Current account imbalances and systemic risk within a monetary union

The aim of this paper is to cast light on possible influences of current account imbalances on the escalation of systemic risk which hit the Eurozone. The hypothesis, which was set up by examining empirical evidence, points to heterogeneity across the macroeconomic conditions prevailing in different clusters of EMU countries. Given the strengthened financial and real interconnections across the EMU countries, the capital flows triggered by widening distances between surplus and deficit trade balances, and also between sound and deteriorating public budgets, represent an important factor magnifying systemic risk and contagion. The econometric estimates we conducted concern two sub-periods, the two decades from the launch of the EMS in 1979 to 1999, and the first twelve years (1999–2010) of the monetary union. The findings sound as a confirmation that the strengthened financial and real interconnections across the EMU countries, instead of facilitating convergence among the Core and the Peripheral economies, have magnified and mutually reinforced imbalances. The divide between surplus and deficit countries – the backward EMU countries running larger current account deficits, and the more advanced countries accumulating larger current account surpluses – have brought about increasing capital outflows from the Periphery to pay for excess imports from the Core. Conversely, increasing capital flows were invested by the banks of the Core countries in the Periphery's public bonds.