Julia Lendvai Laurent Moulin Alessandro Turrini DG ECFIN, European Commission

1. From CAB to CAAB? Correcting indicators of structural fiscal positions for current account imbalances Julia Lendvai Laurent Moulin Alessandro Turrini DG ECFIN, European Commission

2. 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 tooutput 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

3. Absorption booms, current account, fiscal policy

4. 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 elasticitiesgrowingduring the boom, fallingafterwaeds

5. 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

6. 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”).

7. From CAB to CAAB CABt = (b/y)t – λ ygapt CAABt = (b/y)t – βtygapt – γtagapt, βt =λt -γt. agapt = [(at – a*t)/y*t], a*t = y*t – ca*t + itt.

8. 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 (+)

9. Does CAB or CAABmake a difference? (I) Difference between CAAB and CAB,selected euro-area countries(percent of GDP)

10. Does CAB or CAABmake a difference? (II) Difference between CAAB and CABfor selected New Member States (percent of GDP)

11. Does CAB or CAAB make a difference? (III) Difference between CAAB and CABfor selected New Member StatesNFA-stabilisation approach (percent of GDP)

12. Does targeting the CAABmake a difference? (I) • DSGE model simulations help assessing the extent to whichtargeting the CAAB ratherthan the CAB canmake a difference for fiscal prudence and preventingimbalances • Simulation with QUEST III • Model set up • Small open economy, fixed XXR • Calibrated to averageBalticeconomy • 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)

13. Does targeting the CAABmake a difference? (II) Targeting CAB or CAAB balance during absorption booms: DSGE model simulations

14. 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 duringabsorption booms • strengthening the contribution of the fiscal balance in preventing external imbalances