External asymmetries in the Euro-Area and the role of Foreign Direct Investment

1. External asymmetries in the Euro-Areaand the role of Foreign Direct Investment Nicos Christodoulakis Vassilis Sarantides Athens University of Economics and Business January 2011

2. It is by now well recognized that large CA asymmetries between East-West were responsible for the 2008 credit crunch

3. After the credit crunch, alarming spreads in the Eurozone! But not just for the highly indebted countries…

4. Conventional wisdom: The cost of borrowingincreases withindebtedness Correlation between Public Debt and Spreads (10y bond yield over the Bund, averages 1999-2009)

5. Un-conventional wisdom: The cost of borrowingincreases also with CA Deficits Correlation between Current Account and Spreads (10y bond yield over the Bund, averages 1999-2009)

6. Voices of concern too late:When the global crisis hit mostly countries with Public and/or CA Deficits • R. Zoellick (World Bank, 10 Oct. 2008) • …Emerging economies with large CA Deficits will be hit by scarcity of international capital … • UN (R. Shelbourne, June 2008) • … the tightening of credit … can turn the problem of illiquidity into a problem of insolvency ..

8. “NORTH” “SOUTH” TWO GROUPS IN EUROZONE External Surplus, more FDI : AT, BE, LX, FI, IE, NE, GE External Deficit, less FDI: SP, PT, EL, FR, IT

9. Why External balances are widening after EMU? Early theory:Demand-induced Fall in real interest rates è Higher consumption è External imbalances, only temporary … but SGP would reduce fiscal deficits Investment would rise in the Eurozone, and external balances would be corrected.

10. Investment has risen, but …intensity differed: Inward FDI much more in the “NORTH” (exc. Belgium)

11. Three questions are looming: 1. Why the ‘North’ has attracted more FDI, contrary to conventional predictions about capital migration from rich to poor? 2. Why the composition Manufacturing/R-Estate differed between North and South ? 3. Has FDI affected External Deficits and how ?

12. What can we learn from economic theory?Investment in an open economy with traded and non-traded goodse.g. Brock (1989), Turnovsky(1996) Three factors of production

13. FDI

14. Assumptions in the two-sector model

15. 3. In EZ-South, quality of the Regulatory Environment substantiallyinferior to that in EZ-North countries

16. To account for Regulatory impediments in the South, modify production function in the Traded sector For typical values α = 0.70, β = 0.30 North: x = (2 - 1.56)/2 = 0.21 è α-x > β South: x = (2 - 1.02)/2 = 0.49 è α-x < β

17. The intertemporal problem Wealth abroad (B) with an exogenous world interest rate (r)

18. Hamiltonian:

19. First-order conditions:

20. Solving the two-sector model Consumption rule Investment rule Asset price, Q Relative price, p

21. Returns determined from model parameters (complicated expressions)

22. Represent EMU as a permanent fall in real interest rates Fact: After EMU, real interest rates fell about -2.7 p.u.

23. Price equilibrium and Response to Shocks (I) Traded sector intensive in FDI, β< α- x ratio Q for small δ 0 relative prices A permanent fall in interest rates è asset price Q rises è Investment rises Prices of non-traded goods fall relative to traded

24. Price equilibrium and Response to Shocks (II) Non-traded sector Intensive in FDI, β> α - x Q p 0 • A permanent fall in interest rates • Asset price Q jumps , but only temporarily, • Investment rises, but only for a while • Prices of non-traded goods rise relative to traded

25. Stock equilibrium and Response to Shocks Stock-adjustment processes for stocks B and H

26. Equilibrium and Response to Shocks (III) B A permanent fall in interest rates H 0 α-x>β,Productive sector intensive in FDI,

27. B A permanent fall in interest rates H 0 α-x<β, Non-traded sector intensive in FDI

28. Stylised Facts of the Model Proposition 1: Asset prices rise more in the North, North South 0 to time

29. Fact 1: Asset prices higher in the North After EMU, Ratio average Qnorth/Qsouth > 1

30. Proposition 2: Prices of Non-traded Goods rise more in the South: If Traded sector FDI intensive: Prices of Non-traded DOWN If Non-traded sector FDI intensive: Prices of Non-traded UP p South productivity gap=p2-p1 North 0 to time

31. Fact 2: Post-EMU Inflation higher in the SOUTH Productivity Gap isaccumulated

32. Proposition 3: As a result, FDI inflows are expected to be higher in the North Investment rule Compare FDI flows > 1 > 1 > 1 > 1

33. Fact 3: FDI inflows as % of GDP Substantially higher in the North EMU Source: IMF EXCLUDING BELGIUM

34. Proposition 4: FDI composition is changing with p More FDI to Traded sector More FDI to Non-Traded

35. Fact 4: FDI in Manufacturing higher in the North

36. Fact 4: FDI in Manufacturing higher in the North

37. Composition of FDI flows matters • Potential advantages derived from FDI might differ markedly across the primary, manufacturing and services sector [UNCTAD (2001)]. • Ruane and Gorg (1999) showed that Ireland’s economy was transformed because of the massive entrance of foreign affiliates. MNEs were exporting over 70% of their output and accounted for two thirds of manufacturing net output and half of employment. • The empirical discussions that concern spillover effects on productivity and exports are often concentrated in the manufacturing sector [see e.g. Aitken et al. (1997), Dimelis and Louri (2002) and Greenway et al. (2004)].

38. Fact 4a: FDI in Manufacturing is positively correlated with Trade Balances

39. Fact 4b: FDI in Real-estate is negatively correlated with TRADE BALANCES Source: OECD and IMF Belgium, Greece, Italy and Ireland not included, due to very few obs.

40. Financial Times Germany’s unlikely optimists By Ralph Atkins and James Wilson Published: November 23 2010 … Says Mr Thomas Mayer, chief economist at Deutsche Bank, On the underlying strength of Germany’s economic model: “In the UK and US, we are now finding out that there was too much expansion of the non-traded sector – too many people in construction, too many people in real estate and you could even say too many people in finance...

41. Proposition 5: External Balances diverge If Traded sector FDI intensive: UP If Non-traded sector FDI intensive: DOWN Balance North South 0 to time

42. Fact 5: The evolution of Trade and CA Balances EMU

43. Why FDI has affected External Deficits ? Recall Rybsczyncski Theorem (1955): “An increase in a country’s endowment of a specific factor, will increase the output of the sector that is intensive in that factor and decrease the output in the other sector”.

45. Empirical Strategy • We use the Pooled Mean Group estimator [Pesaran et al. (1999)]where short-run coefficients, the speed of adjustment and error variances are allowed to vary across countries, but the long-run coefficients are constrained to be the same. • An additional advantage of this model is that it yields consistent estimates of the long-run parameters irrespectively of whether the underlying regressors are stationary,nonstationary or mutually cointegrated.

46. Empirical evidence for the relationship between Spreads and Current account (quarterly data 1999-09)

47. Using the Pooled Mean Group estimator we find evidence that sovereign bond yield spreadsare, Positively related to Government debt Positively related to fiscal deficits Positively related to external deficits  See e.g. Alexopoulou et al. (2009), Attinasi et al. (2009), Barrios et al. (2009) Empirical evidence for the relationship between Spreads and Current account

48. Empirical evidence for the FDI effects on the trade balance (annual data 1980-09)

49. Composition of FDI flows and trade balance • The relationship of FDI with trade depends on the industry, country and time period investigated [see Pontes (2004)]. Þ Both export-oriented high tech manufacturing goods and labor intensive textiles are included in manufacturing FDI, but they are expected to affect a country’s productivity in a different way. • The FDI effect can differ significantly between the short run and the long run, depending on the nature of the imported goods in the short run [see Fontagne (1999)]. Þ Imported goods in the short run can be intermediate and capital goods that serve as vehicles of positive externalities and improve the host country’s trade balance in the long run though.

50. Trade balance determinants • We expect an increase in competitiveness ( Real Effective Exchange Rate)to be positively related with external balance [see e.g. Arghyrou and Chortareas (2008)] 2. According to Blanchard and Giavazzi (2002), increased economic integration can result in large external deficits in transition economies. Hence, we expect that an increase in the growth rate of output to deteriorate the trade balance [see e.g. Abel and Bernanke (2001), Gandolfo (2004)].