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From CAB to CAAB? Correcting indicators of structural fiscal positions for current account imbalances Julia Lendvai Laurent Moulin Alessandro Turrini DG ECFIN, European Commission Motivation Before the crisis, a number of EU countries have witnessed absorption booms and growing current account deficits as a result of falling risk premia and rapid financial integration. At the same time, fiscal policy in those same countries has not been leaning against the wind effectively so as to contain boom-bust dynamics. This analysis – shows that standard approaches for adjusting budget balances for the cycle could miss part of the temporary revenues accruing during absorption booms – Illustrates a methodology to correct government budget balances for temporary elements linked both to output cyclicality and to absorption booms (CAAB) – Uses DSGE models to assess the implications of tageting the CAAB during absorption booms for output stabilisation and the accumulation of external imbalances Absorption booms, current account, fiscal policy Figure. Developments in macroeconomic and fiscal variables during and after absorption booms Real GDP growth Absorption (percent of GDP) 6 115 T is the peak year of the absorption boom 5 4 Government balance (percent of GDP) 0 T-5 112 109 Current Acc. balance (percent of GDP) 0 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 -2 -1 -4 -2 -6 -3 -8 -4 -10 -5 -12 -6 -14 -7 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 3 2 106 1 103 0 -1 100 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 -2 Gov. primary balance (pct of GDP) Cyclically adjusted balance (pct of GDP) 2 0 1 -1 Gov. gross debt (percent of GDP) 50 45 -2 0 Total government revenue (pct of GDP) 40 39 40 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 -1 -3 35 -4 38 -2 30 -5 -3 -6 25 T-5 -4 T-4 Indirect taxes (percent of GDP) T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 37 T-5 Direct taxes (percent of GDP) T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 T-4 Social contributions (percent of GDP) 14,0 10,0 12 13,5 9,5 12 13,0 9,0 11 12,5 8,5 11 12,0 8,0 10 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 Elasticity of tax revenue to GDP 1,3 1,2 1,1 1,0 0,9 0,8 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 T-4 Total gov. expenditure (pct of GDP) T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 0,7 T-5 Social benefits (percent of GDP) T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 Final gov consumption (pct of GDP) 16 23 6 44 15 22 5 43 14 21 4 42 13 20 3 41 12 19 2 40 11 18 1 39 10 17 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 Gross capital formation (pct of GDP) 45 T-5 T-4 0 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 Absorptiom booms, current account, fiscal policy Some stylised facts: – Current accounts deteriorate during absorption booms, improving afterwards; – Government budget balance improves during the boom, falling afterwards; – CAB broadly constant during the boom, falling afterwards; – Strong growth of indirect revenues/GDP during the boom ; – Apparent revenue elasticities growing during the boom, falling afterwaeds Linking current accounts and structural indicators of fiscal policy (I) CAB approach assumes that revenues are linked to output While this is the case for direct taxes, indirect taxes are levied on imports but not on exports, i.e., they are linked to absorption For the above reason, and since output and absorption are imperfectly correlated, the CAB may miss temporary cyclical components of the budget during absorption booms and busts Linking current accounts and structural indicators of fiscal policy (II) The CAB is built on a well-known benchmark for computing structural revenues and expenditures, i.e., output equal to potential An equally obvious candidate is not available for defining a benchmark for absorption Approach taken: link benchmarks for absorption to benchmarks for current accounts. Current account balances in line with fundamentals (“current account norms”). From CAB to CAAB CABt = (b/y)t – λ ygapt CAABt = (b/y)t – βt ygapt – γt agapt, βt = λt -γt. agapt = [(at – a*t)/y*t], a*t = y*t – ca*t + itt. From CAB to CAAB The current account norm ca* is estimated following the approach developed in Chinn and Prasad (2004) and by the IMF CGER (Lee et al., 2008). Prediction from pooled cross-section/time series regressions Sample: 60 advanced and emerging economies, 1970-2010 Specification: – – – – – – General government budget balance/GDP ratio (+) Old-age dependency ratio (-) Real GDP per capita at PPP (+) Real GDP per capita growth (-) Net foreign asset/GDP ratio (+) Oil balance (+) Does CAB or CAAB make a difference? (I) Difference between CAAB and CAB, selected euro-area countries (percent of GDP) 1.5 1 0.5 -1.5 -2 DE EL PT ES AT 09 08 -1 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 20 98 19 19 97 96 19 19 -0.5 19 95 0 Does CAB or CAAB make a difference? (II) Difference between CAAB and CAB for selected New Member States (percent of GDP) 2 1 0 -1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 -2 -3 -4 -5 BG EE LV LT RO Does CAB or CAAB make a difference? (III) Difference between CAAB and CAB for selected New Member States NFA-stabilisation approach (percent of GDP) 1,5 1 0,5 0 -0,5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 -1 -1,5 -2 -2,5 -3 -3,5 BG EE LV LT RO Does targeting the CAAB make a difference? (I) DSGE model simulations help assessing the extent to which targeting the CAAB rather than the CAB can make a difference for fiscal prudence and preventing imbalances Simulation with QUEST III – Model set up Small open economy, fixed XXR Calibrated to average Baltic economy – Shocks A): Baseline: 500 bp. reduction in risk premium in 2001 B): A)+ CAB=0 since 2005 (max 4% GDP) C): A) + CAAB==0 since 2004 (max 7% GDP) Does targeting the CAAB make a difference? (II) Targeting CAB or CAAB balance during absorption booms: DSGE model simulations Budget Balance (% of GDP deviation from base scenario) GDP (% deviation from steady state) Consolidation targeting CAAB 20 00 A 20 01 A 20 00 A 20 01 A 20 02 A 20 03 A 20 04 A 20 05 A 20 06 A 20 07 A Consolidation targeting CAAB Terms of Trade (% deviation from steady state) CPI (% deviation from steady state) 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 2.5 Base scenario 2 Base scenario 1.5 Consolidation targeting CAB Consolidation targeting CAAB Consolidation targeting CAB 1 Consolidation targeting CAAB 0.5 20 00 A 20 01 A 20 02 A 20 03 A 20 04 A 20 05 A 20 06 A 20 07 A 20 00 A 20 01 A 20 02 A 20 03 A 20 04 A 20 05 A 20 06 A 20 07 A 0 NFA / GDP (%) Current Account / GDP (%) -20 -6 Consolidation targeting CAB -30 -8 Consolidation targeting CAAB -50 -40 -10 -60 -12 -70 -14 -80 20 06 A 20 07 A -10 20 04 A 20 05 A Base scenario 20 00 A 20 01 A 20 06 A 20 07 A 20 02 A 20 03 A 20 04 A 20 05 A 20 00 A 20 01 A -4 20 02 A 20 03 A 0 0 -2 20 06 A 20 07 A Consolidation targeting CAB Consolidation targeting CAB 20 04 A 20 05 A Base scenario 8 7 6 5 4 3 2 1 0 20 02 A 20 03 A 3.5 3 2.5 2 1.5 1 0.5 0 Base scenario Consolidation targeting CAB Consolidation targeting CAAB Concluding remarks The standard EU method for adjusting budget balances during the cycle may miss some temporary revenue components during absorption boom and busts A relatively straightforward modification of the CAB that also takes into account the fact indirect taxes are linked to absorption (CAAB) could be a useful counter-check in assessing the structural fiscal position of countries Taking into account the link between temporary revenues and absorption in constructing indicators for structural fiscal balances would contribute to – Fiscal prudence during absorption booms – strengthening the contribution of the fiscal balance in preventing external imbalances