Thoughts about the Euro Zone's External Accounts

Yesterday, the euro zone reported that its January current account surplus of 4.5 bln euros was largest in almost five years. The December surplus was revised to 3.4 bln from 2.0 bln initially. The monthly swings of the time series can be misleading due to seasonal factors and the schedule of transfer payments.

The 12-month cumulative deficit was 21.2 bln in January 2012 vs 50.6 bln in January 2011. Growth differentials have seen the US current account deficit widen,and the same considerations would seem to favor an improvement in the euro zone's external position.

Yet given that cross border capital flows are many times more than the flow of goods, in our explanatory model of currency movements we tend to put more emphasis on capital flows than trade flows.

The euro zone reported a new outflow of portfolio capital in January. The 46.9 bln euro outflow contrasts to a 4.6 bln inflow in December. This consisted of an outflow of 51.9 bln from the debt market and a 5.0 bln inflow into European equities. By comparison, in December 12.9 bln flowed out of the euro zone debt market and 17.4 bln went into the equity market.

For its part, the euro fall 3.6% against the dollar December, when the euro zone reported new portfolio inflows. It fell 1.4% against the dollar in January when the euro zone reported large portfolio capital outflows.

It seems that foreign investors took advantage of the LTRO-induced bond market rally to liquidate exposure. In January, European investors renewed their foreign bond purchases, for the first time since July 2011.

Prior to the crisis, euro zone officials played down the significance of internal imbalances and may, arguably, over-correcting now. Part of the criticism levied is that while the debtor countries are adopting austerity, the creditor countries are reluctant to adjust. The Bundesbank's latest monthly report claims that Germany's current account surplus with other euro zone countries has fallen in roughly in half since the 2007 peak. Again, growth differentials seem to point to that direction.

The fact that Germany's overall current account surplus has not changed much over the past five years suggests it has diversified its exports away from the euro zone. China is a likely suspect. Germany accounts for 40% of euro zone exports and the euro zone's trade deficit with China in 2011 fell to about 102 bln euros form almost 148 bln euros in 2010.