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Real Convergence, Financial Markets, and the Current Account: Emerging Europe Versus Emerging Asia

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Five Years of an Enlarged EU

Abstract

Global financial integration has been associated with divergent patterns of real convergence and the current account in emerging markets. While countries in emerging Asia have been running sizeable current account surpluses, countries in emerging Europe have been facing large current account deficits. In this paper we test for the relevance of financial market characteristics in explaining this divergence in the catching-up process in Europe and Asia. We assume that the two regions constitute distinct convergence clubs, with the euro area and the United States respectively at their cores. In line with the theoretical literature, we find that better developed and more integrated financial markets increase emerging markets´ ability to borrow abroad. Moreover, the degree of financial integration within the convergence clubs – as opposed to the state of financial integration in the global economy – and the extent of reserve accumulation are significant factors in explaining the divergent patterns of real convergence and the current account in the regions under review.

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Notes

  1. 1.

    According to Lucas (1990) capital seems to flow uphill from poor to rich countries contradicting the prediction of standard neoclassical growth models.

  2. 2.

    In recent years, other emerging market economies have seen improving current account balances as well, mainly reflecting the rise in oil and other raw material prices, which has supported trade and current account balances in many resource-rich countries.

  3. 3.

    The emerging European countries are the new EU Member States Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia as well as the candidate (Croatia, FYR Macedonia and Turkey) and potential candidate countries (Albania, Bosnia & Herzegovina, Montenegro and Serbia) for EU accession.

  4. 4.

    The emerging Asia group refers to developing Asian countries such as China, Indonesia, Malaysia, Philippines and Thailand, as well as the newly industrialized Asian economies, i.e. Hong Kong, Korea, Singapore and Taiwan. India and Vietnam are also part of the sample.

  5. 5.

    It should be stressed that these results are not to be seen as a contribution to the debate on the causes and roots of global imbalances. By focusing on two sub-regions of the emerging market world, our analysis neglects developments in countries not covered by our analysis.

  6. 6.

    See Direction of Trade Statistics, IMF.

  7. 7.

    In China, Hong Kong, Indonesia and Thailand Japanese banks hold the largest claims on the respective countries. See Consolidated Banking Statistics, BIS.

  8. 8.

    For Bosnia and Herzegovina, the average applies to the period 1999–2006 to avoid a bias from the immediate post-war recovery, when annual growth rates were exceptionally strong. Data for Serbia are available only from 1999. Montenegro is not included in the analysis.

  9. 9.

    The GDP per capita is reported in purchasing-power-parity (PPP) adjusted terms.

  10. 10.

    While all Asian countries increased their population between 1994 and 2006, 10 out of 16 CEE/SEE countries report a decline in population. Furthermore, it should be noted that in 1994 euro area GDP per capita was about USD 20,000 compared with around USD 26,000 in the US. Over the review period, euro area GDP per capita rose by 57%, while growth of US GDP per capita reached 65%.

  11. 11.

    However, the relative income position of Korea, although strongly affected by the crisis, increased by almost 30% in the review period.

  12. 12.

    In general, smaller countries recorded higher current account imbalances, explaining the wedge between the weighted and non-weighted average of current account balances in Figures 3.1.5 and 3.1.6.

  13. 13.

    If not explicitly mentioned differently, GDP per capita figures are in PPP terms.

  14. 14.

    On a global scale, Gourinchas and Jeanne (2007) found that capital flows have been more pronounced to emerging market countries with – on average – lower rates of growth. Like the Lucas paradox, this contradicts the predictions of standard economic theory, which is why they refer to the empirical evidence as the allocation puzzle.

  15. 15.

    In Hungary and the Czech Republic a negative income balance has contributed significantly to the current account deficit. Furthermore, in most European countries the income balance has been worsening over time, indicating that non-distributed earnings of foreign-owned firms might have played an increasing role in these countries.

  16. 16.

    Hong Kong even recorded a trade deficit and a current account surplus due to a strong service balance. In the other deficit countries, transfers in the form of remittances have played a major role, in particular in the case of the Philippines, the only country in emerging Asia showing a pronounced trade deficit (on average it corresponds to approximately 9% of GDP).

  17. 17.

    By contrast, most of the traditional literature neglected financial sector development as a potential determinant of the current account balance (Gosh and Ostry 1992).

  18. 18.

    This idea is similar to the approach of Ju and Wei (2007), assuming that underdeveloped financial sectors are by-passed by economic agents through integrating with mature market economies.

  19. 19.

    However, financial integration may also support behaviour in line with the Lucas paradox, if it is a precondition for emerging market economies to invest in mature financial markets (Greenspan 2003).

  20. 20.

    Standard indicators of financial development might fail to capture the borrowing constraints businesses and households effectively face (IMF 2006).

  21. 21.

    It should be noted that in emerging Europe, due to a high level of asset substitution on the banks’ asset as well as liability side (ECB 2007), the spread of local currency interest rates may be less important than the spread on foreign currency loans and deposits.

  22. 22.

    See Kose et al. (2006) and IMF (2007) for a review of financial globalisation and liberalisation.

  23. 23.

    See Chinn and Ito (2007).

  24. 24.

    Capital account liberalisation is part of the acquis communautaire, the body of legislation of the European Union, which candidate countries must accept before they can join the EU.

  25. 25.

    We focus on quantity-based measures of financial integration, as price-based indicators are more vulnerable to bias from common factors or and/or similarities in fundamentals (Baltzer et al. 2007).

  26. 26.

    Thus, the evidence provided by Abiad et al. (2007) suggesting an extraordinary degree of financial integration in Europe is largely driven by cross-border asset accumulation in the core. According to this approach, Europe is financially much more integrated than Asia, as the sum of European economies’ foreign assets and liabilities, expressed as a percentage of GDP (weighted average), is almost twice as high at the end of the current observation period as in emerging Asia.

  27. 27.

    See also ECB (2007).

  28. 28.

    The following variables are part of the empirical investigation: INCOME: country´s relative GDP per capita (PPP); DEPENDENCY: dependency ratio; CAPITAL: gross capital flows (as % of GDP); FDIGDP: FDI (as % of GDP); RESERVES: stock of foreign exchange reserves (as % of GDP); EXCHANGE: real effective exchange rate (log.); CREDIT: private credit (as % of GDP); CRISIS: banking crisis index; CHINN_ITO: capital account openness index; OVERALL INTEGRATION: foreign assets plus liabilities (as % of GDP); INTRA INTEGRATION: consolidated cross border banking claims of euro area/US banks on an emerging country (as % of GDP of the recipient country); FOREIGN BANKING: foreign-owned banking assets (as % of total banking sector assets in the periphery country).

  29. 29.

    As the private credit to GDP ratio has been differentiated, the variable represents the change in the private credit to GDP ratio.

  30. 30.

    The data result from multiplying the estimated parameters by the annual figures of each factor using the average in the two regions. Thus, the analysis informs about the relative contributions of the various variables to the predicted current account/GDP ratio for both peripheries.

  31. 31.

    At least, this conclusion cannot be drawn when financial development and financial integration are measured by indicators commonly used to account for both factors.

  32. 32.

    Comparing financial sector development in all transition countries, i.e. including emerging Europe as defined in this paper as well as the CIS, Berglöf and Bolton (2002) use the term “great divide” to stress the different character and environment of financial sector development in transition countries caused by the fact that some countries have an EU accession perspective.

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Acknowledgment

Excellent research assistance by Silvia Magnoni, Livia Chitu and Michael Grill is gratefully acknowledged. The authors would also like to thank Neeltje van Hooren (World Bank) for data support. The paper has benefited from valuable comments by an anonymous referee, Gerard Korteweg, Heinz Herrmann, Peter Backé and participants in a seminar at the Deutsche Bundesbank, the ECB conference on central, eastern and south-eastern Europe and the ESCB Workshop on Emerging Markets in Helsinki.

Author information

Authors and Affiliations

  1. Deutsche Bundesbank, Frankfurt, Germany

    Sabine Herrmann

  2. European Central Bank, Frankfurt, Germany

    Adalbert Winkler

Authors
  1. Sabine Herrmann
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  2. Adalbert Winkler
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Corresponding author

Correspondence to Sabine Herrmann .

Editor information

Editors and Affiliations

  1. , ECFIN.E.2 - BU1 -1/10, European Commission, Brussels, 1049, Belgium

    Filip Keereman

  2. , ECFIN.A - BU-1 03/209, European Commission, Brussels, 1049, Belgium

    Istvan Szekely

Data Appendix

Data Appendix

We provide below a listing of mnemonics, sources and descriptions for all the variables included in the empirical investigation. Additionally, we supply a listing of all countries belonging to the Asian and European sample. Unless otherwise noted, data were available from 1994 through 2006.

Mnemonic

Source*

Variable description

CAGDP

WEO

Current account to GDP ratio

CAPITAL

IFS

Gross capital flows (as % of GDP)

CHINN_ITO

CI

Capital account openness index

CREDIT

FSD

Private credit by deposit money banks to GDP ratio

CRISIS

CK

Systemic banking crisis index

DEPENDENCY

IFS

Dependency ratio (dependents to working-age population)

EXCHANGE

BIS

Logarithm of the real effective exchange

EXTERNPOSITION

IFS

Foreign assets minus foreign liabilities to GDP ratio

FDIGDP

IFS

FDI as % of GDP

FOREIGN BANKING

WB

Foreign-owned banking assets (in % of the total banking sector assets in the periphery country)

GOVERNMENT BALANCE

WEO

General government balance to GDP ratio

INCOME

WEO

Country’s GDP per capita (PPP terms) to euro area average/US GDP per capita (PPP terms)

INTEREST SPREAD

IFS

Lending rate minus deposit rate

INTRA INTEGRATION

BIS

Consolidated foreign claims of euro area/US banks on the respective emerging country as a percentage of GDP of the recipient country

M2

IFS

M2 to GDP ratio

NPL

GFSR

Non-performing loans to total loans

OVER ALL INTEGRATION

IFS

Foreign assets plus liabilities to GDP ratio

RESERVES

WEO

Stock of foreign exchange reserves at year-end to GDP ratio

RIR

WDI

Real interest rates in %

TOT

WEO

Terms of trade, goods and services

TRADE

WEO

Trade openness (world exports/imports in % of GDP)

STOCKMARKET

WEO

Stock market turnover (shares traded/GDP)

GDP GROWTH

WEO

Real GDP growth rate to euro area average/US

*BIS Bank for International Settlements, CI Chinn/Ito (2007); CK Caprio/Klingebiel (2003); FSD World Bank Financial Structure Dataset; GFSR IMF Global Financial Stability Report; IFS IMF International Financial Statistics; WB World Bank (Claessens, Stijn, Neeltje van Horen, Tugba Gurcanlar and Joaquin Mercado (2008); WDI World Bank World Development Indicator; WEO IMF World Economic Outlook.

Emerging Asian Countries: China (CHN), Hong Kong (HKG), India (IND), Indonesia (IDN), Korea (KOR), Malaysia (MYS), Philippines (PHL), Singapore (SGP), Taiwan (TWN), Thailand (THA), Vietnam (VNM).

Emerging European Countries: Albania (ALB), Bosnia and Herzegovina (BIH), Bulgaria (BGR), Croatia (HRV), Czech Republic (CZE), Estonia (EST), Hungary (HUN), Latvia (LVA), Lithuania (LTU), Macedonia (MKD), Poland (POL), Romania (ROM), Serbia (CS), Slovak Republic (SVK), Slovenia (SVN), Turkey (TUR).

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Herrmann, S., Winkler, A. (2010). Real Convergence, Financial Markets, and the Current Account: Emerging Europe Versus Emerging Asia. In: Keereman, F., Szekely, I. (eds) Five Years of an Enlarged EU. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-12516-4_8

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  • DOI: https://doi.org/10.1007/978-3-642-12516-4_8

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