It is frequently stated that SGIP need an internal devaluation in the magnitude of 20-30%. However, this estimate appears wrong on several counts. They are usually derived by comparing the development of nominal unit labour costs (ULC) in Germany with those in SGIP. For example, nominal unit labour costs increased by approx. 8% in Germany since 1999 whereas they increased by approx. 36% in Greece. This suggests that Greece has lost 28% in competitiveness vs. Germany and hence needs an internal devaluation of the same magnitude.
However, one should not forget that Germany joined the Eurozone at an uncompetitive exchange rate. It took Germany several years to restore competitiveness vs. the other monetary union members which was one factor for its weak economic performance early last decade. Assuming that Germany had re-established competitiveness by the end of 2003, reduces the gap in nominal ULC between Greece and Germany to 15% (and 14% for Spain and Ireland and 13% for Portugal). Finally, SGIP need not restore competitiveness vs. Germany but rather vs. the average of the Eurozone. Nominal unit labour costs in SGIP since 1999 increased by 34% whereas ULC in the rest of the Eurozone increased by approx. 21% (see chart below). The difference between these two developments is substantial but not insurmountable. SGIP either need a reduction in nominal unit labour costs of 10% or the rest of the Eurozone needs an increase in nominal ULC of 11% to restore competitiveness in SGIP. More likely though is that we will get a mixture of the two, falling ULC in SGIP and rising ULC in non-SGIP.
Nominal Unit Labour Costs in SGIP vs. the rest of the Eurozone
Source: Research Ahead, Eurostat
The development of Eurozone country inflation rates suggests that the re-adjustment process has already begun. As the chart below shows, inflation in Spain, Portugal and Ireland (grouped together according to their GDP-weight) dropped into negative territory. More importantly, inflation rates are significantly below those in the rest of the Eurozone. Only Greek inflation is headed in the wrong direction. Greece has clearly more work to do and its outlook remains uncertain even beyond the 3-year lifeline provided. However, Spain, Ireland and Portugal have the ability to restore most of the competitiveness lost within the next 3 years. At the same time the announced austerity measures go a long way in bringing fiscal deficits to much lower levels and in turn restore debt sustainability. The price these economies will pay is negative nominal growth as well as a higher sovereign debt to GDP ratio (which will prove sustainable once fiscal deficits have been reduced and given the relatively low starting point especially in Spain and Ireland).
Inflation developments: SIP have already started to restore competitiveness
Source: Bloomberg, Research Ahead
In turn, we will face a divided Eurozone, a longer-lasting recession with negative nominal growth in SGIP and an export-led growth rebound in the North-East which should take both their real growth and inflation rates into the 2-3% range. Current account deficits in Spain, Portugal and Greece should shrink whereas surpluses in the North-East will rise, leading the overall Eurozone into a significant surplus. In turn, the burden of the necessary adjustment to restore competitiveness and debt sustainability in SGIP will not only fall on the SGIP themselves (via deflation) but also on the north-eastern Eurozone economies (via a somewhat higher inflation in the medium term).