The Elephant in the Room in the EU Competitiveness Debate

In one of our previous posts we argued that the relative loss of competitiveness globally by southern European countries since the introduction of the euro has not been as dramatic as sometimes portrayed, is comparable to that experienced by some of the largest developed trading nations, and does not appear to be caused by “übercompetitiveness” of Germany. In this post we look more deeply into what happened with the Intra EU-27 trade during the same period.

We start by examining the development of the market shares of EU-27 countries in Intra EU-27 exports since 1999. We have excluded from our analysis all countries with market shares below 1% in 2011 and the Netherlands whose export and import statistics are distorted by its role as a logistics hub for Extra EU trade (for example, the Netherlands has a large Extra EU trade deficit and a large Intra EU trade surplus). That leaves us with 16 countries.

Based on the results of this analysis, the countries can largely be divided into three groups. First, there are countries that have seen their market shares stay approximately stable or grow very moderately – Germany, Belgium, Austria and Spain, as can be seen in the chart below.

A number of countries experienced loss of Intra EU-27 market shares as can be seen in the next chart. Eurozone members France, Italy, Ireland and Portugal as well as Finland are in this group, but so are United Kingdom, Denmark and Sweden.

What was the cause of the above changes? A frequently heard argument is that several Eurozone members lost competitiveness to Germany as a result of German productivity rising faster than wages. This is often supported with a picture showing the Unit Labor Costs (ULC) in Germany declining and those of most other EZ members rising.

To take into account both ULC and nominal exchange rate developments, we plotted the relative changes in export market shares of the twelve EU-15 countries from 1999 to 2011 against the average change in ULC deflated REER vis-a-vis the EU-27 trading partners during 2000-2011 compared to 1999. The results are displayed below.

While there is some correlation between REER appreciation and loss of export market shares, its explanatory power is weak. There are also significant outliers, for example, Spain has been able to moderately grow its Intra EU-27 export market share despite REER appreciation while the UK, Finland and France have experienced large losses of market shares despite relatively stable REER-ULC.

Now, to whom did the eight EU-15 countries in our analysis lose market share?  Those were the new EU member states, most notably the Czech Republic, Poland, Romania and Slovakia, and to a lesser extent Hungary, as can be seen in the next chart.

The market share gains were impressive in relative terms, and sizeable also in absolute terms as can be seen below.

In fact, the five new member states taken together gained about 7.2%% of Intra EU market share during the twelve-year period bringing it from 5.0% to 12.2%. This accounts for a large part of the 11.7%% loss of market share by the eight EU-15 countries that experienced significant loss of market share (from 43.8% to 32.1%) while the rest could be mostly explained by the market shares gained by the Netherlands (or reexports of goods imported from outside of EU-27) and the smaller EU-12 states with market shares in 2011 below 1%.

A simplified explanation of the observed trade developments is as follows: after increasing trade liberalization with CEE and subsequent integration into the EU of 12 new member states, several of the EU-15 states lost their competitiveness in the tradable sector to the new member states, most notably the larger ones such as the Czech Republic or Poland.

There are also several other important aspects to note. Plotting the export market share changes against changes in REER-ULC for the five larger EU-12 states shows that if anything, REER appreciation is associated with significant export market share gains as can be seen below.

Our explanation of the Kaldor’s paradox observed above is as follows. First, the new EU member states had price (and wage) levels much below those in the EU-15 to start with as shown in the next chart. Second, sharply rising ULCs in the new member states were due not only to rising wages, but also due to an increase in the labor share in value added due to relocation of labor intensive activities from the EU-15 to the new member states.

 

Furthermore, Felipe and Kumar (2011) referring to a detailed analysis of product and country complexity by Abdon et al.(2010) have claimed that Ireland, Spain and Portugal “do not compete directly with Germany in many products that they export and hence comparing their aggregate unit labor costs and drawing conclusions is probably misleading”. According to Abdon et al. (2010), Germany is the second most complex economy in the world after Japan and ahead of Sweden, Switzerland and Finland. At the same time Ireland (ranked 11th) is just ahead of the Czech Republic (13th) in the complexity ranking, Slovakia (22nd) is similar to Italy (23rd), Hungary (24th), Poland (26th) and Spain (27th) while Romania (48th) is ranked ahead of Portugal (52nd).

Other research has shown that Germany has been able to maintain its global export market share largely as a result of trade relationships with fast growing countries such as China, India and oil exporting countries (see, for example, Danninger and Joutz (2007)) while at the same time taking advantage of lower production costs of labor intensive intermediate goods in the new EU member states (ibid., Curran and Zignago (2009)). The flip side of the trade story has been significant German FDI in the new member states. This might also partly explain the ULC developments in Germany during last decade, i.e., it is likely that the German ULC decreased not only as a result of wage restraint, but also because of decreasing labor share in domestic value added due to replacing labor intensive domestic production by imports of intermediate goods from the new member states.

Conclusions

The focus of recent discussions on external competitiveness in the EU has often been the impact of the euro, in particular, it preventing southern European countries from regaining competitiveness vis-à-vis Germany by way of devaluation. However, the explanatory power of the longer term correlation between ULC deflated REERs and export performance is low. Recent research by Frankel on the effect of the euro on the volume of trade within the Eurozone has also shown that early work in this area had overstated the contribution of the euro.

The elephant in the room when it comes to the EU competitiveness debate is the common market. In particular, the EU enlargements in 2004 and 2007, which were preceded by gradual trade liberalization between the EU-15 and the EU-12 countries since the 1990s, had a profound impact on the economic relationships in the EU. The new EU member states have successfully used the common market to boost their exports and income levels. As a reminder, most of the new member states have not yet adopted the euro and some of the larger ones have not even pegged their currencies to the euro as of today.

Taking all of the above into account and looking at the global picture, the following explanation of the trade patterns observed during last decade emerges: Germany has been able to maintain its global export market shares primarily as a result of strong exports to fast growing economies and the complexity of its export basket while increasingly sourcing intermediate goods in the new EU member states. Some of the other EU-15 states have not been as successful in adapting to the new realities in global trade and are „stuck in the middle” – they have not been as successful as Germany in unlocking global export opportunities while at the same time their wage levels are too high to be competitive as suppliers of intermediate goods to Germany.

References

Abdon, Arnelyn, Marife Bacate, Jesus Felipe and Utsav Kumar (2010), “Product Complexity and Economic Development”, Levy Economics Institute of Bard College, Working Paper No. 616, September 2010

Curran, Louise and Soledad Zignago (2009), „Evolution of EU and its Member States‘ Competitiveness in International Trade”, CEPII, June 2009

Danninger, Stephan and Fred Joutz (2007), „What Explains Germany’s Rebounding Export Market Share?”, IMF Working Paper, February 2007

Felipe, Jesus and Utsav Kumar (2011), “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again”, Levy Economics Institute of Bard College, Working Paper No. 651, February 2011

Frankel, Jeffrey (2008) , “The Euro at ten: Why do effects on trade between members appear smaller than historical estimates among smaller countries?”, VoxEU.org, December 24, 2008

Grennes, Thomas and Andris Strazds (2012), “Is Germany Übercompetitive and Should it Accept Higher Inflation”, EconoMonitor, July 2012