10 April 2014

ECB/Praet: The financial cycle and real convergence in the euro area

Peter Praet, argues that real economic convergence supports the cohesion and smooth functioning of monetary union, but illustrates that there are no shortcuts to achieve this. A sustainable convergence process is achieved through reallocating resources where they are most productive.

In its simplest form, economic convergence can be understood as the process of narrowing income gaps between lower and higher income countries, achieved through faster relative growth in the catching-up economies.

When EMU was launched, the conditions for economic convergence to proceed according to this model seemed to be present. Nominal interest rates between higher and lower income countries converged rapidly. Capital flowed towards lower productivity economies where the marginal product of capital was higher, supported by the elimination of exchange rate risk within the euro area. For example, from 1999 to 2008 exposures from banks in higher-income economies towards those in the catching-up economies (Spain, Ireland, Greece and Portugal) increased more than fivefold. Facilitated by these flows, capital accumulation accelerated in these countries: from 1999 to 2007 average growth in capital services in catching-up economies ranged from around 5% to almost 9%, compared with a range of 2% to 3.5% in more productive economies.

On the surface, these developments appeared to be contributing to convergence: GDP growth in catching-up economies was generally faster than in higher income economies. Yet, with hindsight we know that there was no underlying convergence in labour productivity. In particular, strong capital accumulation in catching-up economies did not translate into faster total factor productivity (TFP) growth. TFP actually diverged between higher and lower income countries in this period. In fact, there was a positive correlation between the initial level of GDP per capita and average TFP growth rates: the highest TFP growth rates were found in Germany, Austria, Netherlands and Finland. A special case here is Italy, where initial GDP per capita was high but TFP converged downwards the catching-up economies. This seems to be because falling real interest rates eased fiscal constraints and reduced the incentive of governments to focus on structural policies.

In other words, the apparent economic convergence in the pre-crisis period was largely illusory. There was a cyclical convergence in GDP levels, but it was not structurally anchored. This poses two questions that can help inform policy choices in the euro area today: first, why did capital flows not lead to productivity convergence? And second, why did more observers not see through the illusion of convergence prior to the crisis?

Why did real convergence not happen?

First, in some sectors the falling marginal product of capital was counterbalanced by rising profit margins, meaning that total compensation from investing in these sectors remained high. This was principally the result of an incomplete single market and a lack of competition – for example, in network industries such as utilities and telecommunications – which allowed incumbent firms to charge excessive rents and distorted price signals. 

Second, specific financial factors also contributed to capital misallocation. In certain sectors in catching-up economies both the marginal product of capital and profitability were relatively low – for example, construction and retail – yet capital formation remained elevated. The explanation for this apparent contradiction seems to have been very loose credit conditions. 

Fixing the financial sector

Improving price signals in these ways is necessary for reallocation to take place in catching-up economies – but it is not sufficient. For example, in several such countries profit margins in the tradable sector have increased relative to non-tradables in recent years, yet these signals have not triggered meaningfully higher investment. Research by the European Commission suggests that financing constraints are an important factor limiting capital reallocation in this direction. [19] Moreover, there is some evidence that weak bank balance sheets have retarded the process of “churn” between firms that drives resource reallocation. One study found that, in the early phase of the crisis, banks that were lowly capitalised were more likely to maintain credit to less creditworthy borrowers – so-called “ever-greening”. [20] This type of behaviour inhibits firm exits and reduces the availability of credit for new entrants.

Addressing these financing constraints has both a short- and a longer-term dimension. The short-term part concerns dealing with the legacy of the previous financial cycle – that is, repairing bank balance sheets and reintegrating the euro area’s financial markets. This is necessary so that capital can once more flow “downhill” from higher income to lower income countries, and so that banks in those countries are sufficiently capitalised to be able to allocate credit efficiently. The main policy initiative that will support this is the Banking Union project and, as part of that, the ECB’s Comprehensive Assessment. Its aim is to dispel doubts about asset quality and levels of capital and provisions, and in doing so to accelerate the process of deleveraging and restructuring in the banking sector that is the inevitable consequence of a major financial crisis.

Over the longer-term, however, it is important that policy-makers also reflect on the quality of financial integration in the euro area – that is, the incentive structures in the financial sector that can lead to inefficient credit allocation, and the channels for sharing risk when financial crises do arise. Indeed, one criticism we could perhaps make of Optimal Currency Area theory is that is does not take account of the financial instability that may arise when capital reallocates across regions, both in terms of inflows and outflows. Banking Union goes some way towards redressing this, which is why it is essential for the longer term stability of the euro area.

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