A Weaker Euro for a Weaker Europe

VIENNA – What can be done to help the “crisis economies” of southern Europe reduce their external deficits? The debate is often presented as a conflict between the deficit-burdened PIIGS – Portugal, Italy, Ireland, Greece, and Spain – and the eurozone’s current-account-surplus countries, particularly Germany. But a new and more important imbalance has emerged in recent years: the PIIGS’ trade and services deficits with China, which suggest a possible solution to southern Europe’s economic malaise – a stronger renminbi.

Until 2004, the PIIGS’ biggest trade and services deficits were with the rest of the eurozone. But in 2005, their combined deficit with the rest of the world, at €37.2 billion ($48.6 billion), exceeded their combined deficit with other euro members by more than €4 billion. Then, in 2008, before the worst of the global financial crisis hit, the PIIGS’ global deficit reached a record-high €116.5 billion, of which €34.8 billion was with China, surpassing their deficit with Germany for the first time – by more than €2 billion (see chart).

Crucially, though the PIIGS’ combined deficit with Germany, the eurozone, and the world narrowed substantially over the next four years, their deficit with China remained huge – at €33 billion in 2010 and €29 billion in 2011.

Two key factors help to explain how this situation came about. The first was the euro’s rapid appreciation against the renminbi in the early 2000’s. The euro rose from an average rate of ¥7.4 in 2001 to ¥10.4 in 2007, before depreciating to ¥7.8 by August 2012. This happened in part because the renminbi was tracking the US dollar, which had fallen dramatically against the euro in 2002-2004.