The Relationship Between the German Current Account and Financial Account: Evidence from the Toda-Yamamoto Causality Approach

2.1 Recording of Balance-of-Payments Transactions

Every international transaction between residents and non-residents is entered twice with equal values in the balance of payments, once as a credit with plus sign and once as a debit with minus sign (International Monetary Fund 2009). The double bookkeeping accounting ensures that the current account always equals the financial account.^[2]

First, the German net exports of goods in 2022 recorded a surplus of 111.9 billion euros, which enters the current account as a credit (plus sign). The resulting receipt of 111.9 billion euros reflects the increase of Germany’s financial claims on the rest of the world, which enters the financial account as a debit (minus sign) of 111.9 billion euros.

The German exports, for instance, could have been financed by German trade credits to foreign importers. It would give rise to a debit (minus sign) of 111.9 billion euros in the financial account as a trade credit represents Germany’s financial claims on the rest of the world. The corresponding credit (plus sign) of the trade credits also enters the financial account. The deposits created by the German trade credits increase Germany’s financial liabilities against the rest of the world. The debit and credit entries are thus netted out to zero in the financial account.

The German exports could also have been financed by the German purchases of foreign bonds issued by foreign importers. A debit entry (minus sign) in the portfolio investment of the financial account reflects an increase of Germany’s financial claims on the rest of the world. The corresponding credit (plus sign) in other investment of the financial account reflects an increase of Germany’s deposit liabilities (financial liabilities against the rest of the world). Both debit and credit entries are cancelled out in the financial account.

Second, a transaction between Germany and other euro-area member states is settled in Target2, the euro-area interbank payment system.^[3] The German Bundesbank’s Target2 claims on the Eurosystem show that the interbank transfer of deposits from banks participating in Target2 via the Bundesbank to banks participating in Target2 via other national central banks is greater than the other way around (Deutsche Bundesbank 2007, 2011). The double-entry bookkeeping records an increase in the Target2 claims as a debit entry (minus sign) under the other investment balance of the financial account.

The corresponding credit entry (plus sign) may appear on the current account if the counterpart is a real transaction, e.g. exports of goods. If the counterpart is a financial transaction, e.g. the sales of foreign securities by residents in Germany or the foreign purchases of German securities, the corresponding credit entry appears on the financial account. In the case of financial transactions, both debit and credit entries are cancelled out in the financial account.

These examples show that the accounting identity between the current account and financial account ensured by double-entry bookkeeping per se does not reveal any causal relationship. From an accounting perspective, a German current account surplus would not develop unless exports exceed imports, regardless of how much German capital flows out of the economy, because the credit and debit entries of the financial transactions are both made and offset on the financial account. Yet from an economic perspective, an excess of German capital outflows over foreign capital inflows can be seen as transfer of purchasing power to abroad with impacts on the real economy. Given the growth of global financial markets since the 1970s (Bayoumi and Macdonald 1995; Borio 2014), international capital flows should therefore be viewed as a current account determinant.

2.2 Standard Approaches to the Current Account Determination

Using the national income identity, Andersen (1990) showed four current account approaches:

where EX stands for total receipts for exports in the current account, IM for total payments for imports in the current account, S for total gross saving, I for total gross investment, Y for total output, D for total domestic demand and F for net capital flows.

The first approach is the trade approach. The current account (EX − IM) is traditionally seen as the outcome of relative income and prices including the real exchange rate. A prominent work related to the trade approach is the elasticity approach by Marshall (1923), Lerner (1936), and Harberger (1950). The second approach is the saving-investment approach which views the current account as the outcome of changes in domestic saving and investment (S − I). The intertemporal approach developed by Obstfeld and Rogoff (1995) made substantial contributions to the saving-investment approach. Also, the saving-investment approach gained wide popularity through the savings glut hypothesis advanced by Bernanke (2005).

The third approach is Alexander’s (1952) absorption approach which views the current account as the outcome of differences in total output and total domestic demand (Y − D). The fourth approach is the capital flow approach. The current account is seen as the outcome of changes in net capital flows (F). Net capital flows refer to the difference between domestic capital outflows and foreign capital inflows. The capital flow approach is perhaps the most unexplored approach in current account literature in comparison to the trade, saving-investment and absorption approaches which sparked a large literature in international economics.

As illustrated in equation (1), the common modelling of international capital flows is net capital flows. Schularick (2016) argues that the current account and net capital flows are the parallel consequence of saving and investment. A similar reasoning is echoed in Krugman, Obstfeld, and Melitz (2015): “[i]f national saving falls short of domestic investment, the difference equals the current account deficit. […] the country is borrowing abroad” (p. 678). In a similar vein, the intertemporal approach treats net capital outflows as the outcome of intertemporal decisions of saving and investment across countries (Gourinchas and Rey 2014).^[4] What is common in literature is the use of the national income identity which allows international capital flows to be presented as a byproduct of other macroeconomic variables. The issue on how international capital flows affect exports and imports, domestic savings and investment or domestic expenditure and income appears to be rarely addressed.

A strand of research holds a critical view of the prevailing approaches in which the analysis of international capital flows goes no further than the realm of the national income identity. Shin (2012: 156) argues that the standard current account analysis treats international capital flows as “the residual to the outcome from the real side of the economy” (See also Johnson 1977). By the same token, Kim and Kim (2011: 498) argue that “adherents to conventional macroeconomic theory dispense entirely with the causal approach and rely instead on the accounting identity approach. Because CA [current account] deficits are identical to KA (financial account) surpluses in this framework, it is impossible, apart from errors and omissions, to observe any causal relationship between the CA and the KA”.

2.3 Gross Capital Flow Approach

Gross capital flows consist of domestic capital outflows and foreign capital inflows. Golub (1990), Turner (1991), and Johnson (2009) point out that it is not net capital flows but gross capital flows which offer a full picture of international capital flows. Similarly, Borio and Disyatat (2015) argue that the Feldstein-Horioka puzzle of international capital flows (1980) is a puzzle of net capital flows but not a puzzle of gross capital flows.^[5] While research attention to gross capital flows has been growing in international finance literature, there is little research which examines the current account imbalances from a gross capital flow perspective.

To fill the gap the paper modifies Andersen’s (1990) capital flow approach. The current account consists of total receipts for exports and total payments for imports. Likewise, net capital flows consist of domestic capital outflows and foreign capital inflows. Based on equation (1), the gross capital flow approach can therefore be formulated as follows:

where KX denotes domestic capital outflows, KM denotes foreign capital inflows and all the other variables remain the same as in equation (1). The sum of EX, IM, KX and KM is always equal to zero since “[a]s with any other account, the total receipts of a country are bound be equal to the total payments of that country, if one includes all the receipts and all the payments of the country in the account” (Meade 1970: 3–4; see also Beretta and Cencini 2020).

The paper follows the common definition in finance literature. Domestic capital outflows are the net of domestic purchases and domestic sales of foreign assets. Foreign capital inflows are the net of foreign purchases and sales of domestic assets. Forbes and Warnock (2012) label the net of domestic purchases and sales of foreign assets as “gross outflows” and the net of foreign purchases and sales of domestic assets as “gross inflows”. Broner et al. (2013) call them “capital outflows by domestic agents” and “capital inflows by foreign agents”. Hwang et al. (2017) use “asset flows” for domestic capital outflows and “liability flows” for foreign capital inflows.

While there is no clear terminology, all the terms refer to the net of domestic purchases and sales of foreign assets and the net of foreign purchases and sales of domestic assets as gross capital flows.^[6] The main reason for looking at gross capital flows is not only to highlight the different investment behaviors by residents and nonresidents (Hwang et al. 2017). It also reveals the different impacts of domestic and foreign capital flows on the real economy (Forbes and Warnock 2012). The analysis on gross capital flows contributes to the understanding about the role of international capital flows in the development of financial crises and current account imbalances (Avdjiev, McCauley, and Shin 2016; Borio and Disyatat 2015; Vercelli 2019; Wolf 2014).

3.1 Data Description and Estimation Procedure

The analysis on the long-term causality between the German current account and financial account contains five variables. EX (exports) and IM (imports) stand for the total receipts and total payments in the German current account.^[7] KX (domestic capital outflows) and KM (foreign capital inflows) stand for the net of domestic purchases and sales of foreign assets as well as the net of foreign purchases and sales of domestic assets in the German financial account.^[8] REER is the German real effective exchange rate index, adjusted by unit labor costs.

All the variables excluding the real exchange rate index are expressed in percent of GDP. The data sample starts from Q1.1980 to Q2.2023. The data for EX, IM, KX and KM is retrieved from the balance of payments statistics compiled by the Bundesbank in line with the International Monetary Fund’s (2009) Balance of Payments and International Investment Position Manual. The REER is retrieved from the OECD Main Economic Indicators.

The paper follows the Toda and Yamamoto (1995) procedure, one of the most applied procedures in causality analysis (Hacker and Hatemi-J 2006), to test for the long-term causality between the German current account and financial account in a multivariate framework. The advantage of the Toda-Yamamoto approach over the Granger approach is the use of a modified Wald (MWALD) test statistic. The Granger causality analysis may suffer from a spurious inference if variables under study are integrated with different orders or cointegrated (Granger and Newbold 1974; Phillips 1986). By contrast, the Toda-Yamamoto modified Wald test allows to examine the causality, regardless of whether or not variables are integrated with different orders or cointegrated (Adriana 2014; Yan 2005; Zapata and Rambaldi 1997). Moreeover, the Toda-Yamamoto procedure allows to use the levels of the data (Giles 2011). It implies that the distortions and loss of the long-run information contained in the levels of the data due to the differencing of the data (Lütkepohl 1982) do not arise.

The paper takes the following steps: (1) Determine the order of maximum integration of the data (dmax) using unit root tests. (2) Specify a multivariate vector autoregression (VAR) model in levels. (3) Determine the optimal lag length (k) of the VAR model using information criteria. (4) Increase the optimal lag length (k) until the autocorrelation in the residuals is removed using LM statistics to ensure that the VAR model is well-specified. (5) Examine a cointegrated relationship between the variables in the VAR model using the Johansen cointegration test to ensure the existence of a long-term relationship (Johansen and Juselius 1990). (6) Estimate an augmented (k + d _max)th order VAR model in levels to ensure that the Wald statistic follows an asymptotic χ ²-distribution. (7) Apply a standard Wald statistic, which follows an asymptotic χ ²-distribution with the degrees of freedom (the number of eliminated lagged variables), to the first k VAR coefficient matrix to investigate the Granger causal relationship.

3.2 Model Description and Results of Unit Root and Cointegration Tests

In line with past research on a Granger causality analysis in a multivariate framework, the real exchange rate is incorporated as a key linking variable for the relationship between the German current account and financial account (see Calvo, Leiderman, and Reinhart 1993; Kim and Kim 2011; Yan 2005).^[9] Our analysis is innovative in that the current account is differentiated between the total receipts (EX) and the total payments (IM), and the financial account is differentiated between domestic capital outflows (KX) and foreign capital inflows (KM). To identify the causality directions in a diagnostically well-specified and parsimonious way, the following four augmented (k + d _max)th order VAR models are estimated:

To determine the order of maximum integration (d _max) for the Toda-Yamamoto causality test, the Augmented Dickey-Fuller (ADF) and Kwiatkowski–Phillips–Schmidt–Shin (KSPP) unit root tests are conducted. Table 1 shows that all the variables are non-stationary in levels and stationary in first differences at the 5 % level. The results indicate that all the variables are integrated of order one, or I(1), implying the maximum order of integration of 1 (d _max = 1).

A cointegrated relationship implies the existence of a long-term relationship between the variables under study (Johansen and Juselius 1990). Rambaldi and Doran (1996) argue that if there is a cointegrated relationship in a system, the Toda-Yamamoto MWALD test is suited for a Granger causality analysis. Since the results of the unit root tests in Table 1 suggest that all the variables under study are integrated, the paper conducts the Johansen cointegration test for all four models. The results in Table 2 suggests that at 1 % significance level, there is one long-run relationship in all four models, which supports the use of the Toda-Yamamoto procedure.

3.3 Results of Toda-Yamamoto Test for Multivariate Granger Causality

Table 3 shows the estimation results for the four models. Evidence from the Tada-Yamamoto causality procedure suggests that conditional on the German real exchange rate (REER), the direction of causality runs from German capital outflows (KX) and foreign capital inflows (KM) in the financial account to the total receipts (EX) and the total payments (IM) in the current account, and not the other way around. This finding is consistent with Yan (2005) which shows the causality running from the financial account to the current account for Germany.

Another finding is that both KX and KM granger-cause REER at 5 % significance level, and not the other way around. By contrast, neither EX nor IM granger-causes REER, while REER granger-causes EX at 10 % significance level (see model 1) and IM at 5 or 10 % significance level (see model 2 and 4). These results imply that the effect of gross capital flows (KX and KM) in the financial account on real resource flows (EX and IM) in the current account might percolate through the real exchange rate.

Figure 1 shows that all the inverse roots of autoregressive polynomial lie inside the unit circle. The results of the residual analysis imply that all the four augmented VAR models satisfy the stability conditions and ensure the robustness of our results (Dinh 2020; Shahzad et al. 2017).

Figure 1:

Inverse roots of AR characteristic polynomial. Source: Own calculation. Notes: No root lies outside the unit circle.

4.1 Bonanzas of Foreign Capital Inflows and Current Account Deficits in the 1990s

There is scarce research on the German current account from a gross capital flow perspective. The German reparation debate in the late 1920s drew attention to the effect of gross capital flows on the German current account. Keynes (1929) called gross capital flows ‘liquids’ which cannot alter such a ‘solid mass’ as the current account.^[10] By contrast, Ohlin (1929) argued that gross capital flows transfer the purchasing power from one country to another, leading to the emergence of current account imbalances.^[11] The Keynes-Ohlin debate led Machlup (1964) and Kindleberger (1976) to examine gross capital flows as a driver of current account imbalances.^[12]

In the following decades, research attention to gross capital flows as a determinant of the German current account has faded away. The German current account deficits in the 1990s (see Figure 2) are usually seen as the reflection of expanded domestic demand due to the unification in 1990. Sinn (2002), and Felbermayr, Fuest, and Wollmershäuser (2017) argued that the drastic increase of domestic investment to rebuild the new eastern territory of reunified Germany surpassed domestic saving, turning the German current account into deficits.^[13] Similarly, Schnabl and Zemanek (2012) argue that the excess of domestic investment over saving led to the repatriation of net foreign assets cumulated by West Germany prior to unification.

Figure 2:

The German current account and financial account (net capital flows). Source: Deutsche Bundesbank. Notes: Positive values mean current account surpluses and net capital inflows. Negative values mean current account deficits and net capital outflows.

According to the common view, Germany imported more real resources and capital as domestic investment exceeded saving. The current account and financial account are, in other words, implicitly assumed to be jointly determined by the saving-investment balance. By resorting to the national income identity, past research dispensed with the analysis of how domestic capital outflows and foreign capital inflows affected the German current account deficits in the 1990s.

Figure 3 shows the bonanzas of foreign bond investment in Germany after reunification.^[14] Along with the emergence of the German current account deficits, the 1990s recorded the cumulated foreign bond investment in Germany of 622.7 billion euros, substantially surpassing the cumulated German bond investment abroad of 268.9 billion euros.^[15] The foreign financing of the German government debt relieved the financing conditions for the rebuilding of the new eastern territory (Seitz 1999; Sinn 2002).

Figure 3:

German and foreign portfolio bond flows. Source: Deutsche Bundesbank. Notes: Positive values mean foreign capital inflows and domestic capital outflows. Negative values mean foreign capital outflows and domestic capital inflows.

Figure 4 also shows that in the 1990s, German and foreign interbank flows followed a similar development as in bond flows. After unification, foreign interbank lending to banks in Germany increased from 21.7 billion euros in 1990 to 142.8 billion euros in 1998. By contrast, German interbank lending abroad fell from 30.8 billion euros in 1990 to −17.5 billion euros in 1994, which suggests that German banks brought back funds which had been lent to foreign banks. Overall, the 1990s saw the cumulated foreign interbank inflows of 586.6 billion euros, which were greater than the cumulated German interbank outflows of 335.7 billion euros.

Figure 4:

German and foreign interbank flows. Source: Deutsche Bundesbank. Notes: Positive values mean foreign capital inflows and domestic capital outflows. Negative values mean foreign capital outflows and domestic capital inflows.

Macroeconomic theory suggests that the current account tends to improve in recession and deteriorate in boom (Baxter 1995; Glick and Rogoff 1995; Sachs 1981). While Germany was in a recession in the late 1990s the German current account deficits persisted (see Figure 2).^[16] From a gross capital flow perspective, the German experience implies that a recession does not necessarily improve the current account when foreign capital inflows contribute to the financing of domestic consumption and investment. The foreign purchases of German government debt and the foreign bank lending freed up the domestic saving for the financing of domestic expenditures in Germany, which sustained the German current account deficits.^[17]

4.2 Surges of German Capital Outflows, Stops of Foreign Capital Inflows and Current Account Surpluses in the Early 2000s

The phenomenon of the German persistent and large current account surpluses dates back to the 2000s (see Figure 3). Three macroeconomic factors substantially changed the behavior of Germany’s gross capital flows which drove the current account into surplus. First, the dotcom bubble created the so-called “Neuer Markt” in Germany, a German equivalent of the US Nasdaq, opened in 1997 and closed in 2003. The Neuer Markt allowed German technology firms with low creditworthiness to obtain access to the international capital market (Taylor 2006; Vitols 2001). Figure 5 shows that the bonanza of foreign capital inflows from the end of the 1990s to the turn of the millennium was followed by a sudden stop of foreign capital inflows.^[18] The sharp decline of foreign investment inflows weakened aggregate investment in Germany (Koo 2013).

Figure 5:

German and foreign direct investment flows. Source: Deutsche Bundesbank. Notes: Positive values mean foreign capital inflows and domestic capital outflows. Negative values mean foreign capital outflows and domestic capital inflows.

Second, the process of the euro-area interest rate convergence involved a decline of interest rate levels in the southern European countries relative to Germany (Figure 6). From the European Exchange Rate Mechanism crisis in September 1992 to the end of the euro-area interest rate convergence in December 1999, the Bundesbank cut its policy rate by 5.75 % points, whereas central banks in southern Europe cut their policy rates in average by 10.8 % points.^[19] Immediately after the start of the common monetary policy in 1999, the ECB cut the policy rate from 3.75 % in October 2000 to 1.0 % by June 2003 in response to the bust of the dotcom bubble. The transition from a high to low interest rate level eased the financing constraints in southern Europe, resulting in region-specific Mises-Hayek-type overinvestment booms (Schnabl 2017). The high demand for the financing of consumption and investment expenditures in the southern European countries led to the surges of German capital outflows from the late 1990s, inter alia via German purchases of foreign bonds and German interbank lending (see Figures 3 and 4; see also Bonatti and Fracasso 2013).^[20]

Figure 6:

Policy rate convergence in Europe. Source: ECB.

Third, the economic reforms “Agenda 2010” under Chancellor Gerhard Schröder, started from the year 2003, increased aggregate saving in Germany. The structural reforms curtailed government expenditure and cut the future obligations of the social security system. It promoted household saving by giving subsidies to the retirement saving plans (Riester-Rente) and by raising consumption tax. It increased corporate saving as a result of the wage austerity triggered by the structural reforms (see Murai and Schnabl 2021). The harsh structural reforms in Germany not only curbed domestic consumption and investment, but also raised aggregate saving which equals the amount of income not consumed or invested. The low demand for the financing of domestic expenditures resulted in the decline of foreign interbank lending (see Figure 4). The resulting increase of German saving supported German capital outflows.^[21]

Seen through the lens of gross capital flows, the mix of German fiscal tightening and the ECB’s monetary easing led to the surges of German capital outflows and the declines of foreign capital inflows from the late 1990s. The rise of German capital outflows and the fall of foreign capital inflows tightened the domestic financing constraints and eased the financing constraints abroad, in particular in other parts of the euro area. As Tinbergen’s (1962) gravity theory suggests that the volume of bilateral trade is closely linked to the economic size and the distance of two countries, the development of German capital outflows and foreign capital inflows was linked to the strong growth of German net exports, inter alia vis-à-vis other European countries (Murai and Schnabl 2021). The outcome is the sharp improvement of the German current account in the early 2000s and the deterioration of the current account in the southern European countries, giving rise to the emergence of the intra-euro area current account imbalances.

4.3 Gross Capital Flows and Persistent Current Account Surpluses from the Late 2000s

The US subprime crisis in 2008 triggered a sharp contraction of international capital flows (Borio and Disyatat 2015; Forbes and Warnock 2012) which led to the outbreak of the European financial and debt crisis (Litsios and Pilbeam 2017; Unger 2017). Nevertheless, Germany continued to record the huge current account surpluses which persisted even during the coronavirus crisis and the Russia-Ukraine war. There are three macroeconomic channels through which German capital outflows and foreign capital inflows have contributed to sustaining the persistent German current account surpluses since the late 2000s.

The first channel is the German public capital outflows via Target2, or the euro-area interbank payment system which allows commercial banks to settle cross-border transactions with central bank money. The Eurosystem’s national central banks are responsible for the creation of central bank money in their own jurisdiction in accordance with the ECB’s monetary policy. If, for instance, central bank money created in Italy is transferred to Germany, the Deutsche Bundesbank acquires Target2 claims and the Banca d’Italia acquires Target2 liabilities. From a balance of payments perspective, the Bundesbank’s Target2 claims can be seen as German public capital outflows as they de facto equal public credit from the Bundesbank to other central banks, which automatically occurs in the Target2 system.^[22] The balance of payments statistics records Target2 claims as an increase of domestic assets abroad in the financial account.

A rising Target2 imbalance thus reflects a creation of central bank money for commercial banks in one part of the euro area, allowing for the transfer of central bank money to commercial banks in another part of the euro area. As the creation of central bank money is closely linked to the ECB’s monetary policy, the Target2 imbalances developed along with a series of the ECB’s monetary policy measures in the European financial and debt crisis (Reinhart 2017, 2018; Sinn 2020).^[23] It included inter alia unlimited credit provision to banks at a fixed interest rate from 2008 (full allotment policy), the Securities Market Programme (SMP) from 2010, subsidies for bank lending to firms and households from 2014 (targeted longer-term refinancing operations, TLTROs) and the Asset Purchase Programme (APP) from 2015.^[24] In 2020, the ECB started with the Pandemic Emergency Purchase Programme (PEPP) in response to the coronavirus crisis.^[25] Figure 7 shows that the Bundesbank’s Target2 claims mainly reflects the Target2 liabilities of central banks in Greece, Italy, Portugal and Spain.

Figure 7:

Target2 Balances of the Eurosystem. Source: ECB. Notes: Others include ECB, Austria, Belgium, Cyprus, Estonia, France, Croatia, Lithuania, Latvia, Malta, Slovenia, Slovakia, Out-NCBs.

The effects of German public capital outflows via Target2 on the German current account percolate through the financial system. When the financial crises dried up intra-euro area private capital flows, banks in southern Europe resorted to the borrowing from the Eurosystem (Merler and Pisani-Ferry 2012). Thus Target2 sustained the financing of the imports of German goods as well as the purchases of German financial assets by southern European countries, as reflected in the close correlation between the Target2 claims and the German current account surpluses until the early 2010s (Sinn and Wollmershäuser 2012).

The ECB’s asset purchases under the APP from 2015 and the PEPP from 2020 expanded the Target2 imbalances (see Figure 7). The ECB’s quantitative easing led to the transfer of the bulk of newly created euro deposits to Germany (Eisenschmidt et al. 2017) as commercial banks inside as well as outside the euro area often access Target2 via the Bundesbank (Hristov, Hülsewig, and Wollmershäuser 2019). If, for instance, a US commercial bank holds a current account at the Bundesbank, the Banca d’Italia’s purchases of the Italian government bonds from this US bank involve the transfer of euro deposits from Italy to Germany. Accordingly, the Bundesbank acquires the Target2 claims and the Banca d’Italia acquires the Target2 liabilities.

The ECB’s asset purchases may have blurred a close relationship between the intra-euro area Target2 imbalances and current account imbalances. German exports, for instance, can result in the transfer of deposits from foreign creditors’ bank accounts at the Bundesbank to the banks of German exporters which also have bank accounts at the Bundesbank. The transactions do not involve the Target2 system. Seen through this lens, it is not surprising that the close relationship between the Target2 imbalances and the intra-euro area current account imbalances pointed out by Sinn and Wollmershäuser (2012) weakened with the start of the ECB’s asset purchases. What remains unchanged from a gross capital flow perspective is that the Eurosystem’s asset purchases contributed to more favorable financing conditions in the euro area (Hristov, Hülsewig, and Wollmershäuser 2019) with a positive impact on the German current account balance.

The second channel is the fall of private foreign capital inflows and the rise of private German capital outflows. The German restrictive fiscal policy stance since the late 1990s (Deutsche Bundesbank 2005; Murai and Schnabl 2021; OECD 1998; Rodden 2003) has been a major impediment to foreign capital inflows in Germany. Prominently, the debt brake introduced in 2009 limited the supply of new German government bonds to roughly 0.35 % of annual GDP. Figure 8 shows the decrease of the German government debt from 2012 to 2020. Moreover, the Bundesbank’s government bond purchases via the ECB’s Public Sector Purchase Programme (PSPP) from 2015 decreased the foreign investors’ holdings. From Q1.2015 to Q4.2018, the German government bond holdings by foreign investors decreased by 347 billion euros, which corresponds to the increase of 344 billion euros in the bond holdings by the Bundesbank.

Figure 8:

Outstanding German government debt by holders. Source: Deutsche Bundesbank.

The debt brake has restricted foreign capital inflows from the late 2000s (see Figure 3) and curbed the wage growth in Germany which had been under pressure from the late 1990s.^[26] Figure 9 shows that a devaluation of the real effective exchange rate (REER) occurred since the late 1990s relative to the nominal exchange rate. From 1995 to 2012, the REER depreciated by 34.4 %, while the nominal effective exchange rate (NEER) appreciated by 3.6 %.

Figure 9:

Nominal and real effective exchange rates. Source: OECD. Notes: The NEER is calculated as the geometric weighted average of bilateral exchange rates with 27 countries; the REER is adjusted by unit labor costs in manufacturing. An increase of the index shows depreciation and a decrease of the index shows appreciation.

Moreover, the ECB’s monetary easing from 2008 led to the fall of interest rate levels in the euro area. The fall of returns on domestic saving products encouraged German capital outflows, inter alia to foreign stock markets.^[27] Figure 10 shows that until the coronavirus crisis, the German foreign stock investment from the late 2000s was at historical highs.

Figure 10:

German and foreign equity investment flows. Source: Deutsche Bundesbank. Notes: Positive values mean foreign capital inflows and domestic capital outflows. Negative values mean foreign capital outflows and domestic capital inflows.

From a gross capital flow perspective, the mix of fiscal tightening and monetary easing restrained foreign capital inflows and stimulated German capital outflows. It implies an impediment to the circulation of German and foreign capital into the German economy, putting the growth of domestic wage levels under pressure. The resulting real devaluation contributed to the international competitiveness of German export industries at the expense of domestic-market-oriented industries, sustaining the German current account surpluses.

The third channel is the substantial increase of Germany’s net foreign assets. Assuming no revaluation effects arising from changes in asset prices or exchange rate movements, net foreign assets display the accumulated net purchases of foreign assets.^[28] Put differently, in the absence of revaluation effects, net foreign assets can be seen as the accumulation of an excess of domestic capital outflows over foreign capital inflows from the past to the present.

With the persistent excess of German capital outflows over foreign capital inflows from the 2000s, Germany’s net foreign assets have grown. Figure 11 shows that the growth of net foreign assets is closely related to the growth of the primary income balance which records the net investment income received and paid via-a-vis the rest of the world. From 2004 to 2022, the average growth rate for Germany’s net foreign assets and primary income balance was 24.6 and 19.7 %.

Figure 11:

Primary income balance and net foreign assets. Source: Deutsche Bundesbank.

Since the primary income balance is part of the current account balance, Germany’s large net foreign assets have gradually developed as a key determinant of the persistent German current account surpluses. In fact, the year 2022 recorded the primary income surplus of 150 billion euros, surpassing the trade surplus of 111.9 billion euros. Seen through the lens of gross capital flows, the growing importance of primary income in the German current account surplus is not only a long-term outcome of strong German capital outflows and weak foreign capital inflows. It also points at the growing dominance of the financial account over the current account.