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Capital Inflows and Costs: The Role of the Euro


The changing environment that the Euro has brought to its member countries could have fuelled the deteriorating effect that net capital inflows potentially have on their cost competitiveness. This paper uses a difference-in-differences (DID) approach to assess the effect of the Euro on the relationship between capital inflows, as measured by current account imbalances, and unit labour costs over the period 1993-2007. The sample used consists of annual data for 24 developed economies, comprising both the first EA12 countries as well as non-EA countries, with the latter used as the comparison group in the analysis. We find that the Euro seems to have amplified the deteriorating effect of capital inflows on costs. This finding suggests that the Eurozone should monitor cumulative current account imbalances, the associated inflows of capital, and the potential vulnerability of each country to the detrimental effects that capital inflows may have on their economies.

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  1. Related to this line of theories, López Salido et al. (2005) show that wage indexation clauses are major determinants of inflation differentials in Spain, and Zemanek et al. (2010) show a significant impact of private restructuring and public structural reforms on intra-EA competitiveness.

  2. Among other factors, López Salido et al. (2005) set out the Balassa-Samuelson effect, price convergence, different cyclical positions, different exposure to oil prices or structural rigidities as possible underlying factors of price differentials. They focus on the case of Spain in order to examine these factors more closely.

  3. More evidence for the European periphery is provided and discussed by Monastiriotis and Tunali (2019).

  4. Follow-up studies include those of McKinnon and Pill (1997) and Corsetti et al. (1999) or Hoffmann and Schnabl (2008).

  5. Aizenman et al. (2013) investigate the relationship between economic growth and lagged international capital flows using data for about 100 countries during 1990 - 2010, and find that the relationship between growth and lagged capital flows depends on the type of flows, economic structure, and global growth patterns.

  6. In addition to the evidence shown here, in a previous version of this paper (working paper version in Beneito and Cháfer (2017) we applied panel Granger causality tests to the EA12 economies in our estimation sample for a longer period of time (1982-2011). While these tests did not allow us to establish structural causality, they did allow us to conclude that the direction of the relationship between capital inflows and costs runs from the former to the latter more than the other way around.

  7. The Taylor rule, first proposed by Taylor (1993), aims at describing the optimal response of nominal interest rates set by central banks, seeking to foster price stability and full employment. In our formulation above, weights on inflation and output deviations have been retrieved from Taylor (1993).

  8. Data from the Bank of International Settlements shows that the major part of banking claims against EA economies have their origin in other EA economies. However, London acts as an intermediary in the channeling of funds, making the UK the main origin of banking claims.

  9. See the Appendix at the end for the list of the countries used.

  10. Greece entered the EA the 1st of January of 2001, and transaction costs in goods and capital markets were not eliminated until 2002.

  11. The countries for which there are no data available at the sector-country-year level are: Australia, Canada, France, Greece, Ireland, Korea, Poland, Portugal and Spain.

  12. Together, the growth rate of real GDP and the change in unemployment account for possible changes in productivity. In fact, in exploratory work, we also considered a measure of productivity as an additional control variable in the estimation; we found it to be not statistically significant in all estimated specifications that also included GDP and unemployment changes.

  13. The year dummies control for common shocks varying on a yearly basis that may affect countries’ costs, while the inclusion of country-fixed effects controls for any idiosyncratic and constant characteristics of countries that could confound the identification of the Euro treatment effect.

  14. Bertrand et al. (2004) point out the inconsistency of resulting standard errors when we focus on serially correlated outcomes in DID estimation. The authors propose alternative corrections depending on the number of ’states’ (units). For moderate numbers (they consider 10 as small, and 50 as large enough) a cluster option by state is found to work well. According to their proposal, in our case, with 24 countries, clustered errors blocked by country should suffice to solve the problem.

  15. According to specification 6, the coefficient that corresponds to term PosttEAki, t− 1 has to be added to the coefficient of term Posttki, t− 1 to give us the total additional effect of ki, t− 1 on costs for EA countries after the introduction of the Euro as compared to the pre-introduction effect. The result is positive in all the estimated cases.

  16. When country-fixed effects are included, the EA dummy disappears from the estimation since it is a time-constant characteristic for a given country.

  17. In exploratory work, the possible significance of the Pre- effects have been checked in all cases; no significant effects are found in any case. These results are available upon request.

  18. Although not reported here, we also checked for possible non-linearity in the relationship between capital inflows and costs. In particular, to each of the terms with kit− 1 in the specification we added its squared term, \(k_{it-1}^{2}\). Non-linearities could matter if, for example, the magnitude of the capital inflows entering an economy determines their impact on costs, that is, if the effect differs as kit− 1 increases. We found no evidence of significant effects of such squared terms, and so we discarded them in estimation. Additionally, we identified periods of high and low inflows for each country in the sample and checked if the results could be driven by such periods of abnormal flows. Following Hannan (2017), high and low inflow periods were defined as those with levels of kit− 1 one standard deviation above and below the mean, respectively. Then, we crossed the capital inflow measure with dummy indicators accounting for such periods; the results presented here did not change notably. These results are available upon request.

  19. Placebo tests consist in designing an estimation strategy, that is, an estimation equation and/or sample, for which there is no reason to believe that the alleged effect exists. That is, the placebo estimation, which has neither a theoretical nor an empirical basis, must show no significant treatment effect, thereby ruling out the possibility that the results obtained with the valid estimation strategy are found ‘by chance’.


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Correspondence to Pilar Beneito.

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We grateful acknowledge the editor, George S. Tavlas, and three anonymous referees for their helpful comments, which greatly contributed to improve the quality of the paper. Pilar Beneito also acknowledges financial support from the Spanish Ministerio de Economía y Competitividad (ECO2017-86793-R) and Generalitat Valenciana (PROMETEO-2019-95).



1.1 A.1 Estimation sample

Table 4 Treated (EA) and non-treated (non-EA) countries
Table 5 Summary statistics, country-year level sample

1.2 A.2 Analysis of unit roots allowing for structural breaks

Prior to the main econometric exercise of this paper we analyse the possible presence of unit roots in the main series, that is, current account imbalances and unit labour costs. Both are classic non stationary variables when taken in levels, which indicates that the relationship should rather be specified in first differences to avoid spurious regression results. Below we show the results of the routines by Clemente et al. (1998) to perform unit root tests allowing for up to two structural breaks in the series. Both, an additive outlier scheme and an innovational outlier scheme are modelled. The tests lead to rejection of stationarity of both the unit labor costs and the current account levels in all countries over the period; however, after taking first differences of these same series, the tests allow us to accept stationarity in all cases.

Table 6 LEVELS of the unit labour cost and current account series: Unit Root Tests allowing for up to 2 structural breaks. (Clemente, J., Montañés, A., & Reyes, M. , 1998)
Table 7 FIRST DIFFERENCES of the unit labour cost and current account series: Unit Root Tests allowing for up to 2 structural breaks. (Clemente, J., Montañés, A., & Reyes, M. , 1998)

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Beneito, P., Cháfer, C. Capital Inflows and Costs: The Role of the Euro. Open Econ Rev 31, 977–1008 (2020).

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