Capital Flows and Income Convergence in the European Union. A Fresh Perspective in View of the Macroeconomic Imbalance Procedure

Abstract

In this paperwe conduct an empirical analysis regarding the impact of current account imbalances, as counterparts to net capital flows, on the income convergence in the European Union during 1995 – 2007. Our results show that the current account deficits had an income convergence effect in the area, more specifically they contributed to a higher economic growth in the countries with lower levels of initial GDP per capita. As a consequence, compliance with the indicative thresholds established by the European Commission through the Macroeconomic Imbalance Procedure – according to which the current account balances should be maintained within the range (-4% GDP, +6% GDP) – would be equivalent to a maximum value of the convergence parameter of -1.833. However, exceeding the lower limit of the interval (of -4% GDP), through the increase in the current account deficits, would lead to gains on the income convergence side within the European Union. The implications are important for the Central and Eastern European economies. Our results suggest that a more appropriate approach of net capital flows, and thus of current account imbalances, would be their regulation in order to avoid overheating and to limit the adverse impact of volatility, rather than their direct limitation.