The econometric strategy

The basic formulation of the gravity equation relates the amount of bi-lateral trade to the economic mass of the trading partners, proxied by GDP, to the bilateral exchange rate, and to spatial variables such as geo-graphical distance, dummies for neighbouring countries, common lan-guage and so on.

The baseline model specification that we use in order to estimate the determinants of export and import flows among the EMU countries, is the following:

IN SEARCH OF A NEW EQUILIBRIUM.ECONOMIC IMBALANCES IN THE EUROZONE

(1)

where the log of export at constant prices of country i toward country j

(Expi,j,t,) is regressed on: the log difference between importer’s and

ex-porter’s GDP (GDPreli,j,t); the inflation rate differential between the im-porting and the exim-porting country (πreli,j,t); a set of pairs and time-specific dummies (γi,j and θt); a vector of variables (Xi,j,t) representing the different determinants of European imbalances proposed in the lit-erature completes the equation. The inclusion of pair-specific fixed ef-fects (i.e. importer-exporter combination) allows us to neglect other ge-ographical and time-invariant variables normally required in gravity models. GDPreli,j,tcaptures both relative demand and catching-up effects so that conclusions about the growth process of European countries are not univocal. The relative inflation (πreli,j,t) captures the impact of the standard price competitiveness: a higher relative inflation of the export-ing country reduces its export competitiveness. Hence, we expect a posi-tive impact of these variables, independently of the surplus or deficit position of the considered country. Finally, the vector Xi,j includes the following variables:

• changes in the net international investment position of import-ing and exportimport-ing country (∆NIIPj and ∆NIIPi);

• absolute difference between the interest rates of importing and exporting country (AbsDifIntij);

• relative real unit labour costs of the importing and exporting country (RULCrelj,i);

• gross fixed capital formation to GDP ratio of the importer coun-try (GFCFj);

• share of construction and real estate activities in total capital formation (NTshj).

On average, the NIIP deteriorated in the deficit countries and improved in surplus countries. The deterioration of the net position in the deficit countries implies a net inflow with the rest of the world and a rise in imports, hence, it should show a negative sign. If external financing is

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used to improve the productive structure, then exports should also ben-efit from the increased deficit (negative sign of exporter’s ∆NIIP). By contrast, if foreign capital is used to finance domestic consumption or investment in non-productive sectors, the impact on exports is expected to be zero or even negative and the expected sign is positive (i.e. a dete-rioration of the net position reduces export).

Surplus countries, on the other hand, are net lenders to the rest of the world, and to the rest of the euro area in particular. This means that we should expect a positive impact of improvements in NIIP on export, and a zero or positive impact on imports as the financial integration raises the overall intra-area trade. In this case too, the expected sign of the im-porter’s ∆NIIP is positive.

Interest rates are important indicators of financial integration. The introduction of the euro and the resulting reduction of the exchange rate risk level in peripheral members brought about a convergence in the in-terest rates of peripheral countries to the lower levels of surplus coun-tries. Such convergence, associated with the still positive differential en-joyed by southern Member States, stimulated cross-country capital flows especially from core to peripheral Europe.¹⁰ In order to seize the convergence of interest rates, we used the absolute value of the differ-ence between partners’ interest rates.

As we stressed in Chapter 3, the divergence of unit labour costs is a key issue in the alternative explanations of macroeconomic imbalances.

The more competitive countries should find it easier to export their products to the less competitive economies which, at the same time, in-crease their demand for imports from the more competitive ones. We define the relative real unit labour cost (RULC) as the ratio of importer’s to exporter’s real ULC. This means that its effect, if significant, should have a positive sign since an increase in this ratio signals a relative loss of competitiveness of the importing country. Note that even though this effect is present in all countries, we expect the RULC differences to have a higher impact on deficit countries’ import flows. If this holds true, it

10 Differences in returns on capital are roughly captured by financial flows. The in-clusion of simple difference between the interest rates was never significant.

IN SEARCH OF A NEW EQUILIBRIUM.ECONOMIC IMBALANCES IN THE EUROZONE

will follow that competitiveness losses played a significant role in in-creasing European imbalances.

The last two groups of variables (GFCFj and NTshj) are introduced to better qualify the growth process of European countries. Fixed invest-ment has a positive effect on the amount of imports as long as imported capital goods are used in the production process; however, the net ef-fect on imbalances depends on the nature of investments. In order to distinguish between productive and non-productive investment, we added the share of construction and real estate activities in total in-vestment. This variable captures the effect of both speculative bubbles, as in the case of Spain and Ireland, and of the excessive development of the non-tradable sector. Relatively high shares of such kind of invest-ments are also present in other deficit countries like Italy and Slovenia;

therefore this variable can capture the general process that strongly af-fected not only Spain and Ireland but also the whole group of non-core countries.

Equation (1) is estimated on a panel of bilateral export of 14 euro ar-ea countries over the sample period 1999-2007.¹¹ To better identify the role of the different factors, we estimated six specifications which alter-natively restricted the sample of export and import flows for the GIPS, the deficit and the surplus countries, respectively. We further divided the sample into two sub-periods, that is, the years 1999-2002 and 2003-2007. This is done in order to take account of the strong increase in im-balances since 2003. As a matter of fact, trade and current account bal-ances experienced small changes before 2003, which suggests the pres-ence of structural breaks between the two sub-periods.