External asymmetries in the Euro area and the role of foreign direct investment

Soon after the introduction of the common currency, a divide emerged between two groups in the Euro area: one comprised of the North-European countries achieving external surpluses and the other of the South-European countries with large external deficits. This paper shows that different patterns of Foreign Direct Investment (FDI) inflows across the Euro area countries contributed to this divergence. Our theoretical framework shows that if the economy is relatively capital-intensive in the production of traded (non-traded) output, FDI will be channeled in greater proportions to the traded (non-traded) sector, thus improving (deteriorating) the trade balance. Focusing on ten Euro area countries over the period 1980- 2009, we establish a positive (negative) long-run effect of FDI inflows on the trade balance in the North (South). In the North the positive effect stems from the traded-sector FDI inflows that were significantly higher in comparison to the South, both before and after the EMU. In contrast, in the South the increased FDI inflows in the post-EMU era were dominated by investments in the non-traded sector. When industry-level data are employed, a positive (negative) long-run effect of manufacturing (non-manufacturing) FDI inflows on the trade balance in the North (South) is further established.