Implications of the Euro Zone's Current Account Deficit

The euro zone reported one of its largest monthly current account deficits on record. The 16.7 bln euro short fall in January compares with a 9.8 bln surplus in December. There seems to be a seasonal factor that makes the January shortfall typically large. In January 2009 the current account deficit was 19.9 bln euros and in January 2008 the deficit was 17.9 bln euros.

Yet what is disturbing about the January report is the widespread deterioration. The merchandise trade balance swung into deficit (7.4 bln euros vs a surplus of 5.2 bln in Dec). The service surplus all but evaporated (100 mln euros vs 4.6 bln euros in Dec). Investment income slipped back into deficit (-0.8 bln euros vs 1.3 bln euro surplus). Transfer payments increased to an 8.7 bln euro outflow from 1.3 bln outflow in Dec.

On top of the marked deterioration in the current account, key components of the capital account weakened as well. Direct investment became a net outflow of 7.1 bln euros vs a net inflow of 1.7 bln euros in December.

An even larger shift took place in terms of portfolio flows. The 47.8 bln surplus recorded in December became a 4.2 bln euro deficit in January. The demand for euro zone equities remained healthy at 21.2 bln euro, though half of the Dec inflow.

It was on the fixed income side that swung into a big deficit (25.4 bln euros) from a small surplus in December (5.5 bln euros). Underneath these figures was liquidation of money markets (from 11.2 bln inflow in Dec to an 8 bln euro outflow in Jan), and further liquidation of euro zone bonds (17.4 bln euro liquidation in Jan vs 5.7 bln euro sales in Dec).

The one major improvement in the euro zone's January balance of payments was in the other investment category, which appears to be dominated by major financial institutions and this swung from a 63.3 bln deficit in December to a 10 bln euro surplus in Jan.

To be sure, we typically do not place a great weight on the external imbalance of major industrialized countries in explaining or forecasting currency movement. However we do recognize that others do. Most recently, the noted US economist Martin Feldstein acknowledged surprise that the euro had sold off given its external surplus. We argue that the surplus is precarious and in any event an "accident" insofar as many members have large deficits that are masked on the aggregate level by the German surplus.

We have noted that in some months, Japan's investment income is larger than its trade surplus. That is the case in Switzerland as well. In the euro zone, the investment income balance is set to deteriorate. Foreign investors have been substantial buyers of euro zone debt and at interest rates higher than in many other countries where euro zone investors may have bought bonds. At the same time, even though today's sovereign supply appears relatively smoothly absorbed, the debt and deficit trajectories of a number of members may deter foreign investors.

While the US current account deficit is not doubt larger, it may turn out that a combination of the deepest and broadest sovereign debt market, coupled with the trading below most measures of fair value (see PPP or FEER models), and relatively low unit labor costs and the near chronic threat of protectionism, may make the US current account deficit easier to finance that the euro zone's small shortfall.