rest of euro area 88.6 100.0 100.7 101.0 101.9 100.5 103.1Terms of trade (index 2000=100):Goods & services 101.0 100.0 101.8 103.3 101.6 103.0 103.5Goods 97.2 100.0 82.5 81.7 82.2 78.8 79.2Services 108.8 100.0 143.1 139.3 127.7 129.0 130.1Openness:a1. Exports (constant prices) 95.1 92.1 90.1 95.0 86.3 85.3 86.0a2. Imports (constant prices) 111.2 102.7 98.1 100.3 91.0 84.7 85.7a3. Exports and imports (constant prices) 206.3 194.8 188.2 195.3 177.3 169.9 171.8b. Net foreign direct investment (FDI) 3.5 15.5 11.7 12.1 7.2 #N/A #N/Ac. FDI intensity #N/A 8.4 5.5 6.5 #N/A #N/A #N/Ad. Net portfolio investment -12.8 -19.4 -44.7 6.8 6.5 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 97.5 100.0 98.2 101.8 99.8 99.4 100.0b. Gross operating surplus as a % of GVA 50.2 50.8 48.9 50.7 49.8 49.4 49.8c. Employee wage bill as a % of GVA 50.4 49.5 51.9 49.8 50.4 50.7 50.3d. (NDP - TCE) as a % of NKS #N/A #N/A #N/A #N/A #N/A #N/A #N/AEconomic structure (% of GVA):Agriculture (ISIC A_B) #N/A #N/A #N/A #N/A #N/A #N/A #N/AIndustry (ISIC C_E) #N/A #N/A #N/A #N/A #N/A #N/A #N/ABuilding (ISIC F) #N/A #N/A #N/A #N/A #N/A #N/A #N/AMarket Services (ISIC G_K) #N/A #N/A #N/A #N/A #N/A #N/A #N/AOther Services (ISIC L_P) #N/A #N/A #N/A #N/A #N/A #N/A #N/AShare of services in total tradeExports 31.0 30.7 29.0 38.6 43.1 43.4 43.2Imports 19.5 19.0 22.8 33.0 32.5 34.9 34.91. RCA for all exports (vs World):raw-material-intensive 0.2 0.3 0.3 0.4 #N/A #N/A #N/Alabour-intensive 1.0 0.8 1.2 1.0 #N/A #N/A #N/Acapital-intensive 0.2 0.3 0.4 0.4 #N/A #N/A #N/Adifficult-to-imitate research-intensive 2.4 2.5 2.3 2.2 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.3 0.2 0.4 0.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 0.8 0.7 1.1 0.8 #N/A #N/A #N/Amedium-to-low-technology goods 0.3 0.5 0.4 0.3 #N/A #N/A #N/Amedium-to-high-technology goods 0.2 0.2 0.5 0.6 #N/A #N/A #N/Ahigh-technology goods 3.2 2.7 2.3 3.4 #N/A #N/A #N/A- ICT 3.7 3.2 2.7 4.7 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

149


)Table A.11: NETHERLANDS - Indicators related to competitiveness (% of GDP unless otherwise indicatedIndicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 6.2 6.4 7.5 8.6 4.4 2.7 3.1Trade balance - goods & services 5.7 5.5 8.5 8.6 8.3 7.2 8.4Trade balance - goods 5.7 5.7 7.9 8.0 7.4 6.6 6.3Trade balance - services -0.1 -0.1 0.6 0.6 0.9 0.6 2.1Net foreign assets 3.7 -14.8 27.4 44.4 42.8 #N/A #N/AExport market perf. G & S (% change) 2.0 1.9 -0.3 1.6 1.1 3.8 0.3REER (DPC) index 2000=100vs 35 industrial countries 107.4 100.0 109.5 110.4 111.7 112.2 110.9vs rest of euro area 98.3 100.0 103.3 102.9 102.2 101.7 101.9REER (GDP deflator) index 2000=100vs 35 industrial countries 106.9 100.0 110.1 110.2 112.8 112.2 110.8vs rest of euro area 97.3 100.0 104.7 104.0 104.8 102.9 102.9REER (exp. price defl.) index 2000=100vs 35 industrial countries 107.6 100.0 104.8 105.5 108.6 106.3 104.5vs rest of euro area 100.7 100.0 100.2 100.3 102.9 99.5 99.0REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 108.2 100.0 110.6 111.7 113.5 117.5 117.2vs rest of euro area 97.6 100.0 104.7 105.6 105.3 106.7 107.8Terms of trade (index 2000=100):Goods & services 98.5 100.0 102.4 101.6 101.8 100.7 100.3Goods 97.6 100.0 104.0 103.3 103.3 102.2 101.7Services 101.3 100.0 98.8 97.2 98.5 98.0 98.0Openness:a1. Exports (constant prices) 56.1 70.1 78.4 83.7 84.3 80.4 81.8a2. Imports (constant prices) 50.0 64.5 70.4 75.2 76.5 72.6 72.7a3. Exports and imports (constant prices) 106.1 134.6 148.8 158.9 160.8 153.0 154.5b. Net foreign direct investment (FDI) -1.8 -3.1 -13.2 11.2 -3.2 #N/A #N/Ac. FDI intensity 3.7 18.1 14.1 9.5 #N/A #N/A #N/Ad. Net portfolio investment -2.3 -2.3 12.0 -11.7 14.1 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 97.7 100.0 101.9 102.5 102.3 96.5 97.3b. Gross operating surplus as a % of GVA 42.9 43.2 43.9 44.0 44.1 41.7 42.3c. Employee wage bill as a % of GVA 56.5 56.7 55.8 55.6 55.8 58.9 58.3d. (NDP - TCE) as a % of NKS 11.7 12.6 12.7 13.3 13.2 11.0 11.0Economic structure (% of GVA):Agriculture (ISIC A_B) 3.0 2.6 2.5 2.4 2.4 2.5 #N/AIndustry (ISIC C_E) 20.8 19.3 19.0 18.4 18.3 17.5 #N/ABuilding (ISIC F) 6.0 5.6 4.9 4.9 5.1 5.1 #N/AMarket Services (ISIC G_K) 45.5 50.3 51.1 52.7 52.8 52.3 #N/AOther Services (ISIC L_P) 24.8 22.1 22.5 21.7 21.6 22.7 #N/AShare of services in total tradeExports 20.9 20.7 19.2 18.0 18.3 19.1 19.1Imports 23.8 22.7 20.2 18.6 18.6 20.0 19.51. RCA for all exports (vs World):raw-material-intensive 1.8 1.4 1.3 1.3 #N/A #N/A #N/Alabour-intensive 0.7 0.6 0.6 0.6 #N/A #N/A #N/Acapital-intensive 0.8 0.8 0.7 0.7 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.7 0.8 0.8 0.8 #N/A #N/A #N/Aeasy-to-imitate research-intensive 1.3 1.5 1.5 1.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.2 1.1 1.1 0.9 #N/A #N/A #N/Amedium-to-low-technology goods 1.2 1.0 0.6 1.4 #N/A #N/A #N/Amedium-to-high-technology goods 0.9 0.8 0.9 0.8 #N/A #N/A #N/Ahigh-technology goods 0.9 1.2 1.3 1.0 #N/A #N/A #N/A- ICT 0.9 1.3 1.4 1.2 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.12: AUSTRIA - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -2.9 -0.7 2.2 3.4 3.6 2.5 1.4Trade balance - goods & services -1.0 1.8 4.0 5.9 5.8 4.2 3.3Trade balance - goods -3.4 -2.1 -0.4 0.7 0.1 -0.9 -2.3Trade balance - services 2.5 3.8 4.4 5.1 5.7 5.1 5.7Net foreign assets -13.3 -17.9 -12.9 -9.1 -6.9 #N/A #N/AExport market perf. G & S (% change) -1.2 1.7 0.9 2.9 -1.1 -3.9 0.1REER (DPC) index 2000=100vs 35 industrial countries 111.7 100.0 103.3 105.1 105.8 107.7 106.4vs rest of euro area 103.8 100.0 98.7 99.4 99.2 100.4 100.7REER (GDP deflator) index 2000=100vs 35 industrial countries 114.9 100.0 102.1 102.4 102.9 104.4 103.0vs rest of euro area 106.5 100.0 98.4 98.2 98.1 98.7 98.7REER (exp. price defl.) index 2000=100vs 35 industrial countries 108.5 100.0 104.7 105.5 105.8 107.8 106.7vs rest of euro area 102.8 100.0 101.3 101.5 101.7 102.9 102.9REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 117.6 100.0 99.8 100.1 100.5 103.4 103.0vs rest of euro area 108.2 100.0 95.9 96.0 95.6 96.5 97.5Terms of trade (index 2000=100):Goods & services 104.2 100.0 100.9 99.6 98.0 98.7 98.1Goods 102.8 100.0 101.3 100.1 97.9 98.8 98.1Services 109.9 100.0 97.1 95.5 95.6 94.8 94.8Openness:a1. Exports (constant prices) 35.3 46.4 56.7 62.3 61.5 53.9 54.5a2. Imports (constant prices) 37.8 44.7 53.0 55.9 54.4 48.8 49.1a3. Exports and imports (constant prices) 73.0 91.1 109.8 118.2 115.9 102.7 103.5b. Net foreign direct investment (FDI) 0.3 1.6 -0.1 -2.0 -3.8 #N/A #N/Ac. FDI intensity 0.6 3.8 3.7 8.6 #N/A #N/A #N/Ad. Net portfolio investment 4.2 1.6 -4.5 8.4 9.3 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 96.4 100.0 104.7 106.5 105.6 102.1 102.9b. Gross operating surplus as a % of GVA 38.6 41.0 44.4 45.1 44.5 43.0 43.5c. Employee wage bill as a % of GVA 59.6 57.3 54.5 53.7 54.2 56.1 55.7d. (NDP - TCE) as a % of NKS 9.6 10.3 10.7 11.2 11.0 9.7 9.8Economic structure (% of GVA):Agriculture (ISIC A_B) 2.5 2.0 1.8 1.8 1.8 1.9 #N/AIndustry (ISIC C_E) 22.5 23.3 23.7 25.2 25.7 24.1 #N/ABuilding (ISIC F) 8.4 7.5 7.2 7.1 7.0 6.9 #N/AMarket Services (ISIC G_K) 43.8 46.1 47.4 46.9 46.6 46.8 #N/AOther Services (ISIC L_P) 23.0 21.1 20.1 19.2 19.1 20.3 #N/AShare of services in total tradeExports 30.8 27.1 25.8 25.2 25.6 27.4 27.3Imports 24.3 19.6 18.7 18.1 17.9 18.8 18.71. RCA for all exports (vs World):raw-material-intensive 0.5 0.4 0.4 0.5 #N/A #N/A #N/Alabour-intensive 1.4 1.4 1.3 1.3 #N/A #N/A #N/Acapital-intensive 1.1 1.3 1.6 1.3 #N/A #N/A #N/Adifficult-to-imitate research-intensive 1.1 1.2 1.2 1.3 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.7 0.6 0.6 0.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.1 1.1 1.1 1.1 #N/A #N/A #N/Amedium-to-low-technology goods 1.2 1.5 1.3 1.0 #N/A #N/A #N/Amedium-to-high-technology goods 1.1 1.1 1.1 1.2 #N/A #N/A #N/Ahigh-technology goods 0.4 0.4 0.4 0.5 #N/A #N/A #N/A- ICT 0.4 0.4 0.4 0.5 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.13: PORTUGAL - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -3.0 -10.7 -9.8 -9.8 -12.1 -10.6 -10.1Trade balance - goods & services -6.4 -10.9 -8.9 -7.5 -9.6 -7.6 -7.6Trade balance - goods -7.1 -12.0 -10.3 -10.1 -12.1 -10.0 -9.6Trade balance - services 0.7 1.1 1.5 2.5 2.6 2.4 2.0Net foreign assets -3.7 -40.9 -69.1 -89.6 -94.9 #N/A #N/AExport market perf. G & S (% change) 5.5 -2.7 -4.4 2.1 0.3 2.3 0.0REER (DPC) index 2000=100vs 35 industrial countries 102.5 100.0 109.4 111.9 113.5 112.2 111.1vs rest of euro area 94.3 100.0 103.7 104.8 104.5 102.7 102.9REER (GDP deflator) index 2000=100vs 35 industrial countries 99.4 100.0 109.0 111.1 112.6 113.3 112.2vs rest of euro area 91.0 100.0 103.9 105.0 104.8 104.8 104.7REER (exp. price defl.) index 2000=100vs 35 industrial countries 100.9 100.0 104.1 107.5 108.6 107.4 106.5vs rest of euro area 94.8 100.0 99.8 102.2 102.8 100.9 101.0REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 95.5 100.0 111.3 111.2 113.5 117.3 118.1vs rest of euro area 86.6 100.0 105.9 105.3 105.4 107.4 109.2Terms of trade (index 2000=100):Goods & services 100.6 100.0 100.5 102.0 100.3 104.6 103.6Goods 103.6 100.0 99.8 101.8 99.4 104.2 102.8Services 91.4 100.0 97.5 96.0 95.9 96.7 97.3Openness:a1. Exports (constant prices) 26.8 29.8 32.4 36.8 36.6 33.3 33.4a2. Imports (constant prices) 32.9 40.6 42.7 46.1 47.3 44.1 43.9a3. Exports and imports (constant prices) 59.7 70.4 75.1 82.9 83.9 77.4 77.3b. Net foreign direct investment (FDI) 0.0 -1.3 1.0 -1.1 0.6 #N/A #N/Ac. FDI intensity 0.6 6.6 1.6 2.7 #N/A #N/A #N/Ad. Net portfolio investment -1.0 -1.7 -0.8 6.2 8.3 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 102.7 100.0 100.5 103.6 102.0 97.9 97.5b. Gross operating surplus as a % of GVA 45.5 43.2 42.3 43.3 42.6 39.4 38.5c. Employee wage bill as a % of GVA 55.0 57.3 58.7 57.2 58.0 59.7 60.2d. (NDP - TCE) as a % of NKS 14.6 13.7 11.8 12.2 11.5 10.2 10.1Economic structure (% of GVA):Agriculture (ISIC A_B) 4.9 3.8 3.5 3.3 3.4 3.5 #N/AIndustry (ISIC C_E) 19.4 20.0 19.1 19.5 19.0 18.0 #N/ABuilding (ISIC F) 7.2 7.6 6.3 5.9 5.6 5.1 #N/AMarket Services (ISIC G_K) 42.9 44.7 46.5 47.4 47.9 48.4 #N/AOther Services (ISIC L_P) 25.6 24.0 24.6 23.9 24.0 25.0 #N/AShare of services in total tradeExports 23.7 22.3 21.8 23.8 24.5 25.9 25.8Imports 15.6 13.5 12.6 12.7 12.9 13.2 13.21. RCA for all exports (vs World):raw-material-intensive 0.8 0.6 0.6 0.7 #N/A #N/A #N/Alabour-intensive 2.4 2.3 2.2 2.1 #N/A #N/A #N/Acapital-intensive 0.8 1.2 1.4 1.3 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.6 0.7 0.6 0.7 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.4 0.5 0.6 0.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 2.2 2.1 1.7 1.8 #N/A #N/A #N/Amedium-to-low-technology goods 0.6 0.7 1.4 1.1 #N/A #N/A #N/Amedium-to-high-technology goods 0.7 0.9 0.8 0.8 #N/A #N/A #N/Ahigh-technology goods 0.4 0.4 0.5 0.4 #N/A #N/A #N/A- ICT 0.5 0.4 0.6 0.5 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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Table A.14: SLOVENIA - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance -0.8 -3.2 -1.8 -4.5 -6.1 -0.5 -0.2Trade balance - goods & services -2.0 -3.5 -0.4 -1.7 -3.0 1.5 3.1Trade balance - goods -4.7 -5.8 -3.6 -4.9 -7.2 -1.6 -1.3Trade balance - services 2.7 2.3 3.2 3.2 4.2 3.1 4.4Net foreign assets #N/A #N/A -12.0 -21.5 -32.8 #N/A #N/AExport market perf. G & S (% change) -6.4 1.6 4.2 6.8 1.6 -3.4 0.4REER (DPC) index 2000=100vs 35 industrial countries 103.7 100.0 103.0 105.2 108.1 108.3 107.6vs rest of euro area 96.9 100.0 100.3 102.3 104.8 103.7 104.4REER (GDP deflator) index 2000=100vs 35 industrial countries 103.7 100.0 103.5 105.5 107.2 109.4 108.2vs rest of euro area 96.7 100.0 101.5 103.8 105.5 106.0 106.2REER (exp. price defl.) index 2000=100vs 35 industrial countries 104.5 100.0 105.0 105.7 104.5 105.3 104.1vs rest of euro area 99.6 100.0 103.4 104.2 103.3 102.8 102.6REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 111.5 100.0 103.8 104.7 107.6 115.4 112.9vs rest of euro area 103.3 100.0 101.1 102.7 105.4 110.5 109.4Terms of trade (index 2000=100):Goods & services 100.6 100.0 101.3 101.4 99.5 103.8 103.4Goods 101.8 100.0 100.9 100.7 98.9 103.5 102.9Services 97.4 100.0 99.7 101.9 98.2 98.1 98.1Openness:a1. Exports (constant prices) 47.3 53.9 65.5 74.2 73.7 67.5 68.3a2. Imports (constant prices) 49.5 57.4 66.8 77.1 76.6 68.3 67.8a3. Exports and imports (constant prices) 96.8 111.4 132.3 151.3 150.4 135.8 136.1b. Net foreign direct investment (FDI) 0.8 0.4 -0.1 -0.6 1.0 #N/A #N/Ac. FDI intensity #N/A #N/A 2.1 3.7 #N/A #N/A #N/Ad. Net portfolio investment -0.1 0.9 -4.6 -6.5 1.5 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 91.4 100.0 102.3 105.0 102.8 95.7 98.4b. Gross operating surplus as a % of GVA 36.2 39.7 40.3 42.7 41.9 38.6 40.2c. Employee wage bill as a % of GVA 65.2 59.1 58.1 56.7 58.1 62.5 60.8d. (NDP - TCE) as a % of NKS #N/A #N/A #N/A #N/A #N/A #N/A #N/AEconomic structure (% of GVA):Agriculture (ISIC A_B) 3.9 3.3 2.8 2.4 2.3 #N/A #N/AIndustry (ISIC C_E) 28.1 29.1 30.3 30.5 29.7 #N/A #N/ABuilding (ISIC F) 6.3 6.7 6.2 7.4 7.5 #N/A #N/AMarket Services (ISIC G_K) 41.3 40.8 41.1 42.0 42.7 #N/A #N/AOther Services (ISIC L_P) 20.4 20.1 19.6 17.7 17.6 #N/A #N/AShare of services in total tradeExports 21.7 17.7 16.5 15.9 17.9 17.6 17.7Imports 14.6 12.7 11.5 11.5 11.8 12.9 12.91. RCA for all exports (vs World):raw-material-intensive 0.3 0.2 0.2 0.3 #N/A #N/A #N/Alabour-intensive 1.8 1.8 1.6 1.4 #N/A #N/A #N/Acapital-intensive 1.4 1.7 1.8 1.7 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.8 0.9 1.1 1.0 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.6 0.5 0.6 0.6 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.4 1.4 1.1 1.0 #N/A #N/A #N/Amedium-to-low-technology goods 1.1 1.2 1.2 0.9 #N/A #N/A #N/Amedium-to-high-technology goods 1.1 1.2 1.3 1.4 #N/A #N/A #N/Ahigh-technology goods 0.3 0.2 0.2 0.2 #N/A #N/A #N/A- ICT 0.2 0.2 0.1 0.2 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/emwage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capistock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

ployeetal

153


ble A.15: SLOVAKIA - Indicators related to competitiveness (% of GDP unless otherwise indicated)TaIndicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 2.5 -2.5 -8.5 -5.1 -6.7 -3.1 -5.5Trade balance - goods & services 2.3 -2.5 -4.6 -1.0 -2.3 -0.2 -0.6Trade balance - goods -1.2 -5.0 -5.4 -1.8 -1.5 1.6 -0.5Trade balance - services 3.5 2.5 0.8 0.7 -0.7 -1.9 -0.2Net foreign assets 5.8 -21.1 -43.4 -45.2 -43.2 #N/A #N/AExport market perf. G & S (% change) -8.7 -3.3 3.6 6.0 0.6 -4.8 0.5REER (DPC) index 2000=100vs 35 industrial countries 89.9 100.0 129.2 152.4 167.4 178.8 178.3vs rest of euro area 82.1 100.0 128.1 151.5 166.8 174.7 177.0REER (GDP deflator) index 2000=100vs 35 industrial countries 92.4 100.0 125.3 142.5 155.0 160.2 161.1vs rest of euro area 83.7 100.0 125.3 143.7 156.7 158.6 161.8REER (exp. price defl.) index 2000=100vs 35 industrial countries 93.1 100.0 120.7 136.1 145.4 150.2 148.9vs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/AREER (ULC tot. econ.) index 2000=100vs 35 industrial countries 87.9 100.0 123.7 139.7 149.8 164.6 166.9vs rest of euro area #N/A #N/A #N/A #N/A #N/A #N/A #N/ATerms of trade (index 2000=100):Goods & services 101.6 100.0 98.2 95.7 94.2 95.2 96.1Goods 103.6 100.0 99.1 96.2 94.4 95.1 95.8Services 103.4 100.0 92.2 93.0 94.1 98.0 100.1Openness:a1. Exports (constant prices) 54.0 70.5 85.5 98.5 95.7 83.8 84.3a2. Imports (constant prices) 52.7 73.0 89.0 95.4 92.6 80.1 80.5a3. Exports and imports (constant prices) 106.7 143.5 174.4 193.9 188.4 163.9 164.8b. Net foreign direct investment (FDI) 1.2 10.0 4.1 3.6 3.4 #N/A #N/Ac. FDI intensity #N/A 5.3 2.7 2.4 #N/A #N/A #N/Ad. Net portfolio investment 1.1 3.9 -1.7 -0.6 2.5 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 103.9 100.0 103.9 106.4 106.8 98.4 99.4b. Gross operating surplus as a % of GVA 56.1 55.2 58.5 60.0 61.2 58.8 59.5c. Employee wage bill as a % of GVA 44.6 45.7 41.9 40.2 39.5 42.0 41.3d. (NDP - TCE) as a % of NKS #N/A #N/A #N/A #N/A #N/A #N/A #N/AEconomic structure (% of GVA):Agriculture (ISIC A_B) 5.3 4.5 4.8 4.8 4.3 5.0 #N/AIndustry (ISIC C_E) 29.9 29.2 37.8 40.7 40.7 39.1 #N/ABuilding (ISIC F) 6.7 7.1 6.2 6.5 6.4 6.6 #N/AMarket Services (ISIC G_K) 44.2 42.3 38.1 36.9 38.8 38.2 #N/AOther Services (ISIC L_P) 13.5 17.0 14.4 13.3 11.8 12.8 #N/AShare of services in total tradeExports 21.7 15.9 12.6 11.1 10.7 9.6 9.6Imports 16.7 11.9 10.2 9.9 11.2 12.4 12.41. RCA for all exports (vs World):raw-material-intensive 0.9 0.7 0.6 0.5 #N/A #N/A #N/Alabour-intensive 1.3 1.3 1.2 1.0 #N/A #N/A #N/Acapital-intensive 1.7 2.2 1.9 1.9 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.7 0.7 0.8 0.7 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.6 0.4 0.7 1.0 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.0 1.1 1.0 0.8 #N/A #N/A #N/Amedium-to-low-technology goods 2.1 1.1 1.1 1.0 #N/A #N/A #N/Amedium-to-high-technology goods 0.9 1.4 1.2 1.2 #N/A #N/A #N/Ahigh-technology goods 0.2 0.2 0.5 1.0 #N/A #N/A #N/A- ICT 0.2 0.2 0.7 1.3 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

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155

Table A.16: FINLAND - Indicators related to competitiveness (% of GDP unless otherwise indicated)Indicator 1995 2000 2005 2007 2008 2009 2010f

Current account balance 4.0 7.6 3.5 4.3 3.5 1.5 1.2Trade balance - goods & services 7.5 9.1 4.1 5.2 4.0 2.8 2.1Trade balance - goods 9.4 11.1 4.7 5.1 3.7 2.3 2.0Trade balance - services -2.0 -1.9 -0.6 0.1 0.3 0.5 0.1Net foreign assets -42.8 -152.4 -16.7 -30.0 -3.4 #N/A #N/AExport market perf. G & S (% change) 0.7 5.1 -0.1 2.1 5.5 -12.6 2.8REER (DPC) index 2000=100vs 35 industrial countries 113.8 100.0 104.8 106.3 108.7 110.9 108.9vs rest of euro area 100.0 100.0 95.2 94.7 95.4 96.4 96.8REER (GDP deflator) index 2000=100vs 35 industrial countries 115.6 100.0 102.9 103.9 104.5 105.4 103.9vs rest of euro area 100.8 100.0 94.4 94.5 93.8 93.3 93.8REER (exp. price defl.) index 2000=100vs 35 industrial countries 123.6 100.0 99.6 99.6 96.2 95.2 93.6vs rest of euro area 111.8 100.0 93.4 92.8 89.4 86.9 87.0REER (ULC tot. econ.) index 2000=100vs 35 industrial countries 122.2 100.0 108.7 107.7 112.0 118.7 116.5vs rest of euro area 105.1 100.0 99.0 98.2 100.3 103.6 103.7Terms of trade (index 2000=100):Goods & services 107.6 100.0 94.8 91.1 88.4 89.9 89.3Goods 106.9 100.0 94.8 90.5 87.5 88.9 88.0Services 102.3 100.0 97.9 96.6 95.2 97.3 97.6Openness:a1. Exports (constant prices) 32.1 43.6 45.7 50.5 53.2 43.6 45.2a2. Imports (constant prices) 27.5 34.5 39.1 40.8 43.0 36.2 37.3a3. Exports and imports (constant prices) 59.6 78.1 84.8 91.3 96.1 79.9 82.5b. Net foreign direct investment (FDI) -0.3 -12.5 0.3 2.1 -3.9 #N/A #N/Ac. FDI intensity 1.0 13.5 2.3 3.7 #N/A #N/A #N/Ad. Net portfolio investment -1.2 -1.4 -3.5 -2.1 2.5 #N/A #N/AProfitability:a. 1/RULC (index 2000=100): 93.8 100.0 97.3 100.1 96.2 89.9 91.8b. Gross operating surplus as a % of GVA 45.3 47.0 44.6 46.8 44.7 41.1 42.7c. Employee wage bill as a % of GVA 56.7 54.2 56.4 54.5 56.6 60.3 58.6d. (NDP - TCE) as a % of NKS 11.1 14.5 14.4 15.9 14.7 11.8 12.3Economic structure (% of GVA):Agriculture (ISIC A_B) 4.5 3.5 3.1 3.3 3.4 3.5 #N/AIndustry (ISIC C_E) 24.5 28.4 30.6 33.6 33.3 29.1 #N/ABuilding (ISIC F) 6.3 6.2 6.1 6.0 5.9 5.6 #N/AMarket Services (ISIC G_K) 41.3 41.2 41.7 41.1 41.3 42.9 #N/AOther Services (ISIC L_P) 23.7 20.7 18.8 17.2 17.2 18.6 #N/AShare of services in total tradeExports 17.9 13.7 17.7 17.6 19.9 21.1 20.9Imports 29.0 22.9 21.6 20.7 22.9 23.5 23.31. RCA for all exports (vs World):raw-material-intensive 0.7 0.6 0.6 0.6 #N/A #N/A #N/Alabour-intensive 1.7 1.5 1.4 1.3 #N/A #N/A #N/Acapital-intensive 0.7 0.7 0.9 1.0 #N/A #N/A #N/Adifficult-to-imitate research-intensive 0.9 0.8 0.9 1.0 #N/A #N/A #N/Aeasy-to-imitate research-intensive 0.9 1.5 1.4 1.2 #N/A #N/A #N/A2. RCA for exports of goods (vs World):low-technology goods 1.6 1.5 1.1 1.3 #N/A #N/A #N/Amedium-to-low-technology goods 1.1 1.0 1.0 1.1 #N/A #N/A #N/Amedium-to-high-technology goods 0.7 0.7 0.8 0.8 #N/A #N/A #N/Ahigh-technology goods 0.7 1.0 1.2 1.0 #N/A #N/A #N/A- ICT 0.8 1.2 1.4 1.3 #N/A #N/A #N/AFootnotes: f = Commission autumn 2009 forecast; REER = real effective exchange rate; DPC = deflator of privateconsumption; FDI intensity = average of inward and outward FDI flows as a % of GDP; 1/RULC = Nominal GDP/employeewage bill; GVA = gross value added; NDP = Net domestic product; TCE = total compensation of employees; NKS =net capitalstock; RCA = revealed comparative advantage: 1 based on factor intensity of total exports; and 2 based on technologyintensity of exports of manufactured goods.Source: Commission services.

European Commission

European Economy – 1/2010 – Surveillance of Intra-Euro-Area Competitiveness and Imbalances

Luxembourg: Publications Office of the European Union

2010 — x, 162 pp. — 21 x 29.7 cm

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The first decade of EMU has witnessed steady competitiveness divergence between euro-areaMember States together with the emergence of large differences in current account positions. Thesetrends are a cause of concern both for individual Member States and for the functioning of EMU.The Eurogroup has discussed the issue repeatedly in recent years and agreed in 2008 to initiatea regular review of competitiveness divergences and macroeconomic imbalances within the euroarea. The present report is part of the European Commission’s input to the review carried out by theEurogroup in 2010. It provides a comprehensive assessment of the external performance ofeuro-area Member States since the launch of the euro, focusing in particular on the impact of theglobal financial and economic crisis. It also reviews possible policy responses. The competitivenessassessment is broad-based, drawing on the examination of a wide range of indicators. It alsoincludes a review of the domestic imbalances that underlie changes in competitive positions,including excessive growth in private-sector credit and asset prices in some Member States.

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surveillance of intra-euro-area competitiveness and imbalances

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