Europe's Balance of Payments: What Capital Flight?

Understandably the euro area's balance of payments report released earlier today was overshadowed by the Fed's QE and ECB's OMT plans. Yet, there is important insight to be gleaned, especially from the financial account.

First, however, look at the turn around in the current account. In the 12-months through July, the euro area recorded a seasonally adjusted cumulative current account surplus of almost 63 bln euros, which is about 0.7% of the region's GDP. The comparable figure in the 12-months through July 2011 was a deficit of a little more than 22 bln euros. 

The goods balance shifted from a deficit of 2.4 bln euros to a surplus of almost 56 bln euros. The service surplus rose by more than 45% to 76.7 bln euros. The investment income balance rose to 34.1 bln euros from 27.5 bln. The deficit of current transfers was little changed. 

The weakness of the euro area economies has slowed imports and several countries, including some in the periphery, have seen a pick up in exports. Growth differentials probably is the more significant explanation, but we do recognize that from last November through July, the euro had declined about 10% on a trade-weighted basis.

European countries for the most part rely on exports to service foreign demand. For the US and Japan, sales by foreign-based affiliates of domestic companies outstrip exports. We see the a weaker euro not simply as a reflection of the ongoing crisis, but also as part of the eventual resolution.

While the current account is intuitively clear, the financial account is surprising. As the euro was falling in July to multi-year lows, talk circulated of capital flight. Yet, the financial account showed a net inflow of 18 bln euros of combined portfolio and direct investment.

Portfolio inflows amounted to some 24 bln euros, while there was a 7 bln outflow of direct investment.

Looking closer at the portfolio flows, there was a net inflow of 30 bln euros into debt instruments, mitigated by a 5 bln outflow from European equities. Of that 30 bln inflow into the debt market, 18 bln came from foreign investors buying money market instruments and another 9 bln came from euro area residents selling foreign money market instruments. 

Direct investment outflows appear to be largely a function of two components. First, there was about 4 bln euro of inter-company loans. Second, European companies reinvested earnings (and made other equity capital investments) of about 3 bln euros.

The euro system as a whole also reported an increase of about 24 bln in its reserve assets, which the ECB attributed primarily to the increase in the market price of gold. Actual transactions saw an outflow of about 1 bln euros.

Although July data does not shed much light on the current price action, it does suggest that the investment community may not have been as underweight as were speculators. At the CME, the gross speculative short position hit a record of a 250,000 in early June. It has been trending lower since and in the most recent week that ended Sept 11 had fallen a little below 137k contracts (each contract represents 125k euros).