EMU Current Account Plunges Into Deficit

Make no mistake about it this is not the Nestea™ plunge - the pause that refreshes. The European Monetary Union (EMU) current account in July dives to a deficit of 19.9 billion euros after rebounding to a small €4.2 billion surplus; an earlier €6.9 billion deficit was logged in May. The balance on the goods account is at an €18.3 billion deficit in July after a €0.3 billion deficit in June. The goods balance has been eroding for quite some time. Changes in the current account balance over three months to six months to 12 months show consistent erosion. The goods balance has deteriorated by €46.6 billion over 12 months, by €28.2 billion over six months and by €18.2 billion EUR over three months. While current account transfers remain deeply negative, the change in transfers has been diminishing from €3.1 billion over 12 months, a wider €3.3 billion deterioration over six months which has shrunk to €1 billion of deterioration over three months.

The three largest EMU economies Germany, France, and Italy show that Germany still has a surplus in July, but France and Italy both post deficits on their current accounts. For France the deficit is €5.3 billion; for Italy it is €3.8 billion. However, when we look at the period-to-period sequential changes, each of these three countries shows deterioration over each of the three horizons; Germany may still have a surplus but it, too, is eroding. If we annualize the changes over the respective periods, the deteriorations are also getting progressively worse - except for Germany.

Relative Deficit Size and Purchasing Power Parity Purchasing power parity refers to the price adjusted exchange rate value. To create a broad PPP index, we take the ratio of prices in the European Monetary Union to the weighted prices of its trade partners converted into euros using the appropriate spot exchange rate at each point in time for conversion. When the PPP ratio rises, domestic (EMU) prices are rising faster than exchange rate-adjusted trade partner prices. Then, EMU is becoming less competitive. If the ratio falls, EMU is becoming more competitive. When the PPP value rises and gains above parity, the level of the exchange rate is said to be overvalued. At some point, an overvalued exhange rate causes a country to lose enough competitivenss that it will cause deterioration in the trade account and current account. However, a strong exchange rate helps to reduce inflation. A weak exchange rate helps to encourage inflation by nudging import prices higher. The PPP calculations below are based on consumer prices; they show the euro has fallen relative to parity and is undervalued.

Not surprisingly with the Federal Reserve raising interest rates strongly, the dollar has been rising and this has put the euro into negative PPP territory. The deviations from parity show the euro steadily weakening since the third quarter of 2021 in the table. The euro's sharpest pace of descent below parity has occurred since the Fed began raising rates.

The table shows that the euro has generally been 'too weak' (below parity) over the past five years, 10 years and close to parity over the last 15 years by 'definition' it's close to parity over 20 years because we use a 26-year average as a proxy for parity under the assumption that over long periods of time 'the markets' get foreign exchange parity roughly correct.

Exchange rates, however, do not work their magic overnight. And Europe has more complicated problems than competitiveness. The European Central Bank has kept interest rates too low for too long as did the U.S. Federal Reserve. When COVID inflation struck, the ECB was even slower to react than the Fed. Now interest rates in the U.S. are going up far faster than interest rates in the EMU and that is tugging the dollar higher and pushing the euro lower.

In addition, there are growth slowdowns in the U.S. and in the European Monetary Union. GDP growth also has an impact on the current account deficit size. When growth speeds up so do imports and the trade balance usually erodes. If the euro area slows down considerably, and if energy shortages cause a recession, that will cause the current account for the European Monetary Area to contract faster than any euro weakness would be able to do the job as imports weaken. In the months ahead, there are going to be several forces playing out to affect the European deficit. There's going to be no one simple factor responsible for the changes in the European current account. But looking ahead, all forces appear to be moving to create a smaller deficit and arrest the erosion we are seeing. The caveat to this conclusion is that the global economy is slowing as well as Germany. German exports will slow along with German imports. Generally, the import weakness dominates export weakness in a recession. But there are also noneconomic forces at work as past strength in German exports was undone by economic sanctions. Additional sanctions do not seem likely for the period ahead.