Claudia M. Buch, Manuel Buchholz, Alexander Lipponer, Esteban Prieto. Unit labor cost adjustments...

Unit labor cost adjustments since the crisis in GIIPS vs.BELL countries: The role of central bank liquidity and

rescue packages

Claudia M. Buch 1 Manuel Buchholz 2 Alexander Lipponer 1

Esteban Prieto 1

1Deutsche Bundesbank

2Halle Institute for Economic Research (IWH)

Open SeminarEesti PankFeb 19, 2015

The views expressed in the presentation are those of the authors and do not necessarily reflect the viewsof the Deutsche Bundesbank or its staff.

Buch, Buchholz, Lipponer, Prieto ULC adjustments GIIPS vs. BELL Feb 19, 2015 1 / 42

Motivation - Sudden stops in (private) capital flows duringthe recent crisis in BELL countries

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24

2000q1 2004q1 2008q1 2012q1Quarter

BG

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-.2

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2000q1 2004q1 2008q1 2012q1Quarter

EE

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2000q1 2004q1 2008q1 2012q1Quarter

LT

-1-.

50

.51

1.5

2000q1 2004q1 2008q1 2012q1Quarter

LV

Net private capital inflows (EUR bn.)

Data source: Eurostat. Net private capital inflows are defined as total net capital inflows according to financialaccount. No adjustments for official rescue programs. Vertical red line indicates sudden stop period. Countrylegend: BG Bulgaria; EE Estonia, LT Lithuania; LV Latvia.


Motivation - Sudden stops in (private) capital flows duringthe recent crisis in GIIPS countries

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2000q1 2004q1 2008q1 2012q1Quarter

EL

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ES

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IE

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2000q1 2004q1 2008q1 2012q1Quarter

IT

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PT

Net private capital inflows (EUR bn.)

Data source: Eurostat and Eurocrisismonitor.com. Net private capital inflows are defined as total net capitalinflows according to financial account minus increase in Target2 liabilities (data from Eurocrisismonitor.com).Vertical red line indicates sudden stop period. No adjustments for official rescue programs. Country legend: ELGreece, ES Spain; IE Ireland; IT Italy; PT Portugal.


Motivation

GIIPS and the Eastern European BELL countries (Bulgaria, Estonia, Latvia,Lithuania) experienced a sudden stop in private capital flows during therecent crisis.Historically, the resulting adjustment pressure due to a sudden stop oftenmade countries devalue their currency; however, GIIPS countries weremembers of currency union and each of the BELL countries kept the peg tothe Euro throughout the crisis.Adjustment has taken place via internal devaluation, which is e.g. visible inthe development of unit labor cost (ULC) since the crisis (see e.g. Staehr,2012 (Baltics), Blanchard et al., 2013 (Latvia)).There are notable differences between the adjustment paths of GIIPS andBELL countries.


Adjustment in ULC since sudden stop (by country)

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dep

ende

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of p

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Data source: Eurostat. Variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to areduction (increase) in ULC. Country legend: BG Bulgaria; EE Estonia, EL Greece, ES Spain; IE Ireland; ITItaly; LT Lithuania; LV Latvia; PT Portugal.


Adjustment in ULC since sudden stop (GIIPS vs. BELL)

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(% o

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GIIPS BELL

Data source: Eurostat. Variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to areduction (increase) in ULC. Country legend: BG Bulgaria; EE Estonia, EL Greece, ES Spain; IE Ireland; ITItaly; LT Lithuania; LV Latvia; PT Portugal.


Table of contents1 Introduction

MotivationResearch question, related literature, main contribution

2 Aggregate analysisEmpirical specificationEstimation results

3 Sectoral analysisRefining the empirics

Sectoral ULCDependence on external finance

The effect of currency union membershipEmpirical specificationEstimation results

The role of central bank liquidityEmpirical specificationEstimation results

RobustnessRescue programs and other variablesEstimation results

4 Concluding remarksBuch, Buchholz, Lipponer, Prieto ULC adjustments GIIPS vs. BELL Feb 19, 2015 7 / 42

Research questions

Is there a (significant) difference between GIIPS and BELL countriesregarding the adjustment to recent sudden stops?If so, is this difference related to membership in the currency union (EuroArea)?

I Identification issue: separate country-specific factors (e.g. labor marketflexibility, openness) from Euro Area membership.

I Sectoral data will prove useful in this respect.Given that the differences are not linked to currency per se (BELL pegged):What is the role of access to liquidity provided by the ECB and rescuepackages?


Existing literature on economic adjustment since the crisis

Generally, our work relates to the literature on sudden stops andmacroeconomic adjustment (e.g. Calvo, 1998, Calvo and Mendoza, 1996,2000).A couple of papers with focus on EA have recently emerged.Lindner (2011), Gros and Alcidi (2013), Hansson and Randveer (2013)

I give an comprehensive overview on the differences in the adjustment paths inGIIPS and Baltic/BELL countries.

I consider key economic variables such as GDP, the current account,consumption, and exports.

I discuss the role of access to Eurosystem liquidity and rescue packages.Tressel and Wang (2014)

I argue that adjustment in current accounts in GIIPS countries partly due tostructural but mainly cyclical factors.

Kang and Shambaugh (2014)I directly compare GIIPS and Baltic countries.I find that unit labor cost adjustment can to some extent be attributed to

productivity gains but was mainly due to falling employment.


Main contribution

We base the analysis of the adjustment in ULC on sectoral data.I In particular, nominal and real unit labor costs are considered.I As well as their components: (real/nominal) wages, prices, labor productivity.

We assume that adjustment pressure should be higher in sectors whichdepend more strongly on external finance.

I Our empirical specification allows disentangling the effect of Euro Areamembership from country-specific (demand) factors as well as sectoral shocks.

We relate the difference due to Euro Area membership to enhanced liquidityprovision by the ECB during the crisis (reflected in the built up ofcomparatively large Target2 imbalances) and financial assistance/rescuepackages during the crisis.


Empirical specification: Adjustment in aggregate ULC -GIIPS dummy

To quantify the difference in the adjustment process in GIIPS compared toBELL countries, we use the following specification:

ULC-Adjustit = αi + αt + γt [Dt ×DGIIPS] + εit (1)

ULC-Adjustit : percentage change in the unit labor costs since the suddenstop period relative to pre-sudden-stop level. Note that the sign is revertedsuch that positive values in adjustment reflect a reduction in unit labor costs.Country-specific sudden stop periods (last quarter before sudden stop)

I EL: 2007q4; IE: 2008q1; IT: 2011q2; PT: 2010q1; ES: 2011q2BG: 2008q4; EE: 2008q3; LV: 2008q3; LT: 2008q3

DGIIPS: GIIPS dummyDt : dummy indicating a specific quarter since the sudden stopγt : captures difference in adjustment between GIIPS and BELL countries


Estimation results: Adjustment in aggregate ULC - GIIPSdummy

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20

0 5 10 15 20Quarter since sudden stop

95% confidence bands Coefficient

Note: Coefficient is γt from equation (1). Dependent variable is defined in terms of adjustment, i.e. anincrease (decrease) corresponds to a reduction (increase) in ULC.


Refining the empirics - Ingredient I: Sectoral (R)ULC

Identification issue: how to separate currency union membership from sectorand country-specific factors and shocks?Sectoral data can prove useful in this respect.We use data from Eurostat on 9 sectors based on the NACE (Revision 2)classification.The sample period spans 2007q4 to 2013q3 with country specific sudden stopperiods.The (nominal) ULC in sector k of country i are computed using sectoral dataon total compensation for employees and real gross value added (GVA).

ULCik = LaborCostik

LaborProductivityik=

TotalCompensationikTotalHoursWorkedik

RealGVAikTotalHoursWorkedik

= TotalCompensationikRealGVAik

Real unit labor costs (RULC) are given by:

RULCik = ULCik/Pik = TotalCompensationikNominalGVAik

Where Pik is the sectoral price deflator.Buch, Buchholz, Lipponer, Prieto ULC adjustments GIIPS vs. BELL Feb 19, 2015 15 / 42

Sectoral (R)ULC - Components

ULC can be multiplied by the ratio of total employment to dependentemployees to account for the number of self-employed people (see, e.g.,Tressel and Wang, 2014):

ULCadj,ik = ULCik ×TotalEmployment (pers.)ik

TotalDepEmployees (pers.)ik

Applying log differences, (approximate) percentage changes in ULC can bedecomposed into the following components:

%∆ULCadj,ik ≈ %∆RULCik + %∆Pik

= %∆RealWageik − %∆LaborProductivity ik + %∆P ik

Thus, in addition to nominal and real ULC, we investigate adjustment in realand nominal wages, sectoral price deflators and labor productivity.


Refining the empirics - Ingredient II: Dependence onexternal finance (DEF)

Rationale: adjustment pressure after sudden stops is likely to be higher insectors which are more dependent on external finance.Idea: measure for dependence on external finance (DEF) in the spirit of Rajanand Zingales (1998). Link to capital flows: Prasad et al. (2007).However: no such measure is available for the NACE classification on thelevel of aggregation given in our data.We propose two measures for sectoral dependence on external finance (DEF):

I The aggregate growth rate of MFI loans in given sector pre crisis2003q1-2008q3 (Source: ECB SDW). Only variation across sectors notcountries.

I The fraction of firms in need for external loan finance pre-crisis (in 2007)taken from the “Access to finance survey” conducted by Eurostat. Variationacross sectors and countries. However, smaller sample with fewer countries.


Dependence on external finance: pre-sudden stop MFI loangrowth

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Sector legend: 1 Agriculture; 2 Industry; 3 Manufacturing; 4 Construction; 5 Trade; 6 Information; 7 Financial(no data); 8 Real Estate; 9 Science; 10 Public Admin; 11 Arts


Adjustment in sectoral ULC: High vs. low DEF for GIIPSand BELL

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Note: time-varying sector and country fixed effects partialled out. Dependence on external finance (DEF)measure is based on pre-sudden stop MFI loan growth. Variable is defined in terms of adjustment, i.e. anincrease (decrease) corresponds to a reduction (increase) in ULC.


Adjustment in sectoral RULC: High vs. low DEF for GIIPSand BELL

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Note: time-varying sector and country fixed effects partialled out. Dependence on external finance (DEF)measure is based on pre-sudden stop MFI loan growth. Variable is defined in terms of adjustment, i.e. anincrease (decrease) corresponds to a reduction (increase) in ULC.


Empirical specification: Adjustment in sectoral ULC - Theeffect of currency union membership

To identify the impact of currency union membership on adjustment, we usethe following specification:

ULC-Adjustikt =αkτ + αiτ + αit + αkt + βDEFik

+ γt [Dt × DEFik ×DGIIPS] + εit (2)

k: sector; t: quarter since sudden stop; τ : actual quarter.The parameter γt captures the differential effect of currency unionmembership on adjustment given a higher sectoral dependence onexternal finance:

γt =∆ULC-Adjustik,t−t0

∆DGIIPS

∣∣∣∣DEF=d+1

−∆ULC-Adjustik,t−t0

∆DGIIPS

∣∣∣∣DEF=d

The specification controls for i) time-varying country-specific (αit) and ii)time-varying sector-specific (αkt) effects.Standard errors are clustered at the country-sector level.


Estimation results: Adjustment in sectoral ULC - Theeffect of currency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in ULC.


Estimation results: Adjustment in sectoral RULC - Theeffect of currency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in RULC.


Estimation results: Adjustment in real wages - The effectof currency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in real wages.


Estimation results: Adjustment in nominal wages - Theeffect of currency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in nominal wages.


Estimation results: Adjustment in labor productivity - Theeffect of currency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).


Estimation results: Adjustment in prices - The effect ofcurrency union membership

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (2).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in prices.


The effect of currency union membership and the role ofcentral bank liquidity

The estimated parameters measure the effect of being a GIIPS as opposed toa BELL country beyond any impact of country-specific or industry-specificdemand factors or any other shocks in these dimensions.We can therefore plausibly argue that the remaining effect has to be due toanother difference between BELL and GIIPS countries, which is themembership in the Euro Area.This effect does not capture a difference in currencies as the BELL countriespegged their currency to the Euro and kept the peg throughout the observedperiod. The relevant difference is rather one of access to central bankliquidity.Data on Target2 balances provide us with an adequate measure when andto which extent banks in the Euro periphery have drawn on central bankcredit to substitute for dried up private capital inflows.


The role of central bank liquidity: Target2 balances

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Source: Eurocrisismonitor.com


Empirical specification: Adjustment in sectoral ULC - Therole of central bank liquidity

In order to relate the effect to enhanced liquidity provided by the ECB, weintroduce Target2 liabilities (relative to GDP) into the specification:

ULC-Adjustikt =αkτ + αiτ + αit + αkt + βDEFik

+ γt [Dt × DEFik × Target2it ] + εit (3)

Data on Target2 balances is from the Deutsche Bundesbank.Data on Target2 balances is also made available on the websiteEurocrisismonitor.com run by the Institute of Empirical Economic Researchof Osnabrück University (Steinkamp/Westermann).


Estimation results: Adjustment in sectoral ULC - The roleof central bank liquidity

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (3).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in ULC.


Estimation results: Adjustment in sectoral RULC - The roleof central bank liquidity

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Note: DEF measure is based on pre-sudden stop MFI loan growth. Coefficient is γt from equation (3).Dependent variable is defined in terms of adjustment, i.e. an increase (decrease) corresponds to a reduction(increase) in RULC.


Robustness: Rescue programs and other variables

International rescue programs, inflation differentials, and devaluationexpectations in BELL countries might systematically affect adjustment(conditional on DEF).Is the effect of currency union membership robust to inclusion of thesevariables?To answer this question, we use a specification with constant γ:

ULC-Adjustikt =αkτ + αiτ + αit + αkt + β1DEFik

+ DEFik × [γDGIIPS + β2′xit ] + εit (4)

xit reflects included control variables.The parameter γ captures the average differential effect of currency unionmembership over the whole estimation period.Equivalently, to check robustness for the role of central bank liquidity:

ULC-Adjustikt =αkτ + αiτ + αit + αkt + β1DEFik

+ DEFik × [γTarget2it + β2′xit ] + εit (5)


Estimation results: Robustness ULC - The effect ofcurrency union membership

Dependent variable:ULC adjustment (% of pre-crisis) (1) (2) (3) (4) (5)

DEF x REER -2.733*** -2.960**(1.035) (1.226)

DEF x NEER 1.633 1.081(1.502) (1.365)

DEF x 3M-Fwd. Exch. Rate -0.729 0.019(1.051) (0.886)

DEF x RescueProgram/GDP -0.444*** -0.468***(0.130) (0.138)

DEF x DGIIPS -4.048 0.199 -4.020 -4.849 -0.613(4.723) (4.087) (4.705) (4.609) (3.754)

Country-time FE x x x x xSector-time FE x x x x xObs 1,449 1,395 1,449 1,449 1,395R-squared 0.59 0.61 0.59 0.59 0.62

Note: DEF measure is based on pre-sudden stop MFI loan growth. Cluster-robust SE at country-sector level.∗∗∗, ∗∗, ∗ denotes significance at the 1%, 5%, and 10% level. Dependent variable is defined in terms ofadjustment, i.e. an increase (decrease) corresponds to a reduction (increase) in ULC.


Estimation results: Robustness ULC - The role of centralbank liquidity

Dependent variable:ULC adjustment (% of pre-crisis) (1) (2) (3) (4) (5)

DEF x REER -3.197** -3.352**(1.327) (1.581)

DEF x NEER 1.631 0.748(1.562) (1.573)

DEF x 3M-Fwd. Exch. Rate -0.316 -0.335(0.354) (0.318)

DEF x RescueProgram/GDP -5.754*** -5.952***(1.684) (1.779)

DEF x Target2Liab/GDP -0.680 2.273 -0.651 -1.046 1.978(2.010) (1.473) (1.996) (2.010) (1.424)


Note: DEF measure is based on pre-sudden stop MFI loan growth. Cluster-robust SE at country-sector level.∗∗∗, ∗∗, ∗ denotes significance at the 1%, 5%, and 10% level. Dependent variable is defined in terms ofadjustment, i.e. an increase (decrease) corresponds to a reduction (increase) in ULC. Explanatory variables arestandardized (zero mean, unit standard deviation).


Estimation results: Robustness RULC - The effect ofcurrency union membership

Dependent variable:RULC adjustment (% of pre-crisis) (1) (2) (3) (4) (5)

DEF x REER -0.096 0.183(1.530) (1.660)

DEF x NEER 1.294 1.433(1.829) (1.837)


DEF x RescueProgram/GDP 0.067 0.072(0.216) (0.227)

DEF x DGIIPS -16.024** -16.549** -15.941** -15.944*** -16.253**(6.145) (7.513) (6.100) (5.975) (7.120)


Note: DEF measure is based on pre-sudden stop MFI loan growth. Cluster-robust SE at country-sector level.∗∗∗, ∗∗, ∗ denotes significance at the 1%, 5%, and 10% level. Dependent variable is defined in terms ofadjustment, i.e. an increase (decrease) corresponds to a reduction (increase) in RULC.


Estimation results: Robustness RULC - The role of centralbank liquidity

Dependent variable:RULC adjustment (% of pre-crisis) (1) (2) (3) (4) (5)

DEF x REER -0.907 -0.774(1.530) (1.588)

DEF x NEER 2.922* 3.099(1.656) (1.866)


DEF x RescueProgram/GDP 2.106 2.172(2.566) (2.661)

DEF x Target2Liab/GDP -8.632*** -9.818** -8.611*** -8.624*** -9.816**(3.246) (4.187) (3.238) (3.146) (4.080)


Note: DEF measure is based on pre-sudden stop MFI loan growth. Cluster-robust SE at country-sector level.∗∗∗, ∗∗, ∗ denotes significance at the 1%, 5%, and 10% level. Dependent variable is defined in terms ofadjustment, i.e. an increase (decrease) corresponds to a reduction (increase) in RULC. Explanatory variablesare standardized (zero mean, unit standard deviation).


Concluding remarks

We identify the differential effect of currency union membership onadjustment in nominal and real sectoral unit labor to a sudden stop in privatecapital flows.To shut down the currency devaluation channel, the empirical specificationdirectly compares GIIPS and BELL countries. In addition, the sectoralanalysis allows separating the effect from any country and sector specificfactors/shocks.With respect to the effect of currency union membership on adjustment inreal unit labor costs (RULC), we find that

I it is negative (i.e. unit labor costs reduced by less) for most periods, whichpoints towards a slowdown effect.

I it is economically significant: up to 25% lower (cumulative) adjustment insome periods (per one std. dev. higher DEF measure).

I it is conditional on higher sectoral dependence on external finance, which is inline with economic reasoning.

I the confidence bands are rather wide in the flexible specification, but it ishighly statistically significant in simpler specification.

I it is robust to inclusion of other relevant variables such as the amount ofEU/IMF rescue funds.


Concluding remarks

We find evidence that this effect goes indeed beyond the common currencyas it can robustly be related to national central banks’ Target2 liabilities,which reflect to which extent banks in the Euro periphery have substituteddried up private capital inflows with central bank liquidity.However, the effect of currency union membership on adjustment appears tobe less obvious for nominal unit labor cost and labor productivity and doesnot translate to sectoral price deflators.Policy implication: General role of currency union in adjustment process aftersudden stop?


Appendix: Estimation results: Adjustment in ULC - Theeffect of currency union membership - Alternative DEFmeasure

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Note: DEF measure is based on proportion of firms in need for (loan) finance in 2007.


Appendix: Estimation results: Adjustment in RULC - Theeffect of currency union membership - Alternative DEFmeasure

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Appendix: Estimation results: Adjustment in ULC - Therole of central bank liquidity - Alternative DEF measure

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Appendix: Estimation results: Adjustment in RULC - Therole of central bank liquidity - Alternative DEF measure

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Appendix: Estimation results: Adjustment in real wages -The role of central bank liquidity

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Note: DEF measure is based on pre-sudden stop MFI loan growth.


Appendix: Estimation results: Adjustment in nominalwages - The role of central bank liquidity

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Appendix: Estimation results: Adjustment in laborproductivity - The role of central bank liquidity

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Appendix: Estimation results: Adjustment in prices - Therole of central bank liquidity

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Appendix: How to interpret Target2 balances?

Brought to attention by Sinn and Wollmershäuser (2011). In particular in thebeginning debate on how to correctly interpret Target2 balances (Sinn andWollmershäuser, 2011, 2012, Wheelan, 2011, Buiter et al. 2011). To a certainextent, views have recently converged.Target2 balances reflect asymmetric liquidity needs of banks across Euro Areacountries (see, e.g., Blinseil and König, 2011).These needs are encountered by enhanced liquidity provision by the ECB (fullallotment policy, reduced collateral standards).They are a monitor for malfunctioning of private capital markets in Europeand thus a crisis indicator (see website Eurocrisismonitor.com bySteinkamp/Westermann, Ulbrich and Lipponer, 2012).Peculiarities: Official rescue packages settled via Target 2 reduce liabilities:however, not necessarily a sign of relaxation of crisis.⇒ adjust Target2 balances


Appendix: Target2 balances in the Balance of Paymentsand sudden stops in private capital flows

Sudden increase in Target2 liabilites (e.g. structural break) can be interpretedas a sudden stop in private capital flows (see, e.g., Tornell and Westermann,2011, Merler and Pisany-Ferry, 2012).Balance of Payments, Financial Account (simplified): TotalCapitalInflows =PrivateCapitalInflows − ∆Target2Balance + EU/IMF net inflows −∆ForeignReserves.Thus, given an erosion of private capital inflows, the change in Target2liabilities has to make up for repatriated funds from abroad as well as capitaloutflows by residents for total capital inflows to stay constant (see, e.g.,Cour-Thimann, 2013).Increase in Target2 liabilities is thus a measure of when and to which extentbanks have substituted dried up private capital inflows with liquidity providedby the central bank.


Claudia M. Buch, Manuel Buchholz, Alexander Lipponer, Esteban Prieto. Unit labor cost adjustments...

Economy & Finance

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