Do countries need a current account surplus?

Does any country need a current account surplus to grow in a sustainable manner and render its currency consistently stable over a long period? The answer is no, albeit a ‘qualified’ no. Consider Germany as an extreme example. Germany has been running a very high current account surplus over so many years that no one can remember. The surplus has edged up to 8.5% of GDP recently, and it has averaged 8% over the last three years whereas the EU ceiling for such surpluses has been set at 6%. It is ‘against the rules’ in a manner of speaking. Why is that so, and in general does any country – in this case Turkey – need a current account surplus to grow at a decent pace and keep a stable income distribution? After all, it is welfare that counts, isn’t it, not just profits? Also, as a prerequisite and as a bonus, exchange rate stability may be achieved through current account surpluses, though I wouldn’t be so sure. If we accept this line of thought, since Turkey ordinarily generates current account deficits instead of surpluses, to what extent can the ratioto-GDP of the deficit be curtailed if Turkey were to achieve financial and economic stability for good? If the economy cannot produce a surplus, that is, at least the deficit can be reduced to easily manageable levels, i.e. 2-3% of GDP.

Let’s look at the German case in a nutshell and turn to Turkey briefly to see if any argument can be inferred from Germany’s last 15 years. The issue at hand concerns financial stability, in particular the stability of the lira, because external deficits are often directly associated with a rising country risk premium. We will come to the rising FX-denominated indebtedness of the private sector, and the international investment position to see whether the c. 20 percentage-point increase in that statistic conveys any short- or medium-term information about the exchange rate and lira interest rates.

Germany’s 8% current account surplus

Since the introduction of the euro in 1999, Germany is said to have economically dominated the euro area to such an extent that according to some observers Southern Europe has become an internal dominion. The debate around the Greek debt especially sparked controversy to that effect a few years ago. Germany’s high and persistent foreign trade surplus has been attributed to low unit labor costs, especially before the Lehman collapse. In recent years, German wages have increased, but the surplus has remained nonethe- less. Is it true that “wage dumping ” has caused an eye-catching current account surplus both because domestic demand and therefore demand for imports weakened and because German export goods cheapened? It is true that after the advent of the single currency area, lower wage and price increases have had the effect of a covert depreciation relative to other euro area members. It is also true that a weak euro helps boost German exports to areas outside the euro zone. Hence, these two factors may have indeed caused the c. 8% average current account surplus. Does an advanced industrial country such as Germany even need low unit labor costs, a covert currency depreciation and weak import demand to fuel large trade surpluses? Could there be another mechanism whereby German exports may have still boomed, but not at the expense of the domestic consumers and wage earners? Does Turkey have to keep low labor costs, distort the income and wealth distribution further, reduce the share of wages in total income and contain import demand to keep the deficit under control? The argument can only be fully determined if one considers both quantity and price effects because such reasoning should cover both aspects. Lower wages and lower prices reduce import volumes and trigger higher export volumes, but what about the productivity and price effects?

According to a recent paper (Gustav A. Horn, Fabian Lindner, Sabine Stephan, Rudolf Zwiener, IMK Report 125e, June 2017), it turns out that neither exports nor imports are price-elastic for Germany, which in a sense invalidates the unit labor cost hypothesis. Wages may have been kept higher and Germany could still have generated high current account surpluses. Contrariwise, keeping labor costs low may not be required to gain international competitiveness, and imports need not fall in value terms (price x import volumes) because domestic demand is constrained. However, the same argument may hold water if both exports and imports are sensitive to prices. In that case, if an economy is in dire need of reducing its current account deficit or generating a surplus, is a low wage policy the appropriate response so exports can compete in prices due to low unit labor costs? That is a good question, and the old wisdom could well say ‘yes.’ Is this the case in Turkey today? In a partial equilibrium setting, the answer seems to be a ‘qualified’ yes, although the answer to the question “do we need a surplus?” is a ‘qualified’ no. Firstly, we observe that wages have increased between 2005 and 2016, and possibly this extends into 2017. Secondly, wage growth may have contributed only slightly to the soaring current account deficit during this period if we exclude fluctuations in energy prices. Credit growth is the main factor that amplified domestic demand, wage growth only

making this phenomenon possible from a risk management perspective. Recently, public expenditure has also fuelled domestic demand. Because earnings have stagnated, such measures as the Credit Guarantee Fund and rampant public spending have been resorted to, and that saved the day for the moment. Electoral politics aside – there the policy space is two-dimensional, with economic voting taking the upper hand and ‘ideology’ playing a complementary role – Turkey’s population is now above 80 million and domestic demand cannot be ignored. Turkey cannot become an export hub, just as any small country can turn itself into, only for that reason. Rebalancing of any sort as to the sources of growth – domestic demand versus external demand – warrants fine-tuning at best, not a complete sea change. Furthermore, as the structure of Germany’s current account shows, trade balance dominates the current account, other factors canceling each other to a large extent. This is not the case for Turkey since at least tourism revenue makes a big difference. From the trade balance to the current account there is a large difference in Turkey. If tourism revenue falls, for instance, no matter what structural transformation is tried to achieve in the production of export goods, and export high-tech expensive goods, the upshot will not be different.

Turkey is not Germany

We have to look at two factors. Are imports and exports price-elastic to such a degree that “wage dumping” is key? Add to this transfer payments that grew above inflation by c. 5 percentage points over the last 15 years and high loan growth rates that made it possible for households to spend much more than their incomes. This is not only about housing and car loans, but also general consumer loans and credit cards. Hence, almost everyone is indebted to some extent, firms and households alike. A wage growth path in tandem with much less transfer spending and suchlike may indeed have curtailed the deficit through a weaker import demand, and further export price competitiveness through lower unit labor costs. Here enters the second factor: yes, if you are not placed at the technology frontier like Germany your exports become price-elastic, and your imports are quite sensitive to income. Exchange-rate elasticity is also part of it since the real effective exchange rate is meaningful in any export demand regression, and since it affects the composition of domestic demand and sometimes shifts it towards external demand. Turkey is not Germany.

However, just as the lower unit labor cost argument is not generically valid in explaining the strong export performance of Germany – it has more to do with technology and efficiency – the converse argument is not universally correct in the case of Turkey. In general equilibrium, the argument becomes more complicated. True, even when labor productivity stagnated, nominal wages and labor costs continued to rise. In fact, real wage increases have been trending above productivity.

Add to this all transfers and you get one of the keys of the Justice and Development Party’s recurrent electoral successes. Nevertheless, unit labor costs are not the main culprit behind the chronically large foreign trade and current account deficits. Maybe the whole scheme of continually triggering domestic demand is.

Maybe the whole path between 2005 and 2017 was inevitable and necessary because people wanted to consume more, and global cross-border capital flows were favorable to that.

In sum, although the minimum wage has never been low – and is definitely not low at the moment – and wages have increased above labor productivity in the last so many years on average, it is difficult to imagine a way that could render this channel effective in boosting exports.

True, the price elasticity of exports seems to favor this argument prima facie – or in partial equilibrium. Nevertheless, it is not the main link in explaining export performance although it could carry more weight than the German case in the short run. Rather, it is better to accept the deficit as a constant of economic life for the foreseeable future, and not relate financial and exchange rate stability to the performance of exports.

Furthermore, even if the trade deficit could be reduced in the span of a few years, the composition of intermediate goods imports and other inputs should receive priority rather than labor costs and the technological content of final export goods. Germany may well have generated high – but maybe not that high – trade surpluses with a higher wage bill because neither German exports nor imports are price elastic. Turkey is not similar: so, lower unit labor costs may have helped a bit. Then, the macroeconomic argument enters in full: what would households do in that case, and could a bit of increase in the export volume replace domestic demand?

Best to admit this situation as a fact of life, and not underline the current account or the net international investment position over-emphatically as sources of financial stability risks. Therein the answer doesn’t lie.