Monetary Policy & the Economy Q1/05 - Oesterreichische ...

Monetary Policy & the Economy

Quarterly Review of Economic Policy

O e s t e r r e i c h i s c h e Nat i ona l b a n k

E u r o s y s t e m

√

Q1/05

The OeNB�s quarterly publication Monetary Policy & the Economy provides analysesof cyclical developments, macroeconomic forecasts, studies on central banking andeconomic policy topics as well as research findings from macroeconomic workshopsand conferences organized by the OeNB.

Editorial board:Josef Christl, Peter Mooslechner, Ernest Gnan, Eduard Hochreiter, Doris Ritzberger-Gru‹nwald,Gu‹nther Thonabauer, Michael Wu‹rz

Editors in chief:Peter Mooslechner, Ernest Gnan

Coordinator:Manfred Fluch

Editorial processing:Karin Fischer

Translations:Jennifer Gredler, Ingrid Haussteiner, Irene Popenberger, Ingeborg Schuch, Susanne Steinacher

Technical production:Peter Buchegger (design)OeNB Printing Office (layout, typesetting, printing and production)

Inquiries:Oesterreichische Nationalbank, Secretariat of the Governing Board and Public RelationsPostal address: PO Box 61, AT 1011 ViennaPhone: (+43-1) 404 20-6666Fax: (+43-1) 404 20-6696E-mail: [email protected]

Orders/address management:Oesterreichische Nationalbank, Documentation Management and Communications ServicesPostal address: PO Box 61, AT 1011 ViennaPhone: (+43-1) 404 20-2345Fax: (+43-1) 404 20-2398E-mail: [email protected]

Imprint:Publisher and editor:Oesterreichische NationalbankOtto-Wagner-Platz 3, AT 1090 ViennaGu‹nther Thonabauer, Secretariat of the Governing Board and Public RelationsInternet: www.oenb.atPrinted by: Oesterreichische Nationalbank, AT 1090 Vienna' Oesterreichische Nationalbank, 2005All rights reserved.May be reproduced for noncommercial and educational purposes with appropriate credit.

DVR 0031577

Vienna, 2005

Analyses

Slowdown in Global Economic MomentumAsia and the U.S.A. To Remain Growth Drivers of World Economy in 2005 6Johann Elsinger, Gerhard Fenz, Ingrid Haar-Sto‹hr, Antje Hildebrandt, Thomas Reininger,Gerhard Reitschuler

Demographic Fluctuations, Sustainability Factors and Intergenerational Fairness —An Assessment of Austria�s New Pension System 23Markus Knell

The Research and Development System in Austria — Input and Output Indicators 43Ju‹rgen Janger

Fundamental and Nonfundamental Factors in the Euro/U.S. Dollar Market in 2002 and 2003 58Hannes Haushofer, Gabriel Moser, Franz Schardax, Renate Unger

The International Monetary Fund�s Balance Sheet Approach to Financial Crisis Preventionand Resolution 77Andrea Hofer

Highlights

Company Taxation in an Enlarged European Union 96Walpurga Ko‹hler-To‹glhofer, Margit Schratzenstaller, Andreas Wagener

Notes

Abbreviations 104Legend 106List of Studies Published in Monetary Policy & the Economy 107Periodical Publications of the Oesterreichische Nationalbank 110Addresses of the Oesterreichische Nationalbank 112

Opinions expressed by the authors of studies do not necessarily reflect the official viewpointof the OeNB.

Monetary Policy & the Economy Q1/05 3�

Contents

Analyses

In 2004, despite the sudden jump in oil prices and the ballooning trade deficit, the U.S. economy grewby 4.4%, or more robustly than ever since 1999. In the same year, growth in consumer prices peakedat 3.3% — the highest level in four years. In early February 2005, the U.S. Fed raised its key interestrates by 25 basis points for the sixth time since mid-2004. Whereas Japan slipped back into a periodof recession, other Asian economies continued growing apace in 2004.

The second half of the year 2004 saw a slowdown in GDP growth momentum in the euro area.Despite positive stimuli from investments, growth rates declined, due to weaker net exports and still verysubdued private consumption demand. Consumer restraint can partly be explained by the sluggishgrowth in real disposable income as a result of higher energy prices, which are also responsible forthe rise in inflation.

In the first three quarters of 2004, most new Central European EU Member States expanded ata faster pace than in 2003 as a whole. The upward pressure on prices (partly induced by EU acces-sion) was very strong in the new Member States in 2004. In Romania, an EU candidate country, growthrocketed to an outstanding 10.0% in the third quarter.

Following weak growth in the fourth quarter of 2004, Austria�s economy is regaining steam, but isnot immune to the current slowdown in growth in the euro area as a whole. The OeNB�s short-termindicator forecasts 0.4% seasonally adjusted growth in Austria�s real GDP for the first and 0.5% forthe second quarter of 2005 (each compared with the previous quarter).

1 U.S.A. and Asia RemainGrowth Drivers of WorldEconomy

1.1 U.S.A.: Tightening of MonetaryPolicy Continues

For the last 18 months or so, theannualized gross domestic product(GDP) has been trending above thelong-term average of 3.5% (quarteron quarter), with the exception ofthe second quarter of 2004 when thesudden jump in oil prices curbedthe momentum of GDP growth to3.3%. In the third quarter of 2004,real GDP growth accelerated to4.0%, driven by the far greater paceof private consumption momentum(5.1%) and by unabated expansivegrowth in investment in plant andequipment (+13%). Marginallyweaker GDP growth of 3.8% in thefourth quarter of 2004 is attributableprimarily to a deterioration in netexports.

At 4.4%, real GDP growth in 2004as a whole was the strongest ever since1999. According to Consensus Fore-casts, GDP growth is expected toslow to 3.5% in 2005 and 3.4% in2006. Weaker private consumption,

in particular, is likely to be responsiblefor this since the rescheduling ofmortgage loans at ever more favorableterms is coming to an end, with inter-est rates now on the rise. In view ofthe tight budget scenario, moreover,further fiscal stimuli in the form oftax cuts cannot be expected. Besides,increased household debt will narrowthe financial leeway available to con-sumers.

At 4.1%, the vigorous productiv-ity growth of the past few years(2003: +4.4%) continued in 2004,albeit at a slower tempo. Towardyear-end, however, the pace of growthslowed markedly, which could indi-cate largely exhausted gains in eco-nomic efficiency.

Labor market conditions are start-ing to ease. In January 2005, the un-employment rate fell from 5.4% to5.2%. As a result, the huge job lossestriggered in 2001 by the recessionwere offset in early 2005. However,the risk remains that the robustgrowth in consumer demand willslacken if the labor market�s recoverydoes not accelerate in the comingmonths. Sluggish growth in industrial

Johann Elsinger,Gerhard Fenz,Ingrid Haar-Sto‹hr,Antje Hildebrandt,Thomas Reininger,Gerhard Reitschuler

6 Monetary Policy & the Economy Q1/05�

Slowdown in Global Economic MomentumAsia and the U.S.A. To Remain Growth Drivers

of World Economy in 2005

employment is responsible for thelabor market�s slow recovery. Somethree million jobs have been lost sincemid-2000. In early 2004, jobs stoppedbeing axed.

In 2004, consumer prices rose attheir fastest rate in four years. January2005 saw a slight dip in inflation. Fol-lowing a rise of 3.3% year on year inDecember 2004, the consumer priceindex edged down to 3% — owing,in particular, to the smaller increasein energy prices. In January 2005,core inflation rose by 2.3% year onyear, or marginally (+0.1 percentagepoint) more steeply than in the previ-ous two months (strongest growthsince October 2002).

At its first meeting of 2005(February, 1 and 2), the Federal OpenMarket Committee (FOMC) of theU.S. Federal Reserve System (Fed)raised its target for the federal fundsrate by 25 basis points to 2.5%. Thisincrease represented the sixth suc-cessive key rate hike since mid-2004and confirmed the U.S. Fed�s repeat-edly expressed intention of removingpolicy accommodation at a measuredpace. The statement accompanyingthis decision almost chimed with thatissued at the previous meeting onDecember 14, 2004. The FOMC de-scribed U.S. GDP growth as robust,inflationary expectations as containedand the labor market as steadily im-proving, and deemed the current levelof interest rates to be still stimulatingthe economy. The upside and down-side risks to the attainment of sustain-able growth and price stability in thenear future were perceived to beroughly equal. As a result, the strategyof monetary policy tightening is likelyto be pursued in a series of moderatemeasures.

Risks for the U.S. economy are thehigh energy prices, the deep deficits in

the external sector (2004 currentaccount deficit: almost —6% of GDP)and the general government budget(2004 budget deficit: —3.6% of GDP),as well as high consumer debt andconsumers� low saving propensity.

1.2 Asia Still Fueling Growth despit�Technical� Recession in Japan

�Technically� speaking, the Japaneseeconomy is back in a recession. Hitby private consumption and the exter-nal sector, real GDP in the fourthquarter of 2004 (based on the newchain indices for data of Japan�s Sys-tem of National Accounts — SNA)contracted by 0.1% quarter on quar-ter after registering a revised —0.3%in the third quarter and —0.2% inthe second quarter. However, realGDP in 2004 as a whole increasedby 2.6% thanks to extremely healthygrowth in the first quarter. Althoughconsumer confidence remained rela-tively high, the households surveyedreduced their real spending by 0.3%quarter on quarter, which mightpartly reflect concerns about futuretax increases. However, extraordinaryfactors such as cyclones and a majorearthquake in north Japan towardthe end of the year also adverselyaffected consumption. Trading datareveal that company exports per-formed poorly, posting their slowestgrowth in a year in December 2004.The labor market, by contrast, wasnot in the least affected by the coolingeconomy. Since early 2003 the unem-ployment rate has fallen from 5.5%to 4.4% (in December 2004), thelowest level since 1998. High com-modity prices and the relative strengthof the Japanese yen are currentlyclouding Japan�s economic outlook.Although the government and the Bankof Japan (BoJ) have forecast a deceler-ation in GDP growth to 1.5% in the


Slowdown in Global Economic Momentum

fiscal year 2005 (ending March, 31,2006), they believe the Japanese econ-omy will continue to recover in thelong term. Consensus Forecasts antic-ipates real GDP growth of 1.1% incalendar year 2005 and 1.8% in 2006.

At —0.2% year on year, core infla-tion for December 2004 (less freshfoods, including energy) remainedslightly negative. In 2005, consumerprices are expected to largely stag-nate. The BoJ is sticking to its zerointerest rate policy. Choosing the rightmoment is key to an exit strategy. Onthe one hand, the BoJ should nottighten monetary policy too early ifinflation rates are low, or Japan willreturn to the days of deflation. Onthe other, the BoJ should not maintainstrong monetary growth for a pro-tracted period, or the economy willbe exposed to inflationary pressures.

In 2004, the emerging economiesin non-Japan Asia (NJA) continuedto recover thanks to strong externaldemand, China�s investment boomand more robust domestic demand.Despite attempts to dampen the pace,China�s economy grew by 9.5%.

Regional integration strengthened, asindicated by rapid growth in intra-regional trade and by flows of in-vestment. Toward end-2004, growthmomentum started to decelerateowing to continued high oil prices.In 2005, growth momentum is likelyto slacken — in particular, due toflagging export demand induced byglobally weaker economic expansion.

2 Euro Area: Slowdownin Economic MomentumContinues

2.1 GDP Growth Driven byGross Fixed Capital Formationin Third Quarter of 2004

According to Eurostat�s first estimatefor the fourth quarter of 2004, growthcontinued to slow to 0.2% and 1.6%on a quarterly and annual basis, re-spectively. This is primarily due tonegative quarterly GDP growth inGermany (—0.2%) and Italy (—0.3%).As early as the third quarter of2004, growth slowed in the euro area:Real GDP climbed by 0.3% quarteron quarter and 1.8% year on year.This was primarily attributable to

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net exports, which were markedlynegative owing to flagging exportgrowth, with imports surging stronglyat the same time. Real GDP growth inthe third quarter was fueled by grossfixed capital formation, in particular.

Trends in gross fixed capital for-mation were positive. After this com-ponent dwindled by 0.2% in the firstquarter of 2004, growth rates of0.3% and 0.7% (quarter on quarter)were posted for the second and thirdquarters of 2004, respectively. Themain reason for this is that gross fixedcapital formation in the third quarteralso generated positive growth inGermany. For instance, the declinein gross fixed capital formation inthe first quarter was due primarilyto the slump in construction invest-ment in Germany. In countries suchas Spain, France and Italy, by contrast,gross fixed capital formation alreadyexpanded in early 2004. At 0.9%, in-ventory build-up in the third quarterposted the highest growth in tenyears, which meant that this compo-nent made by far the biggest contri-bution to GDP growth.

Following a relatively vigorousrate of 0.7% in the first quarter of2004 (induced primarily by tax cutsin certain euro area countries), pri-vate consumption growth slowedsignificantly to 0.1% (quarter onquarter) in both the second and thirdquarter. This is likely to be due to thefact that real disposable income rose ata slower pace owing to the steepincrease in energy prices. Other fac-tors are the still unfavorable labormarket conditions and the uncertain-ties about healthcare and pension sys-tem reforms. These uncertainties arealso reflected in consumer confidence(as surveyed by the European Com-mission), which has been stagnatingsince February 2004. Overall, house-

holds are therefore consuming far lessand saving instead. A study released bythe Gesellschaft fu‹r Konsumforschung, aconsumer research body, shows thatGermany�s retail industry has beenbadly hit by current �precautionarysaving.� For instance, the retail indus-try�s share of nominal householdspending in 1993 still exceeded49%. By 2003, however, this hadfallen (with a commensurate rise inthe saving rate) to 41%. However,the recent improvement in themonthly indicators for private con-sumption — retail sales and new carregistrations — suggests the sluggishconsumption observed in the previoustwo quarters may have been merely ofa temporary nature.

As for exports, their growth mo-mentum slowed in the third quarterof 2004 as imports bounced backstrongly. The contribution of netexports to growth was thereforedistinctly negative in the third quar-ter. A reason for this decline inexports is the slight downturn in thegrowth of the world economy frommid-2004. Furthermore, the negativeimpact of the euro�s appreciation, ad-versely affecting the competitivenessof euro area exports, is only nowlikely to take full, albeit delayed,effect. In view of the modest domesticdemand, the strong surge in importswas unexpected.

The pace of public consumptionpicked up recently. After postinggrowth of just 0.1% in the first quar-ter of 2004 — in this case, public con-sumption is likely to have been curbedby the bleak budget situation in somecountries (with deficits close to orabove the budget deficit ceiling of3%) — this component rose moresteeply in the second and third quarterof 2004, up 0.4% and 0.5% (quarteron quarter), respectively.



The leading indicators for GDPgrowth have been presenting a rela-tively changeable picture in the lastfew months, which nonetheless con-firms the impression that the economymight have recently lost some steam.

2.2 Industrial Production Down,Unemployment Still Flat

Following a steady, albeit volatile,uptrend in growth until mid-2003,industrial production has been indecline since summer 2004. The lead-ing indicators for industrial produc-tion also confirm this picture. Boththe industrial confidence and eco-nomic sentiment indicator of theEuropean Commission signaled aslight downturn in economic momen-tum.

As in previous months, the season-ally adjusted unemployment rate wasjust below 9% in December 2004.The tight labor market conditionscan also be seen in the steadily fallingshare of job vacancies (since early

2001) as a percentage of the totalworking population in the euro area.In the third quarter of 2004, employ-ment posted its highest rise in twoyears (+0.4%). In addition to theservice sector, employment also in-creased in the construction industry.

2.3 Energy Prices Still FuelingInflation

After peaking at USD 52.07 on Octo-ber 22, 2004, the price for a barrel(Brent) tumbled sharply by more thanUSD 12. In the previous few months,oil price trends have been marked byhigh volatility. For instance, oil pricesinitially rose in mid-January 2005 —according to traders, investor con-cerns about potential new attacks onoil installations in Iraq before theelections and the cold wave in theU.S.A. depressed market sentiment.After falling in early February 2005on account of OPEC maintaining out-put — OPEC refrained from cuttingquotas at its previous meeting in

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January 2005 — and of the absence ofterrorist acts in Iraq, oil prices latterlyclimbed back in mid-February 2005on fears of supply constraints. The factthat OPEC has maintained output at-tests to a certain willingness on itspart to take currently high oil pricesinto account when controlling output.

Crude oil price trends are also re-flected in the HICP (Harmonised In-dex of Consumer Prices) inflationrate: since April 2004 inflation has in-creased primarily because of the en-ergy component. In December2004, inflation rose to 2.4% (energycomponent: + 6.9%), with the con-tribution to inflation of the energycomponent equaling 0.6 percentagepoint. In January 2005, the HICP slip-ped back to 1.9% and was forecast torise to 2.0% in February. In the pastfew months, food price increases have

been very feeble, which has partly ab-sorbed the energy price effect. For in-stance, the year-on-year rates ofchange for unprocessed food priceswere negative from September to No-vember 2004.

Since May 2004 core inflation (risein the HICP excluding energy and un-processed foods) has been fluctuatingbetween 1.9% and 2.2% (January2005: 1.8%). A sizeable proportionof core inflation comes from the �alco-hol and tobacco� product group,which has been in excess of 7% sinceMarch 2004. Accordingly, the rise inthe overall index excluding energy,food, alcohol and tobacco is a mere1.7%. Furthermore, if the effects ofhealth sector reforms in several coun-tries are factored out of the core infla-tion rate, the latter is then likely to beonly slightly more than 1.5%.

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2.4 Private Borrowing in Euro AreaContinues to Expand

The upturn in total lending continuedto show a positive trend. In particular,loans to the private sector have risensince mid-2003. Total lending growthstabilized due to flagging expansion inpublic sector lending. The upturn inprivate sector lending is basically at-tributable to an increase in home loansowing to low long-term interest rates.By contrast, consumer loans and loansto nonfinancial corporations contin-ued to grow less dynamically, althoughrecently a trend reversal might haveoccurred in an upward direction.

The three-month average of M3growth rose to 6.3% for the periodof November 2003 to January 2004,with a further resumption of the trendin accelerating growth since May2004. This is due to the uptick ingrowth in other short-term depositsand in marketable financing instru-ments. Continued robust growth ofcurrency in circulation and demanddeposits is also attributable to strongforeign demand for euro banknotesand to low interest rates. Healthy

demand for saving vehicles includedin M3 can be explained by two fac-tors: first, households� continued highdegree of risk aversion and, second,the relatively flat yield curve and his-torically low long-term interest rates.

2.5 Euro Exchange Rate Peaksat End-2004

Since peaking at USD/EUR 1.36 onDecember 31, 2004, the U.S. dollarhas recently made up lost ground.The somewhat greater strength of thegreenback is attributable to favorableU.S. economic data, where industrialorder intake and the purchasing man-agers� survey point to further buoyantgrowth. Relative to pound sterlingand other currencies — in particular,the Japanese yen — the euro exchangerate was comparatively stable. EUR/USD exchange rate trends are cur-rently generally being interpreted asU.S. dollar weakness. Concerns aboutfinancing the high current accountdeficit and, in this context, the highbudget deficit in the U.S.A. are citedas one reason for the soft dollar.

Until early February 2005, long-term interest rates in the euro area fellto 3.5% before bouncing back slightly.

As a result, the downtrend in 10-yeargovernment bond yields since July2004 has thus far continued. The

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spread vis-a‘-vis long-term interestrates in the U.S.A. has also widened.Above all, somewhat bleaker growthprospects are likely to have generateda strong demand for bonds. In addi-tion, healthy demand for safe invest-ment vehicles such as bonds is likelyto reflect continued marked risk aver-sion amid ample liquidity supply.

2.6 Muted Optimism aboutEconomic Growth

The economic outlook for 2005 is nolonger considered to be as optimisticas in the first half of 2004. In itsshort-term target range forecast forthe first half of 2005, the EuropeanCommission anticipates quarterlygrowth of 0.2% to 0.6%, whichimplies that economic momentum isnot set to accelerate significantly.The ECB�s projections released inDecember 2004 show that real GDPshould increase by 1.4% to 2.4% in2005 and by 1.7% to 2.7% in 2006.The February 2005 Consensus Fore-casts predicts growth of merely1.7% in 2005, followed by 2% in2006. In the current forecasts, down-side risks, consisting primarily in lag-ged effects of the euro�s appreciationand in increased crude oil prices, aremostly emphasized.

3 Economic Performancein the New CentralEuropean MemberStates and in EUCandidate Countries

3.1 Rapidly Accelerating Growthin Most Countries in 2004

In Poland, Slovakia, Slovenia, Hun-gary and the Czech Republic, theeconomy in the first three quartersof 2004 grew at a weighted averagerate of 4.9% (year on year), whichwas still far more dynamic than inthe euro area (1.9%). In this period,growth in the new Central EuropeanEU Member States ranged between3.7% (Czech Republic) and 5.9%(Poland) and, in most cases, was thusexceeded by GDP growth in the EUcandidate countries Bulgaria (5.8%)and Romania (8.1%). With a growthrate of 3.9%, Croatia, also a candidatecountry, lagged behind most of thesecountries.

Furthermore, most Central andEastern European countries generatedhigher growth in the first nine monthsof 2004 than in 2003 as a whole. In thenew Central European EU MemberStates, growth ticked up at the samerate as in the euro area (by 1.4 per-centage points). In this group ofcountries, Poland and Slovenia postedthe fastest acceleration, up by 2.2 and2.0 percentage points, respectively.

Table 1

Real GDP Growth in Central and Eastern Europe

annual change in %

2000 2001 2002 2003 Q1 04 Q2 04 Q3 04

Poland 4.0 1.0 1.4 3.8 6.9 6.1 4.8Slovenia 3.9 2.7 3.3 2.5 3.9 4.7 4.9Slovakia 2.0 3.8 4.6 4.0 5.4 5.5 5.3Czech Republic 3.9 2.6 1.5 3.7 3.7 3.8 3.5Hungary 5.2 3.0 3.5 3.0 4.3 4.2 3.7

Bulgaria 5.4 4.1 4.9 4.3 5.3 6.0 5.8Croatia 2.9 4.4 5.2 4.3 4.2 4.0 3.9Romania 2.1 5.7 5.0 4.9 6.1 7.0 10.0

Source: Eurostat, national statistical offices, WIIW.



At 3.2 percentage points, Romaniaregistered the strongest pick-up ingrowth among the entire group ofcountries.

The demand-side growth momen-tum in the countries under review hasinteresting features in common. Thesecountries are broken down intogroups in terms of changes in the firstthree quarters of 2004 (comparedwith 2003) in the contribution ofdomestic and net external demandto growth.— In Croatia and the Czech Repub-

lic, both with slightly flaggingGDP growth, the contribution ofnet exports to growth was lesssharply negative compared with2003. However, this positive de-velopment was more than offsetby a weaker contribution of do-mestic demand. The change inthese contributions has conse-quently resulted in a more bal-anced pattern of growth in bothcountries.

— In Bulgaria, Slovenia and Hungary,where GDP growth accelerated inthe first three quarters of 2004(compared with 2003 as a whole),the negative contribution of netexports to growth also proved tobe smaller. These three countrieswere marked not only by acceler-ated GDP growth but also by amore balanced pattern of growth.

— In Poland, Slovakia and Romania,the positive contribution of do-mestic demand to growth in-creased, resulting in a concomi-tant rise in GDP growth. How-ever, the contribution of net ex-ports to growth developed lesspositively in these three countries.In each of the countries where the

contribution of domestic demand togrowth increased (i.e. in Poland, Slo-vakia and Romania) growth in gross

fixed capital formation acceleratedfaster than consumer growth. InHungary and the Czech Republic,growth in gross fixed capital for-mation accelerated rapidly whereasconsumer growth declined. Bulgariawitnessed a slowdown in both growthin gross fixed capital formation andconsumer growth, with the latterfalling more sharply. In 2004, a rela-tive shift from consumer growth toinvestment growth was seen in mostcountries. There were two exceptionsto this rule: first, Slovenia, whereboth consumer growth and invest-ment growth rose slightly, and, sec-ond, Croatia, where growth in grossfixed capital formation fell sharplyfrom a high level and consumergrowth remained almost unchanged.

In general, net export levels fluc-tuated less wildly than in the previousperiod — with the exception of Roma-nia, where the negative contributionof net exports to growth remainedunchanged. In each country exceptfor Croatia, change was based on ac-celerated export growth. By contrast,import growth increased less rapidlyor, in some cases, even decelerated.

The above-mentioned changes inthe contributions of net exports togrowth in the first three quarters of2004 (compared with 2003 as awhole) implied a positive contributionof net exports to growth only in Po-land, whereas the most negative con-tributions were observed in Bulgaria(despite a significant reduction) andin Romania. As a result, Poland im-proved its real net exports (smallerdeficit), while the deficits of Bulgariaand Romania widened. Interestingly,contributions of net exports to growthwere the most negative in the coun-tries with the highest GDP growth(i.e. in Bulgaria and Romania). Thecontribution of domestic demand to



growth was the highest in both thesecountries, indicating an unbalancedpattern of growth.

An analysis of the goods and serv-ices subaccounts shows that, in thefirst three quarters of 2004, Bulgariaand Romania (at 6.6% and 8.6% ofGDP, respectively) had the deepestdeficits. Slovenia is the sole Centraland Eastern European country underreview with a slightly positive, almostbalanced goods and services subac-count. In Bulgaria and Romania, how-ever, the results of the other subac-counts reduced the current accountdeficit, which the goods and servicessubaccount alone (4.0% and 5.9%,respectively) would have generated.In Hungary and the Czech Republic,by contrast, the negative income bal-ance increased the goods and servicessubaccount deficit from 3.2% and0.2% of GDP to a current account

deficit of 9.1% and 5.5%, respec-tively.

3.2 Accelerating Inflation in 2004 —Partly a Result of EU Accession

Price trends in the region were ex-tremely variable. In the new CentralEuropean Member States, inflationrates (year-on-year change in con-sumer prices in the fourth quarter of2004) ranged between 2.7% in theCzech Republic and 6.0% in Slovakia.In the group of Central and EasternEuropean countries under review,Croatia had the lowest rate of inflation(2.3%) whereas Romania was the onlycountry with inflation in double digits(10.0%). In November 2004, how-ever, Romania registered single-digitinflation of 9.9% for the first timesince the start of the transformationprocess.

In 2003, prices came under strongupward pressure. In addition to therise in energy prices worldwide, in-creases in indirect taxes and agricul-tural producer price adjustments —both factors are attributed to EU ac-cession — generated inflationary pres-sures in the new Member States. InBulgaria, the rise in energy pricesworldwide was further increased byregulated energy price adjustments.Food prices continued to climb

steeply in this country, partly as a re-sult of a period of drought. The subin-dices of the HICP reveal that the infla-tionary pressures induced on the de-mand side in the new EU MemberStates merely played an insignificantrole. In Bulgaria and Romania, de-mand-side factors (also in conjunctionwith a massive credit expansion) defi-nitely contributed to inflation.

Compared with the average rate ofinflation in 2003, prices in four of the

Table 2

Inflation Trends in Central and Eastern Europe

annual change in HICP in %

2002 2003 2004 Q1 04 Q2 04 Q3 04 Q4 04

Poland 1.9 0.7 3.6 1.8 3.4 4.8 4.5Slovenia 7.5 5.7 3.6 3.7 3.8 3.6 3.5Slovakia 3.5 8.5 7.4 8.2 8.0 7.2 6.0Czech Republic 1.4 �0.1 2.6 2.0 2.4 3.0 2.7Hungary 5.2 4.7 6.8 6.8 7.4 7.0 5.9

Bulgaria 5.8 2.3 6.1 6.4 6.7 6.7 4.8Croatia 1.7 1.8 . . 1.9 2.3 1.9 2.3Romania 22.5 15.3 11.9 13.6 12.3 11.9 10.0

Source: Eurostat, national statistical offices, WIIW..



eight countries soared in 2004 (Bulga-ria, Poland, the Czech Republic andHungary), although annual inflationrates in the fourth quarter were lowerthan those posted in the second andthird quarter. Despite strong pricingpressures, inflation fell in three coun-tries (Slovakia, Slovenia and Roma-nia). In Slovakia, relatively low coreinflation (some 2%) depressed theoverall inflation rate, which risingadministered prices and tax cuts hadaccelerated. Furthermore, the posi-tive base effect (due to sharp increasesin administered prices in 2003) andfierce retail competition by foreignsuppliers helped. In Slovenia, the rel-atively small degree in unit wage costincreases due to the gradual de-index-ation of the economy led to a declinein inflation.

3.3 Improved Ratings in Second Halfof 2004 for EU CandidateCountries and Slovakia

Both Moody�s and Standard & Poor�scontinued to award Slovenia the bestratings for long-term foreign currencyliabilities. The two agencies gave theCzech Republic and Hungary the sec-ond-best rating. In December 2004,Standard & Poor�s upgraded Slovakia,which means that the country nowhas exactly the same rating from thisagency as Hungary and the CzechRepublic. Moody�s continues to rankPoland third, followed closely by Slo-vakia (which has had a promising out-look since October). Since Standard &Poor�s upgraded Croatia in December,both agencies rate the country justbehind the new Member States (i.e.still ahead of Bulgaria and Romania).Bulgaria and Romania�s ratings havealso improved in the past few months.For instance, Moody�s upgraded Bul-garia in November following Standard& Poor�s upgrade of Romania in Sep-tember.

Table 3

Ratings for Long-Term Foreign Currency Liabilities

Currency Moody�s Standard & Poor�s

Old rating Latest change Current rating Old rating Latest change Current rating

PLN Baa1 12. 11. 2002 A2 BBB 15. 05. 2000 BBB+SIT A2 12. 11. 2002 Aa3 A+ 13. 05. 2004 AA—SKK Baa3 12. 11. 2002 A3 BBB+ 13. 12. 2004 A—CZK Baa1 12. 11. 2002 A1 A 05. 11. 1998 A—HUF A3 12. 11. 2002 A1 BBB+ 19. 12. 2000 A—

BGN Ba2 17. 11. 2004 Ba1 BB+ 24. 06. 2004 BBB—HRK . . 27. 01. 1997 Baa3 BBB— 22. 12. 2004 BBBROL B1 11. 12. 2003 Ba3 BB 14. 09. 2004 BB+

Source: Bloomberg.



Economic Outlook for Central and Eastern European Countries

The OeNB compiles on a biannual basis forecasts of economic developments in Poland, Hungary, theCzech Republic as well as in Russia. The above-mentioned three new EU countries together accountfor more than 75% of the GDP of the ten new EU Member States and are thus representative of trendsin this region of the EU.1

In 2004, the euro area�s current economic recovery and, possibly, an EU accession effect helpedannual GDP growth increase moderately in the Czech Republic and accelerate sharply in Hungaryand Poland compared with 2003. In the Czech Republic the contribution of net exports to growthwas significantly less negative than in 2003, and in Hungary this component even changed from negativeto positive. This improvement in foreign trade more than offset sluggish growth in domestic demand. InPoland, despite accelerated growth in domestic demand, the contribution of net exports to growth wasagain positive, albeit to a lesser extent than in 2003.

Compared with the OeNB�s fall outlook for 2004 GDP growth in these three countries, Poland�sfigure for 2004 is a tad lower, as the rapid acceleration of investment growth commenced somewhatlater than anticipated. In Hungary GDP growth for 2004 is slightly higher than predicted, as privateconsumption growth slowed somewhat less than expected.

In 2005, the uptick in domestic demand is likely to continue in Poland. In the Czech Republic andHungary domestic demand is anticipated to rise again. In all three countries, consumer price inflationcan be expected to fall due to a base effect, among other factors. In addition, all three countries shouldsee a modest increase in employment together with relatively high investment growth. In Hungary, fur-thermore, tax cuts and changes in the social transfer system, which are designed to favor low-incomehouseholds, were implemented in early 2005. At the same time, however, a slowdown in growth oflending to households is anticipated in Hungary for several reasons.2 Overall, these factors are likelyto generate far stronger private consumption growth in all three countries. Whereas gross fixed capitalformation in Poland is expected to expand far more vigorously in 2005 thanks to high corporate profits,relatively low real long-term interest rates in historical terms and effects arising from structural fundstransfers from the EU, it is likely to contract (from the, in part, very high level of the previous year) mod-erately in the Czech Republic and significantly in Hungary. Nonetheless, relatively high investmentgrowth will also be attained in these two countries, especially as transfers from the EU�s structural fundswill fully take effect in 2005.

In Poland the z�oty�s marked appreciation in the last twelve months as well as the anticipated rapidacceleration of growth in import-intensive gross capital formation may lead to imports growing moresteeply than exports in real terms. This is likely to imply a deceleration in GDP growth in 2005. Bycontrast, weaker investment expansion in Hungary should dampen the rise in imports. Neverthelessthe contribution of net exports to GDP growth is projected to be markedly less positive than in 2004,which is set to dampen GDP growth somewhat.

In 2006, Hungary and the Czech Republic could witness a slight acceleration in consumptiongrowth in connection with their parliamentary elections. By contrast, in Poland higher indexed-basedsocial transfers will buttress private consumption growth. Combined with stronger investment activityand main trading partners� improved growth prospects, this is likely to result in slightly higher GDP growthin all three countries.

In addition to euro area growth and oil prices diverging from built-in expectations to a greaterextent, the risks for the outlook of these three new EU countries include unexpectedly sharp exchangerate movements and upcoming elections in all three countries.

In 2004, Russia posted GDP growth at almost the same high levels as in 2003, driven by the highprice of oil and other commodities. In addition, prudent monetary and fiscal policies, domestic stabilityand, to a certain extent, previously implemented structural reforms fueled growth. However, the invest-ment climate in the fourth quarter of 2004 deteriorated in conjunction with increased interventions bythe tax and judicial authorities and the further aggravation of the Yukos affair.

In 2005 and 2006, however, GDP growth is likely to slacken. Private consumption growth will remainrobust due to wage and pension increases and, to a lesser extent, to high corporate profits, and modestfiscal easing will take place (reduction of the budget surplus). However, uncertainty about future policies



of reform could dampen hitherto strong investment growth. Above all, however, Russia�s persistently highinflation differential with the rest of the world and nominal upward pressure will result in the ruble�s con-tinued appreciation in real terms. Consequently, in addition to the demand for imports on the back ofvigorously growing domestic demand, there will increasingly be cost-induced import competition, which,although also likely to accelerate restructuring, will very probably trigger a further decline in net exportsinitially.

The Russian economy�s even greater dependency on sources of energy in the last few years remainsa key risk factor for both growth and this forecast. In addition to a potential sharp drop in prices, capacityconstraints (e.g. in oil pipelines) could also lead to a shrinkage in net exports over and above the volumepredicted. Furthermore, there is the risk that the ruble will appreciate excessively rapidly in real terms,which would adversely affect the competitiveness of industrial goods. Finally, it is also currently difficult toassess the macroeconomic consequences of the continuing uncertainty about the course of reform andthe respect for property rights by the authorities.

f = forecast1 These forecasts (Russia�s, in particular, is compiled in collaboration with Suomen Pankki, Finland�s central bank) are based on pre-

liminary global growth projections and technical assumptions about oil prices and USD/EUR exchange rates, which are preparedby the ECB for the Eurosystem by means of broad macroeconomic projection exercises. These assumptions are central to the currentoutlook owing to two factors: first, the sizeable export links of these three new EU countries with the euro area and, second, the factthat Russia is one of the world�s biggest oil-producing nations.

2 For instance, subsidies for home loans were cut, which means households will require a higher share of self-financing for this purpose.

4 Austria: OeNB RevisesEconomic Outlook forFirst Half 2005 SlightlyDownward — AustrianEconomy WithstandsEuro Area SlowdownRather Well

Booming exports chiefly carried theeconomy in the first half of 2004. Inthe light of the decelerating globaleconomy, the high oil prices and thestrong euro, exports, however, startedto slow in the remaining months of2004. At the same time, economicgrowth was driven increasingly bydomestic demand, in particular bythe very lively investment activity. Inthe fourth quarter of 2004, realexports were down 0.6% quarter onquarter. For 2004 as a whole, exportsnevertheless expanded by a solid 9%.

Yet businesses� assessment of orderbooks implies that exports are un-likely to match the year-earlier expan-sion in the first half of 2005.

The years 2003 and 2004 saw ex-ceptionally robust investment growthowing to brisk demand for replace-ment investment and to the stimulusprovided by a subsidy granted for in-vestment that exceeds the average in-vestment level of the previous threeyears. Meanwhile, an investmentshare of GDP that has outperformedthe figures posted in the record year2000 points to a forthcoming slow-down in investment activity. The expi-ration of the above-mentioned invest-ment growth subsidy at year-end 2004and current survey data corroboratethe assessment that investment activ-ity has already peaked.

Table 4

Three New EU Member States and Russia: March 2005 Forecast

annual change at constant prices (%)

GDP 2001 2002 2003 2004 2005f 2006f

Poland 1.0 1.4 3.8 5.3 4.5 4.7Czech Republic 2.6 1.5 3.7 4.0 4.4 4.6Hungary 3.8 3.5 3.0 4.0 3.8 4.0

Russia 5.1 4.7 7.3 7.1 5.7 4.5



Economic development in 2005will depend essentially on the extentto which households step up theirconsumption expenditure. The sec-ond stage of the tax reform coupledwith ongoing employment growth —irrespective of the moderate wagesettlements — translate into a tangibleincrease in nominal household in-come. The higher inflation, however,is dampening purchasing power. Atthe same time, subdued consumerconfidence suggests sustained con-sumer restraint. Overall, the OeNBnonetheless expects the positive mo-mentum to carry the day and private

consumption growth to accelerate in2005.

Labor market conditions — one ofthe reasons for the rather low con-sumer confidence — are marked byvigorous employment growth amidsustained high unemployment. Thegreater influx of foreign workers andthe pension reforms of the previousfew years are at the root of the excep-tional rise in the labor supply. As thenumber of registered job vacancies isincreasing further, robust employmentgrowth is expected to continue in2005 and subsequently to ease the sit-uation on the labor market somewhat.

Table 5

Breakdown of Real GDP Growth in Austria

Change from previous period(year; quarter) in %

Contributions to GDP growthin percentage points1)

Q1 04 Q2 04 Q3 04 Q4 04 2004 Q1 04 Q2 04 Q3 04 Q4 04 2004

GDP 0.6 0.8 0.8 0.3 2.0 0.6 0.8 0.8 0.3 2.0Private consumption 0.4 0.3 0.2 0.3 1.5 0.2 0.2 0.1 0.2 0.8Public consumption 0.2 0.3 0.3 0.2 1.1 0.0 0.1 0.1 0.0 0.2Gross fixed capitalformation 0.7 1.0 1.6 1.2 4.8 0.2 0.2 0.4 0.3 1.1Exports 2.7 3.4 1.8 �0.6 9.0 1.4 1.8 1.0 �0.3 4.5Imports 1.2 1.5 1.4 1.0 5.7 �0.6 �0.7 �0.7 �0.5 �2.7Domestic demand x x x x x 0.4 0.4 0.5 0.5 2.1Net exports x x x x x 0.8 1.1 0.3 �0.8 1.8Statistical discrepancy2) x x x x x �0.6 �0.8 �0.1 0.6 �1.8

Source: Eurostat.1) Based on chain indices, for which contributions to growth can only be approximated.2) Including changes in inventories.



Results of the OeNB Economic Indicator of March 2005:

OeNB Revises Expectations for Economic Developmentsin the First Half of 2005 Slightly Downward1

The OeNB now assesses the growth prospects for the first half of 2005 somewhat more cautiously thanindicated by the OeNB�s economic indicator published in January 2005. The slowdown in economicgrowth is, however, expected to be of a temporary nature only; the economic outlook for the remainderof 2005 is more optimistic. The OeNB�s economic indicator forecasts 0.4% seasonally adjusted growth inAustria�s real GDP for the first and 0.5% for the second quarter of 2005 (each compared with the pre-vious quarter). Compared with the most recent release of January 2005, the growth expectations for thefirst quarter 2005 were reduced by 0.2 percentage point. Year on year, this points to a slight contractionof economic growth in the first two quarters of 2005 from 2.2% to 2.0%.

1 Since the first quarter of 2003, the economic indicator of the OeNB has been published four times a year. It forecasts real GDP growthfor the current quarter and the next (in each case, on a quarterly basis, using seasonally adjusted data). The figures are based on theresults of two econometric models: a stochastic state space model and a dynamic factor model. Further details on the models employedcan be found at www.oenb.at in the Monetary Policy and Economics section. The next publication is scheduled for June 2005.

4.1 Slight Deterioration ofConfidence Indicators

Current confidence indicators reflectthe uncertainty over the future eco-nomic development in Austria. TheEuropean Commission�s economicsentiment index, on a steady rise lastyear, posted its highest level to datein October 2004. Since then this con-fidence indicator retreated four timesin a row, plummeting to the lowestlevel in 12 months in February2005. This slide is likely to be ascrib-able to the worsened growth pros-pects for Italy and Germany, Austria�stwo main trading partners, the euro�sappreciation and the continued highunemployment ratio.

The subcomponents of this eco-nomic sentiment index are only mod-estly indicative of the further devel-

opment of the expenditure-side GDPcomponents in 2005. The weakerorder book assessment for exportssuggests a deceleration of shipmentsabroad over the course of this year.With capacity utilization in the fourthquarter of 2004 continuing to be athigh levels, the demand for capacity-enhancing investment may safely beassumed to be still high irrespectiveof the sizeable investment share inGDP. This, however, conflicts withthe results of the WIFO InvestmentSurvey and the sliding industrial aswell as service sector confidence.On balance, evidence of a slowdownin investment activity prevails. Inaddition, a sharp uptick in privateconsumption does not seem to beon the horizon. In early 2005, retailconfidence stabilized at the low level

Table 6

Short-Term Outlook for Austrian GDP in the First and Second Quarter

of 2005 (Seasonally Adjusted)2003 2004 2005

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

change from same quarter a year ago in %

0.6 0.5 0.8 1.1 1.4 1.9 2.5 2.4 2.2 2.0

change from previous quarter in %

0.3 0.3 0.2 0.4 0.6 0.8 0.8 0.3 0.4 0.5

annual change in %

0.8 2.0

Source: OeNB — Results of the OeNB Economic Indicator of March 2005, WIFO.



of the second half of 2004, whereasconsumer confidence has remainedunchanged for some time now.

4.2 Higher Inflation owing toOil Price Surge

In 2004, average annual HICP infla-tion stood at 2.0% and thus markedlyabove the 2003 level of 1.3%. Infla-tion progressively rose over thecourse of 2004, climaxing at 2.5%in December. Subsequently, it edgeddown to 2.4% in January 2005 andto 2.3% in February. Price trendswere basically determined by the in-crease in crude oil prices. An analysisof the HICP subcomponents showsthat inflation was particularly high inenergy and housing costs, but it alsoremained above average in the servicessector, unchanged from the previousyears. Conversely, the trend of be-low-average price growth of industrialgoods likewise continued. Energy pri-ces will determine the path of infla-tion in 2005. On the assumption thatthe oil price will more or less move insynch with the forward rates, thesurge of the oil price over the pastfew months — sporadically to aboveUSD 50 per barrel Brent — is likelyto keep inflation high until mid-2005or so. After that, the base effect ofthe previous oil price spike willdampen the inflation rate. Core infla-tion is expected to remain below the2% mark.

In terms of the Negotiated Stand-ard Wage Rate Index, wages aug-mented by 2.1% in 2004, basicallymirroring the increase in consumerprices. In the second half of 2004,consumers suffered real incomelosses. This trend continued into2005 but is likely to cease in the firsthalf of this year.

4.3 2004 Current Account onCash Basis almost Balanced

Austria�s current account was virtuallybalanced in 2004, with the deficit(based on payment flows) coming toEUR 0.8 billion or 0.3% of GDP.Compared with 2003, the current ac-count improved slightly by EUR 0.2billion. This improvement is entirelyascribable to the vigorous export ac-tivity yielding, as expected, a pro-nouncedly higher surplus of the goodsand services subaccount in 2004. Theshortfall of the goods subaccount wasreduced from 1.7% of GDP in 2003to 1.1% in 2004, while the surplusof the services subaccount climbedfrom 2.4% to 2.5%. The deficits ofthe income and current transfer sub-accounts, by contrast, widened to0.6% and 1.1% of GDP, respectively.

The export boom of 2004 is alsoreflected in the foreign trade statis-tics compiled by Statistics Austria.The merchandise trade balance im-proved from —0.9% of GDP in 2003to —0.1% in 2004. Goods exportsexpanded by 13% against 2003. Ananalysis of the intrayear trend ofannual growth rates does not yet pointto a perceptible slowdown in exportactivity. Seasonally adjusted monthlydata, however, show that exportspeaked in the second quarter of 2004and noticeably decelerated in the sec-ond half of the same year, especiallyin the fourth quarter. Real exportfigures, taken from the nationalaccounts, confirm this pattern. Ananalysis of the merchandise trade bygeographic region reveals that thedeficit vis-a‘-vis the EU-15 mountedto —2.8% of GDP (2003: —2.5%),while the surplus vis-a‘-vis the newMember States remained more or lessunchanged at 0.6% of GDP. Merchan-dise trade with countries outside theEU was very robust, with the surplus



rising by 1 percentage point to 2.0%of GDP. In particular, the dynamicgrowth of shipments to the U.S.A.(+32% in the first 11 months of2004) came as a surprise, not leastbecause of the gradual appreciationof the euro against the U.S. dollarsince mid-2001 and the concomitant

deterioration of price competitive-ness. Part of this surge may, however,be explained by a statistical effect.Automobile industry exports, whichused to be shipped via Germany,now increasingly go directly to theU.S.A.



This study discusses important elements of Austria�s recently harmonized statutory pension system.In particular, the author investigates in how far the new system responds to the twofold demographicchallenge of declining birth rates and increasing life expectancy and what this means in terms of fiscalsustainability and intergenerational redistribution.

Austria�s defined benefit system is found to have more in common with Germany�s system ofearnings points than with Sweden�s notional account system — with the exception that the sustainabilityfactor, the adjustment mechanism triggered by demographic changes, has been designed differently inGermany and in Austria. A critical analysis of the Austrian provisions identifies the following problems:First, the application of the sustainability factor is activated only by deviations from projections andnot to demographic movements as such. Second, adjustments are not to be automatic. Third, therequirement of an �even adjustment� is not spelled out in detail. Fourth, it is doubtful whether evennessis a desired feature in the first place since generation-specific reproductive behavior is neglected in thisscenario.

Overall, the basic structure of Austria�s new model gets a favorable rating, as it increases the degreeof intergenerational fairness, supports individual, intersectoral and international flexibility and correctssome design flaws of the old pension regime. Conversely, weaknesses are identified with regard tothe transitional arrangements, the contribution side and the sustainability factor.

1 IntroductionIn early 2005, a new acronym — APG(Allgemeines Pensionsgesetz — Gen-eral Pension Act) — was added to theAustrian legal framework. The APGlays down the fundamental structureof the new, harmonized statutorypension system in 16 articles, makingspecific reference to those sections —specifically transitional arrangements —where the provisions of the existingsocial security acts continue to apply.This study discusses important ele-ments of the APG. Special emphasisis placed on the basic design princi-ples of the new system. The mainobjective is to identify in how far thenew system responds to demographicchanges and what this means in termsof fiscal sustainability and intergenera-tional redistribution.

The basic structure of the APG ispresented in chapter 2 and comparedwith the German and Swedish pensionmodels. According to this compara-tive analysis, Austria�s new (definedbenefit) pension system has more in

common with the (classical) Germansystem than with the Swedish model,which is likewise structured as anotional account system, yet is ofthe defined contribution type.

Chapter 3 is dedicated to thequestion on how the demographicchallenge is tackled under the newsystem. In addition, the Austrian sus-tainability factor is juxtaposed withits German counterpart and criticallyexamined.

The study concludes with a sum-mary assessment of Austria�s new stat-utory pension system in chapter 4.

2 A Comparison of theAustrian, German andSwedish Pension Systems

Let us start out by studying and com-paring the central design principlesunderlying the Austrian, Swedish andGerman pension systems. The Swed-ish and German systems lend them-selves as benchmark models as theyare frequently discussed in the litera-ture and represent two archetypes of

1 The author wishes to thank Hans Brunner, Doris Ritzberger-Gru‹nwald and Stefan Schmitz for their valuablecomments and suggestions. The opinion expressed in this study is that of the author and may differ from the viewsof the Oesterreichische Nationalbank.

Markus Knell1

Refereed byJohann K. Brunner,University of Linz.


Demographic Fluctuations, Sustainability Factorsand Intergenerational Fairness — An Assessment

of Austria�s New Pension System

a pay-as-you-go (PAYG) pension sys-tem.

2.1 Austria�s New Pension Model —A Notional Defined BenefitSystem

Austria�s harmonized pension systemrevolves around a personal notionaldefined benefit (NDC) account. Suchan account was already proposed bythe Austrian pension reform commis-sion as a possible design principle. Thenew pension system, indeed, broadlyreflects the conclusions and recom-mendations of the commission�s report(PRK, 2002) in this respect and on anumber of other points.

The formula 45-65-80 encapsu-lates the target benefit that the con-tributions accrued on the notionalaccount are designed to provide —namely on (average lifetime) earningsreplacement rate of 80% at a retire-ment age of 65 after 45 years of con-tributory service. To this effect,1.78% (accrual rate) of the attainedearnings (i.e. of the contribution baseunless this exceeds the maximumcontribution base) are credited tothe account per year and accrueinterest at the growth rate of the aver-age contribution base, which over aperiod of 45 years results in 80.1%(= 1.78%645). This rate can onlybe reached in case retirement be-comes effective at the normal retire-ment age of 65. Retirement during apension corridor, i.e. between theage of 62 and 68, results either in abenefit decrease (pre-65) or increase(post-65) of 4.2% p.a.; but only per-sons with at least 37.5 years of pen-

sionable service are eligible for sucha �corridor pension.� The notionalaccount captures all paid-in contribu-tions and the accrued interest, and asfrom 2007, the pension insurance sys-tem must send an account statementon the insured person�s request.2

The uniformly applied contribu-tion rate stands at 22.8% (with em-ployees accounting for 10.25% andemployers for 12.55%). Farmers andself-employed persons, by contrast,pay a rate of only 15% and 17.5%,respectively. Existing pensions areindexed to the inflation rate. For sub-stitute contribution periods,3 statutorycontributions are credited to thenotional account. Special provisionsapply to heavy workers (in particularregarding retirement eligibility ageand benefit deductions). The transi-tion from the existing to the harmon-ized pension system is based on a par-allel calculation (for all persons under50 years of age). In other words, atthe time of retirement, pension bene-fits are calculated both according tothe old and the new legal provisions(for the entire service period), andthe definitive pension is then deter-mined in line with the principle ofpro rata temporis. A cap is to beapplied to losses resulting from the2003 pension reform, which is set toincrease from 5% in 2004 to 10%by 2024. Last, but not least, theAPG introduces a sustainability factor,which will be activated when centraldemographic (life expectancy) varia-bles deviate from projections. Thesustainability factor will be discussedin more detail further below.

2 For examples of such account statements, see the explanatory notes to the APG (p. 55) or Stefanits et al. (2004,p. 429).

3 Periods during which a person subject to compulsory insurance does not pay contributions into the statutory pen-sion scheme but which are counted towards the qualifying period necessary for benefits, including particularlychildcare periods, periods of unemployment/welfare benefits, sick benefits, military and alternative civilianservice as well as compassionate care leave.


Demographic Fluctuations, Sustainability Factors

and Intergenerational Fairness — An Assessment


2.2 Sweden�s Pension Model —A Notional Defined ContributionSystem

Sweden is beyond doubt the best-known example of a country switch-ing from a traditional PAYG pensionsystem to a notional account, i.e. anotional defined contribution system.Before comparing it with the Austriansystem, let us take a brief look at itsmain characteristics.4

The total contribution rate onearnings amounts to 18.5% (splitevenly between employer and em-ployee), 16% of which is paid intothe PAYG account and the remaining2.5% is channeled into a mandatoryfunded component, i.e. a capital-mar-ket based pillar.5 Contributions paidinto the personal notional accountare revalued at the notional interestrate, which in Sweden equals thegrowth rate of average earnings. Atthe time of retirement, the capitalaccumulated in the notional accountis converted into an annuity. In themost straightforward version of thismodel, the notional capital is simplydivided by life expectancy, which iswhy increased longevity automaticallytranslates into reduced pension bene-fits.6

2.3 Germany�s Pension Model —Earnings Points and CurrentPension Value

The German pension system is de-signed as a point system.7 An insuredperson�s annual earnings points aredetermined by dividing his or her

annual income by the average earningsof all future pensioners. Hence, anannual income equivalent to the aver-age earnings in a given year is worthone earnings point; two points areassigned for double, half a point forhalf the average income. The sum totalof earnings points times the currentpension value, which indicates thepension entitlement represented byone earnings point, equals the pensionbenefits. Like in Austria, deductionsor supplements apply when retire-ment is taken before or after the nor-mal retirement age of 65. The targetbenefit that the system is designed toprovide thus broadly depends on thedefinition of the current pensionvalue. In the past, the pension valuewas defined such that the �bench-mark� pensioner (who takes retire-ment at the age of 65 after 45 yearsof contributory service) was assureda net replacement rate of around70%. However, the recently intro-duced sustainability factor has consid-erably changed the way the pensionvalue is determined. We will comeback to this later.

2.4 Comparison of the PensionSystems in Austria, Germanyand Sweden

The example presented in the box�Different Methodologies for Calcu-lating Pension Benefits� highlights thesimilarities and differences betweenthe Austrian, German and Swedishpension systems.

4 For a description, see Palmer (2000), Disney (1999) and Holzmann (2004). For in-depth, partly critical dis-cussions of the NDC system, see Bo‹rsch-Supan (2003) as well as Williamson and Williams (2003).

5 For details on this second pillar, see Sunde«n (2004).6 This mechanism is accompanied by �frontloading� in Sweden, which partly moves expected pension adjustments

forward (Palmer, 2000, Appendix 1).7 For a detailed description of the German pension system, see Bo‹rsch-Supan and Wilke (2003) as well as Bo‹rsch-

Supan et al. (2003).





Different Methodologies for Calculating Pension Benefits

The workings of the three different systems are illustrated in table 1. This simple example does notreflect the exact parameterization of the existing pension systems but is mainly meant to capturethe basic structures, using the example of a fictitious person who is employed for four periods andthen spends two periods in retirement. Column 2 shows the individual earnings per period, whilecolumns 3 and 4 display the level and the growth rate of average earnings, respectively. The contributionrate is assumed to stand at 25%.

Columns 5 and 6 reflect the entries in a notional defined contribution (NDC) account, whichcorresponds to the Swedish model.1 The annual contributions are given by 2,500 = 0.25610,000,3,900 = 0.25615,600, etc. The (notional) total capital comprises the current annual contributionand the account value of the previous period indexed to the rate of growth of covered average earn-ings (column 3), i.e. 6,500 = 3,900 + 2,50061.04, 13,390 = 6,695 + 6,50061.3, etc. Upon retire-ment in period 5, the total capital (reflecting also the revaluation from period 4 to 5, i.e.22,071= 21,63861.02) is divided by life expectancy, which stands at two periods in this example.The initial pension benefit thus equals 11,035.5 = 22,071/2. The determination of the pension benefitin period 6 will be discussed below.

Columns 8 and 9 reflect the development of pension benefits and entries in a notional definedbenefit (NDB) account, which resembles the new Austrian system. This example has been construedsuch that the NDB account yields the same pension benefit as the Swedish NDC account, i.e. thatthe replacement rate of 50%, which implies that the accrual rate must be set at 12.5%. The yearlypartial credit is calculated as follows: 1,250 = 0.125610,000, 1,950 = 0.125615,600, etc. The cur-rent aggregate credit consists of the annual credit amount and the aggregate credit of the previousperiod revalued at the average wage growth rate. The initial pension benefit in period 5 equals the(revalued) aggregate credit of the last working period, amounting to 11,035.50.

Germany�s system of earnings points is illustrated in columns 11 and 12. The earnings points reflecta person�s relative income in the individual periods; in our example, they amount to 0.5, 0.75, 1.25 and1.5 for the four periods. The example has been construed such that the earnings points add up to 4,which corresponds to the amount of earnings points accumulated by a benchmark pensioner duringhis or her working life. Once again, the replacement rate is assumed to be 50%, which translates intoa current pension value of 2,758.88 and adds up to pension benefits of 11,035.50 (= 462,758.88).

All three systems evidently yield identical initial pension benefits, provided the parameters are setaccordingly. If the pension benefits are adjusted synchronically under all three models, later pensionpayouts will not diverge, either. On the assumption of wage-based indexation, the pension benefits inperiod 6 reach 11,366.57 in all three cases (this is assumed in table 1). In line with the APG, existing

Table 1

Comparison of the Austrian, German and Swedish Pension Systems

Notional defined contributionaccount (Sweden) contribution rate:25%

Notional defined benefit account(Austria) benefit target: 50%accrual rate: 12.5%

Point system (Germany)benefit target: 50%Pension value (period 5): 2,758.88

1 2 3 4 5 6 7 8 9 10 11 12 13

Perio

d Individualearnings

Averageearnings

Growthrate ofaverageearningsin %

Annualcontribu-tion

Totalcapital

Pensionbenefits

Annualpartialcredit

Aggregatepensioncredit

Pensionbenefits

Earningspoints

Totalearningspoints

Pensionbenefits

1 10,000.00 20,000.00 x 2,500.00 2,500.00 1,250.00 1,250.00 0.50 0.502 15,600.00 20,800.00 4 3,900.00 6,500.00 1,950.00 3,250.00 0.75 1.253 26,780.00 21,424.00 3 6,695.00 13,390.00 3,347.50 6,695.00 1.25 2.504 32,457.36 21,638.24 1 8,114.34 21,638.24 4,057.17 10,819.12 1.50 4.005 22,071.00 2 22,071.00 11,035.50 11,035.50 11,035.50 11,035.506 22,733.13 3 11,366.57 11,366.57 11,366.57

Source: OeNB calculations.





pensions are to be adjusted only for the inflation rate, i.e. they remain constant in real terms. This, how-ever, does not alter the general conclusion that in a demographically stationary society the three systemsmay be designed such that they produce equivalent outcomes.1 For an in-depth illustration of an NDC account, see Palmer (2000, p. 7).

The following observations resultfrom this comparative analysis:— Constant demographic structure. In

a demographically stationary soci-ety, the differences between thethree systems are small. If the pa-rameters are chosen in an appro-priate way, all models produceidentical contributions and pen-sion benefits, as shown in table 1.8

This, in turn, ensures that theequivalence between contribu-tions and benefits is the same inall three systems.9 What is more,the German and Austrian systemsare also nearly identical in design.The definition of the benchmarkpensioner under the German sys-tem (who receives the definedreplacement rate at the age of 65after 45 years of contributory serv-ice) corresponds to the 45-65-80formula in Austria. Furthermore,calculating pension entitlementsvia earnings points is fully equiva-lent to the accrual rate method ofthe Austrian system, provided allincome years are taken intoaccount and revaluation is basedon the growth rate of the average

wage and not of the wage bill.10

In contrast, a marked differenceis evident in the way pensionbenefits are adjusted. In Austria,existing pension benefits aremerely adjusted for the inflationrate, while in Germany — due tothe earnings point method — in-dexation is based on wage growth.In conclusion, while designed asa notional account system, theAustrian pension system never-theless has more in common withthe German model than withSweden�s NDC account system.11

— Increasing life expectancy. In thedefined contribution model, anincreasing life span automaticallyreduces pension benefits.12 Instandard defined benefit systems,a targeted replacement rate (asopposed to annuitization) deter-mines the pension payout, whichis also why such systems as a ruledo not feature an automatic ad-justment mechanism. Of course,it would be possible to link thedefinition of the benchmark pen-sioner or the 45-65-80 formulato life expectancy, but this is at

8 �Notional accounts are, in effect, identical to a well designed defined benefit pay-as-you-go scheme with rea-sonable actuarial adjustments and benefits based on revalued average lifetime earnings.� (Disney, 1999, p. 36);see also Bo‹rsch-Supan (2003).

9 In the literature on PAYG pension systems, this type of equivalence is frequently called �actuarial fairness� or�quasi-actuarial fairness� (Lindbeck and Persson, 2003).

10 In a first stage, any demographic adjustment factors and mechanisms are not accounted for. Such factors maynaturally lead to considerable differences between the systems and, in an extreme case, blur the lines betweendefined benefit and defined contribution systems.

11 In the literature, differing definitions are used for �defined contribution�2 and �defined benefit� systems. In thisstudy, a defined contribution system refers to a system in which the pension benefits depend on the accrued con-tributions. In contrast, a defined benefit system denotes a system in which the effective pension benefits are notdetermined by total contributions.

12 If life expectancy rose from 6 to 7 periods in the example given in table 1, the initial pension at the time ofretirement in period 5 would amount to a reduced 7,357 = (22,071/3) and many subscribers would probablyopt to prolong their working life to counter the decrease in pension benefits.





present not planned, at least not inAustria.13

— Variable cohort sizes. None of thethree models (according to thebasic design principles) automati-cally responds to fluctuations inthe cohort size. In the case of anongoing trend (e.g. a sustained re-duction in the birth rate), at onepoint or another adjustments willhave to be made on the contri-bution and/or the benefit side.According to the Swedish model,a change in the contribution rateentails an increase in the funds tobe paid into the notional accountand thus also in the future pensionclaims. For this reason, adjustingto a demographic shock provesparticularly difficult in a definedcontribution system and an auto-matic budget balance can nolonger be guaranteed in such case(Valde«s-Prieto, 2000).14 As a mat-ter of fact, the transparency andindividual determinability of no-tional account systems mightprove to be disadvantageous in thiscontext, since for political reasonsit is difficult to alter such �securi-tized pension claims.� In a typicaldefined benefit system, definitivepension benefits are determinedonly at the time of retirement,which makes it easier to imple-ment changes in benefit calcula-tion (Bo‹rsch-Supan, 2003).

3 The Implications ofDemographic Fluctua-tions and the Role ofSustainability Factors

3.1 Empirical Developmentsin Austria

As mentioned earlier, two demo-graphic processes pose a challenge topension systems, potentially jeopard-izing fiscal sustainability.— Fluctuations in the size of birth and

work cohorts. In Austria, the birthrate has been on a steady declinein the past decades, as reflectedby chart 1. While migration andstepped-up labor force partici-pation have helped to somewhatconstrain the effects of this down-ward trend on the size of the workcohorts, fluctuations in the cohortsize are nevertheless problematicfor a pension system designed tobe sustainable and intergenera-tionally fair.15

— Life expectancy has continuouslyrisen over the past decades. Thetrend line in chart 1 indicates thatlife expectancy in Austria has beenincreasing incrementally by 0.24years per calendar year since1951.16 If this process persistswhile the retirement eligibilityage remains constant, the ratio ofthe employment period to thepension period will continue toshift steadily.The pension reform commision

calculated that the aggregate impactof these demographically induced

13 The provisions on the sustainability factor in Austria and Germany will be discussed in detail later on.14 The Swedish system has a built-in automatic balance mechanism (Settergren, 2001), which fails, however, to

achieve a complete balance.15 This is a widespread phenomenon: �Given the underlying demographic ageing of the OECD population, it is

striking as to how few countries have a fall in the support ratio. [�] Demographic ageing has largely beenoffset by rising participation rates, especially among married women. However, when the baby boom, with itshistorically high economic activity rates, retires from 2010 on it is likely that economic support ratios will startto fall sharply unless offset by later retirement.� (Disney, 2004, p. 308).

16 Looking at the increased life expectancy as at the age of 60, we see that the gain has been smaller (by an average0.12 years since 1951), but still marked.





fluctuations might drive up the old-age dependency ratio (= persons agedover 64 divided by persons aged be-tween 15 and 64) from 22.9% (2000)to 40.7% (2030) (PRK, 2002, p. 72).

The Swedish NDC account auto-matically reacts to extended longevity,but there is no mechanism in placefor dealing with a continual declinein the cohort size. Some countriesusing defined benefit pension systemshave chosen a different strategy, as willbe discussed in the following sectionsfor the examples of the German andAustrian models.

3.2 The Sustainability Factor in theGerman Pension System

The 2004 German pension reform in-corporated a demographic adjustmentfactor (sustainability factor) into thepension system. Should the pensionerdependency ratio change over time,the sustainability factor stipulates thata share � of the necessary adjustmentbe brought about by reducing therelative pension level (or the replace-ment rate) and a share (1—�) by rais-ing the contribution rate. The para-meter � was set at 0.25.17 In the eventof an increased old-age dependencyratio, pensions will rise to a lesserextent than gross earnings. By 2030

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17 See Bo‹rsch-Supan et al. (2003); Sachversta‹ndigenrat (2004). These papers provide more information on thespecificities of the German system (e.g. the phased increase in private supplementary pensions also referred toas �Riester ladder�), which will not be discussed in this study. In addition, the minimum retirement eligibilityage was raised to 63 years in 2004.





the contribution rate is projected tohave advanced from about 19.5% to23% and the gross pension level isexpected to have fallen from 52.5%to around 43% (Bo‹rsch-Supan et al.,2003).

The German sustainability factor(GSF) has a number of interestingcharacteristics, which will be descri-bed below to subsequently contrastit with its Austrian counterpart.

3.2.1 The GSF Reacts to an Increasein Life Expectancy as well as toFluctuations in the Cohort Size

The pensioner dependency ratio mayincrease on account of various devel-opments, namely higher life expect-ancy against an unchanged cohortsize, decreased cohort size againstunchanged life expectancy and (as isto be expected) a combination ofthese two scenarios. A rise in the pen-sioner dependency ratio will at anyrate result in a reduced pension leveland a higher contribution rate.18

3.2.2 The GSF Reacts Automaticallyto Demographic Change

Owing to the statutory provision, ad-justments will be automatic and nottriggered by discretionary measures.

3.2.3 The GSF Spells out ExplicitlyHow to Respond toDemographic Fluctuations

It is stipulated by law which para-meters — the contribution rate and

the pension level — are to be usedto ensure sustainability. Furthermore,the relative weighting of these para-meters is defined precisely given that� = 0.25. Note that this specificationblends elements of a defined contribu-tion and a defined benefit system. At� = 0, the sustainability factor wouldbe inactivated and aging processeswould result in an increase in the con-tribution rate only (defined benefitapproach), while � = 1 would corre-spond to a typical defined contribu-tion approach entailing only an adjust-ment of the pension level. Setting� = 0.25 is tantamount to blendingthese two pension formats, which theGerman government�s council of in-dependent economic advisers labeleda �paradigm shift� (Sachversta‹ndigen-rat, 2004, p. 299).

It is important to add that thechosen value of � seems to be tracea-ble primarily to fiscal criteria.19 At thesame time, it should not be over-looked that variations of � wouldentail disparate effects on intergen-erational burden sharing. A chieflydefined benefit adjustment with a var-iable contribution rate (low �) placesgreater demands on today�s younggeneration than an adjustment of thepension level (high �). We will comeback to this crucial issue later on. Thefollowing assessment will be based ona measure of intergenerational distri-bution (MID) described in the boxbelow.

18 The Ru‹rup commission proposed the GSF — and preferred it over other adjustment factors, such as a purely lifeexpectancy-linked factor — exactly for the reason that it responds to both demographic processes (Bo‹rsch-Supanet al., 2003).

19 See Bo‹rsch-Supan et al. (2003). According to a statutory target, the contribution rate must not exceed 22% by2030.





Measure of Intergenerational Distribution (MID)

Pension systems should be assessed not only in terms of sustainability, but also in terms of inter-generational burden sharing. Depending on whether demographic shocks are absorbed primarilythrough rising contributions or through pension cuts, different generations will have to bear the brunt.A number of procedures and indicators may be used to measure and illustrate intergenerationalredistribution effects. Measures frequently used in this context include the internal rate of return, implicittax rate and generational accounts (Geanakoplos et al., 1999; Fenge and Werding, 2003). The inter-generational redistributiveness of Germany�s pension system and various reform proposals has beenexamined in a number of studies using either the internal rate of return (Schnabel, 1998; Sach-versta‹ndigenrat, 2004, p. 302f) or the implicit tax rate (Thum and von Weizsa‹cker, 2000; Fenge andWerding, 2003). To date, no such studies have been published for Austria.

Knell (2005a, 2005b) presents another method, which seems to lend itself particularly to theanalysis of intergenerational redistribution aspects in theoretical pension models. This method, whichis based on a proportionality measure, is also applied in this study to assess intergenerational redis-tribution. The MID for the average member of generation t is defined as follows:1

MIDt ¼sum of relative benefits

sum of relative contributions:

The denominator values denote the contribution rates prevailing in the respective years, the relativebenefits correspond to the respective promised pension level (i.e. the pension amount relative to theprevalent average wage). In the example presented in table 1, the MID for the fictitious person citedin the example is given as 0:5þ 0:5

0:25þ 0:25þ 0:25þ 0:25¼ 1:

In general, a balanced pension system has a constant across-generational MID of 1 given a demo-graphically stationary society. Section 3.3 presents cases with demographic nonstationarities, wherethe MID is no longer identical across all generations. For further details, examples and a discussionof this method, see Knell (2005a, 2005b).1 Generation t refers to that generation which enters the labor force at time t.

3.3 The Austrian Sustainability Factoras a Process

The new Austrian pension system alsofeatures a sustainability factor, whichhas, however, little in common withits German counterpart. Rather thanhaving been explicitly defined with aformula, the Austrian sustainabilityfactor (ASF) refers to a scenario pro-cess deviations from which willtrigger adjustments. This process isdefined in Article 108e paragraph 9ASVG (General Social Security Act)and is summarized as follows in theexplanatory notes: �A sustainabilityfactor is introduced with a view to

securing long-term funding [of thepension system]. This factor is basedon life expectancy figures for peopleaged 65 up to 2050 reflecting themedium scenario of Statistics Austria.Deviations from this �medium forecast�automatically impact — in equal finan-cial proportions — the contributionrate, growth rate, retirement eligibil-ity age, pension adjustments and thegovernment�s contribution in orderto safeguard fiscal sustainability.�20

The ASF differs from the GSFin all three characteristics mentionedin section 3.2, as will be discussedbelow.

20 In the legal act, these five potential adjustment parameters are explicitly referred to as �sustainability factors.�Such usage of the term �sustainability factor�, however, may be misleading and cause confusion with the GSF.





3.3.1 The ASF Responds to Deviationsfrom Forecasts and RefersPrimarily to Life ExpectancyDevelopments

While the pensioner dependency ratioand thus also the GSF react to changesin the cohort size and in life expect-ancy, under the Austrian system thefocus is on the discrepancy of effectivefrom projected life expectancy. It iseven quantified by law when measuresmust be taken, namely if �for theperiod starting from the first deviationof the revised average period-linkedlife expectancy at the age of 65 fromthe reference life expectancy laiddown in Appendix 12 of the APG adiscrepancy of more than 3% on aver-age is ascertained by the year 2050�(Article 108e paragraph 9 ASVG).Even though lit f stipulates that ananalogous procedure is to be appliedin case of �other demographic andeconomic assumptions [�], in partic-ular with regard to the factors laborforce participation and productivity�it is nevertheless noteworthy that forthese factors no quantifiable triggerpoints are set forth, and interestinglyenough, the law does not explicitlyrefer to population (and cohort) de-velopment projections, either.

It is in particular important tonote that (unlike the GSF) the ASFdoes not respond to demographicchange as such, but only to deviationsof a projected value from the actualoutcome (or revised forecast). Thereference scenario, however, envi-sages fundamental shifts in both dem-ographic dimensions, namely an in-crease in the reference life expectancy(at age 65) from 18.5 to 21 (2030)and 22.9 (2050) as well as a decrease

in the economically active population(persons aged between 15 and 64)from 5,499,360 to 5,217,195 (2030)and 4,748,987 (2050).21 Should actualdevelopments correspond to thistrend path, the parameters laid downin the APG are set to remain un-changed. In other words, the financ-ing needs arising from the foreseeabledemographic development will haveto be met through higher governmentcontributions to pension payments.This arrangement, however, impliesintergenerational inequities, even forthe trend path of the demographicdevelopment. The exact nature ofthe intergenerational sharing of thisdemographic burden will depend onwhich tool — taxation or debt — is usedto fund the government�s pensiontransfers. The consequences of thisprovision are, however, in any casestraightforward. First, the envisagedadjustment to the demographic devel-opment is limited to the revenue sideand does not translate into any changeon the benefit side (i.e. pension leveland retirement eligibility age remainunchanged), and, second, the fundingsource will increasingly shift fromcontributions to taxes.

The wisdom of such an arrange-ment may be challenged. As will bediscussed in section 3.3.4, an exclu-sively revenue-oriented adjustmentmay lead to an unwanted intergen-erational redistribution, placing themain burden on the younger genera-tions. Increased tax-based funding,by contrast, might lower the degreeof �actuarial fairness,� which is gener-ally regarded as a cornerstone andasset of Bismarckian social securitysystems.22

21 However, the labor force participation rate is assumed to advance from 68.8% to 71.8% (2030) and 75.8%(2050), which would dampen the slide in the active population.

22 See Lindbeck and Persson (2003). Only the redistributive elements of the pension insurance system (e.g. means-tested top-up benefits, substitute contribution periods) should be tax-funded according to this rationale.





3.3.2 The ASF Does Not Includea Mechanism for AutomaticAdjustments

While the GSF reacts even to minimalchanges in the pensioner dependencyratio on a yearly basis, the ASF onlyprovides for measures once a stateddeviation is reached or the pensionreform commission identifies a needfor more funding. This may be tanta-

mount to �phasing in� intergenera-tional injustice, as illustrated by theexample presented in the box �Inter-generational Distribution for Con-tinuous and Abrupt Adjustment toDemographic Changes.� Normally,steady adjustment, as built into theGSF, is preferable to a policy of abruptreform measures.

Intergenerational Distribution for Continuous and

Abrupt Adjustment to Demographic ChangesThe following example is meant to illustrate the divergent consequences ensuing from continuous orabrupt adjustment. Let us assume that the cohort size remains constant, but life expectancy growsby an annual 0.2 years. The reference case rests on the assumption that the pension insurance systeminvariably has a balanced budget, which is exclusively attributable to a continuous increase in theretirement eligibility age. An in-depth discussion of this matter in Knell (2005b) reveals that the eligibilityage has to be raised by an annual 0.15 years (given the target pension years

work years equals 1/3). Such a continualadjustment means that all cohorts have an identical MID of 1

1�0:2 (see chart 2).1

Abrupt adjustment produces a different outcome, though. The underlying assumption in thisscenario is that the eligibility age is changed only if the deficit of the pension system exceeds a specifiedlimit (20%). Any adjustment of the eligibility age is aimed at restoring a balanced budget. Deficits of theyears in between adjustments are funded from general tax receipts. Generations taking retirementduring years of reform measures show a lower MID than those to which an unchanged retirementeligibility age applies regardless of higher life expectancy.1 A steadily rising life expectancy — similar to a growing population — may be regarded as an increase in the �biological interest rate�

(Knell, 2005b), which explains why the MID is greater than 1 for all generations.

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3.3.3 The ASF Provides Only BroadGuidelines on How AdjustmentsAre to Be Made

As cited above, the law stipulates thatany necessary adjustment be spreadevenly among the parameters contri-bution rate, accrual rate, eligibility age,pension adjustment and federal subsidy.Unlike the GSF, for which adjust-ments are distributed according to� = 0.25, the ASF is not based onany explicit weighting. Two questionsarise in this context. First, how canthe requirement of an even distribu-tion be implemented, and, second,under which circumstances is suchan even distribution meaningful ordesirable in the first place? Let us dealwith the first question right away,while we will consider the secondissue in section 3.3.4.

Operationalizing the requirementof distributing the reform measuresevenly among the five parameters isdifficult for at least two reasons. Firstof all and as mentioned in the APGitself, the effects of these parametersmanifest themselves with varying timelags. As a case in point, of the twoparameters that are linked to thepension level the accrual rate impactsthe level of future pension benefits,whereas the pension adjustment affectsthe current pension level.23 Second,the adjustment parameters are meas-ured in different units (e.g. percen-tages against years), which is why theyare not directly comparable. A ten-per-cent increase in contributions (from20% to 22%) cannot automatically becompared with a ten-percent reduc-tion in benefits (with the replacement

rate falling from 60% to 54%) andeven less so into a ten-percent hikeof the retirement eligibility age (from65 to 71.5 years).

To analyze this in more detail, letus draw on a model patterned on theGerman pension insurance systemwith only three adjustment parame-ters.24 Under these conditions, it ispossible to formulate a heuristic andfeasible operationalization of the pos-tulate of an even distribution. To thisend, we first calculate to what extenta given parameter x would have to beadjusted for it to neutralize demogra-phic change, while all other parame-ters remained constant. This �extremevalue� (or �ceteris paribus value�) isdenoted as x�, the original value asx0. The value that must actually bechosen for the parameter x is set viaa linear combination of the initialvalue x0 and the extreme value x�,with �x referring to the relativeweight, i.e. x ¼ �xx� þ ð1� �xÞx0.Even adjustment means that �x is iden-tical for all parameters — contributionrate, pension level and eligibility age(i.e. �x ¼ �; 8x). It can be shown thatunder these conditions the value for �is uniquely determined.

The following simple example ismeant to illustrate how this wouldwork in practice. The initial state ofa pension system is given as a con-tribution rate of 20%, a replacementrate of 60%, life expectancy of80 years and a retirement eligibilityage of 65 years (in addition, workinglife is assumed to commence at theage of 20, which results in a workinglife of 45 years). The cohort size is

23 Here, the Austrian system differs significantly from the German system of earnings points, where — as has alreadybeen mentioned — all pensioners having accumulated a given number of earnings points draw identical pensionbenefits. By extension, a change in the pension value (or the pension level) affects all pensioners in the samefashion irrespective of their age. This is also why the earnings point system has only four adjustment parameters(and does not need to differentiate between the accrual rate and the pension adjustment factor).

24 The federal subsidy is assumed to be constant; in other words, this scenario posits a balanced budget.





assumed to remain constant overtime,25 but life expectancy climbsfrom 80 to 84 years. In line with theproposed definition of evenness, thecontribution rate would have to beraised from 20% to 21.67%, thereplacement rate would have to becut from 60% to 55.37% and work-ing life would have to be extendedfrom 45 to 46 years in order to keepthe pension budget balanced.

3.3.4 Under Which CircumstancesIs an Evenly DistributedAdjustment Meaningful andIntergenerationally Fair?

This question is, of course, complexand multi-facetted, touching on issuesof welfare economics and on questions

of distributive and intergenerationaljustice. For lack of space, in this studywe can only follow through on someof the implied aspects. To neglect thisissue altogether, however, would notbe expedient since the terms �fair-ness� and �intergenerational justice�are perennials in the public debate,even though the underlying ideas arehardly ever conceptualized.

The problems in this context areself-evident given declining or fluctu-ating reproduction rates. The box �In-tergenerational Burden Sharing WhenReproductive Behavior Changes� cen-ters on such a scenario, which is againbased on a model patterned on theGerman system and its GSF.

Intergenerational Burden Sharing When Reproductive

Behavior ChangesIn analogy to section 3.3.3, the initial state of the pension system is again characterized by a contributionrate of 20%, a replacement rate of 60%, life expectancy of 80 years and a retirement eligibility age of65 years. In this scenario, life expectancy is, however, assumed to remain constant, while the populationis non-constant. In particular, a break is assumed to occur in the development of the cohort size at agiven time t = 0, with the cohort size cut by half (e.g. from 100,000 to 50,000). Note that this exampleis by no means intended to be realistic, but rather to highlight the central features of the various adjust-ment methods.

Chart 3 shows the MID development by generation and sustainability factor (at a constant eligibilityage). A value of � = 1 again corresponds to a defined contribution system, � = 0 to a defined benefitsystem and � = 0.5 to a mixture of the two. In each of the three variants, some generations are facedwith a deterioration of the MID, because the reduced cohort size will cause a decrease in the eco-nomically active population, which in turn lowers the sum total of contributions. For the budget ofthe pension system to remain balanced, the contribution rate must be raised and/or the pension levelhas to be reduced. Any one of these adjustment options affects a (different) set of generations. The pathsof the curves will be discussed in the main text.

25 This assumption serves to keep the example simple. The method proposed here is also applicable to variable cohortsizes.





Box 4 on �Intergenerational Bur-den Sharing When ReproductiveBehavior Changes� and chart 3 illus-trate the intergenerational redistribu-tion effect for various sustainabilityfactors, which is triggered by a plungein the cohort size. Even though theexample is stylized and unrealistic,the conclusions are applicable to thegeneral development path of the co-hort size and the birth rate (Knell,2005a). Two observations are particu-larly noteworthy. For one thing, theMID fluctuations between the genera-tions (measured e.g. by the variance)are smallest for a mixture of the de-fined benefit and defined contributionsystems (� = 0.5). For another, theshare in the adjustment burden placedon generations born after the break inpopulation developments (t = 0) isthe lower, the more contribution-ori-ented (high �) the system. This ishighly plausible, since a policy of con-tribution hikes (low �) places thehighest burden on the cohorts born

shortly after the break. If, by contrast,the adjustment involves pension cuts,the older generations (including thosewith birth dates before t = 0) assumea greater share of the burden.

Various criteria can be used toevaluate the relative merits of differ-ent sustainability factors. Three ofthem will be discussed below: (i) evenburden sharing among all generations;(ii) collective burden sharing accord-ing to the �causation principle�; (iii)individual burden sharing accordingto the �causation principle.�

If an even adjustment mechanismis preferable (i.e. one which causesthe smallest MID variation amongthe generations), � should take onan intermediate value (somewherearound � = 0.5).

On the other hand, one might alsorequire those generations to carrythe highest burden which are �respon-sible� for the declining birth rate.In fact, the potential parent genera-tions, i.e. those born between 20 and

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40 years before a given cohort, areaccountable.26 As of generation 0 a fullreproduction rate is again reached,which is why, according to this crite-rion, the generations from —40 to —1should bear the lion�s share of theadjustment burden. One could, natu-rally, also argue that — indirectly — allgenerations that are alive at a givenpoint in time and thus shape the socialand political life are at least partlyresponsible for the prevailing repro-ductive pattern. From this perspec-tive, the adjustment burden (reduc-tion in the MID) should be placedon all generations born before t = 0.In any event it is difficult to justifywhy the generations born at or aftertime t = 0 should be �penalized� fortheir parent generations� reproductivebehavior, as they themselves again ac-count for an equally large number ofbirths (and thus �equilibrium birthrates� of 2).

In the light of these arguments,it would be better to have pensionsystems in place that feature a more�backward looking� intergenerationalburden sharing, i.e. are rather contri-bution-oriented with a largely con-stant contribution rate (high �). Insome cases a sharp slide in the birthrate may well be attributable to ex-treme events (e.g. natural disastersand wars), which then calls for theapplication of a different set of criteria(e.g. levying contributions from allgenerations according to the ability-to-pay principle). At the same time,it should be stressed that here thefocus is on the basic design principlesof pension systems. It became evidentthat a contraction of the birth rate27

results in a demographic extra bur-den, which must be borne by some

generations. Any decision for oragainst a certain setup of the pensionsystem and sustainability factors inevi-tably implies a decision for or againsta certain mode of intergenerationalburden sharing. Therefore, it seemsappropriate to explicitly consider suchcharacteristics when designing a pen-sion system or a sustainability factor.

The example given in box 4 �In-tergenerational Burden Sharing WhenReproductive Behavior Changes� andthe discussion so far have revolvedaround a scenario marked by decreas-ing birth rates and constant life ex-pectancy. Of course, one may alsowonder whether an intergeneration-ally even adjustment is justified inthe reverse case of increasing life ex-pectancy and largely constant cohortsizes. This question largely dependson the projected path of life expect-ancy. If the linear increase, observedfor many decades now, is consideredto be just a one-off process set to dis-continue once a biological maximumage is reached, evenly adjusting thecontribution rate, eligibility age andbenefit parameters may make a lotof sense. Since a rising life expectancyaffects all generations, to identify thedesirable parameter configuration iseventually a collective political deci-sion. At present, it is, however, verydifficult to predict the life expect-ancy development path. Against thisbackdrop, a slow (ideally, continuous,see section 3.3.2) increase of theeligibility age seems to be the mostappropriate and primary adjustmentmeasure. Otherwise, the contributionrate would at some point reach alevel which would prove unsustainableeither from a factual (>100%) oran economic point of view (Knell,

26 In Austria, 93.5% of all female and 87.5% of all male parents fall into this age bracket.27 If not balanced out by migration or in the absence of a sustained increase in the labor force participation rate.





2005b). To summarize, also in thepresence of rising life expectancy thecontribution rate should be increasedonly with care.

Up to now, we have only talkedabout a generation�s collective respon-sibility and collective reproductivebehavior when referring to intergen-erational redistribution in the face ofdeclining birth rates. This generalizingapproach does not account for the factthat behaviors differ greatly at the in-dividual level. For instance, childlessmembers of a cohort contrast withother members who have numerouschildren. A pension system which dis-regards such differences may be con-sidered ill-designed and intergenera-tionally unfair. A pay-as-you-go pen-sion system essentially represents athree-generation model, where theworking generation not only has theobligation to fund the older genera-tion�s pensions with their contribu-tions, but is also responsible for gen-erating offspring and providing forthe livelihood of the next economi-cally active generation. A pension sys-tem should thus reflect not only ageneration�s aggregate, but also itsindividual behavior.

In recent years, Germans heatedlydebated the idea of child-related pen-sions. In this context, some proposedthat only childless persons should beasked to build up the funded pillar.�To receive pension benefits in oldage, one must have accumulated eitherhuman or real capital. A generationhaving failed to do either must gohungry in old age, because nothing

comes from nothing. [�] Instead ofplacing a collective burden on anentire generation, pension cuts [�]should be exclusively directed at thechildless� (Sinn, 2003, p. 362, 390f).It would be in line with both the cau-sation principle and the ability-to-payprinciple to call especially on thechildless members of the society tofund additional pension plans. Howand to what extent the number of chil-dren are factored into the calculationof pension benefits will, of course,depend on a set of other parameters,in particular on the amount of publicexpenditures that are related to child-care and to education. In the mean-time, several economists have cometo speak out in favor of consideringthe number of children in pension cal-culations. Not only did Hans-WernerSinn promote the concept of a child-related pension in his bestseller �IstDeutschland noch zu retten?� (Sinn,2003),28 but also Peter Bofinger�s(2004) antithesis �Wir sind besser alswir glauben� contains a proposal verymuch along these lines.29

With a view to the Austrian pen-sion system, two observations can begleaned from this digression. First,in the light of these considerations,the demand for an even adjustmentshould be weighed carefully. Boththe arguments presented here andin-depth studies by Knell (2005a,2005b) make a case for moving awayfrom the principle of an even distri-bution of the adjustment burden andfor assigning lower weights to contri-bution hikes than to modifications in

28 �The pension for the childless should not be reduced to zero [..] but it seems to be appropriate to cut the averagepension [�] by half. [�] Those affected by cuts must be called upon to invest in a Riester pension to the extentto which the PAYG system can no longer give a guarantee for lack of contributors� (Sinn, 2003, p. 391).

29 �As a generation that produces fewer children, one cannot demand the same pension level as the (post-war)parents of the baby boom generation� (Bofinger, 2004, p. 155). Further down (p. 218) Bofinger additionallyproposes that women should be credited a third of the insurance cover of the pension insurance for each child(up to a total of three children per woman).





the eligibility age and the benefit pa-rameters. Second, it should be notedthat childcare periods are already ac-counted for under Austria�s currentpension system, albeit only indirectlyby treating such periods as contribu-tion periods. In the new system, awoman�s notional account is creditedwith the median female earnings (inaddition to any contributions resultingfrom employment) for each year dedi-cated to child rearing (up to a maxi-mum of four years). Here, it wouldbe interesting to examine whether thismethod does not underestimate thegenuine contribution a child makes tomaintaining the solidity of the PAYGsystem.30 There is strong evidence infavor of more generous childcare-related credits, which are granted,for instance, in Sweden. Under theSwedish system, the parent with thelowest earnings is automatically ac-credited with childcare pension rightsworth four years of contributory serv-ice, with the imputation based on themost favorable of the following threevariants: (i) a supplementary paymentequal to 75% of average earnings of allpersons covered by the pension insur-ance scheme; (ii) a supplementarypayment of up to the person�s ownearnings the year prior to childbirth;(iii) a fixed-amount subsidy. Such sub-sidies are granted irrespective of theearnings record and are designed suchthat they offer reasonable credits foras many typical earnings histories aspossible (Palmer, 2000, p. 16).

4 Summary AssessmentTo summarize, the basic structure ofAustria�s new, harmonized pensionsystem is in many ways a considerable

improvement over its predecessor.Here, some positive aspects whichwe have not yet dealt with in detailin this study deserve to be brieflytouched upon.— The lifelong averaging period in-

creases the degree of intergenera-tional and actuarial fairness. Pre-ferred treatment of shorter work-ing periods and steeper earningsprofiles is eliminated, which alsominimizes potential negative workincentives (Lindbeck and Persson,2003).

— The presence of a pension corri-dor allows persons to choosewhen to retire in line with theirindividual preferences with regardto pension level and working life.Furthermore these decisions willhave an actuarially neutral effectif the deductions and supplementsare chosen appropriately. A pre-requisite for this is, however, thatretirement is truly voluntary andthat the labor market situationdoes not �force� premature retire-ment.

— Previous contributions are reval-ued adequately. The old revalua-tion formula was not only unnec-essarily complex, but also yieldedundesired results in terms of in-ter- and intragenerational fairness(Knell, 2004).

— The harmonization31 not onlyeliminates inequities among vari-ous occupational groups, but alsoboosts intersectoral flexibilityand portability. A transparentdesign of the notional accountmay, by extension, facilitate a har-monization of Europe�s pensionsystems (Holzmann, 2004) and

30 Calculations for Germany are indicative of this (Sinn, 2003, p. 376f; Werding, 1999).31 Apart from the fact that some occupational groups (such as civil servants at the regional and local level) are not

considered.





the incorporation of additionalelements (e.g. life account model;see Orszag and Snower, 2002).In total, all these improvements

could help maintain confidence inthe PAYG system and strengthen itsacceptance as the centerpiece of theprovision of old-age security.

From this perspective, some ele-ments of the new pension systemmust, however, also be evaluated morecritically as they partly conflict withthe principles of simplicity, transpar-ency and sustainability as well as inter-and intragenerational fairness.— On the contribution side, harmo-

nization is incomplete becausefarmers and self-employed per-sons are still subject to contribu-tion rates that are lower than thoseapplied to employees. In theexplanatory notes to the legal actthis is justified by referring tothe �lack of matching partner con-tributions� for the self-employedand to the fact that the risk ofbecoming unemployed or sick isnot cushioned in the same wayas for employees (via substituteperiods). This argumentation is,however, not entirely convincing.Studies on the incidence of socialsecurity contributions usuallyidentify a high degree of pass-through and a negligible impactof the formal division of fundinginto employers� and employees�contributions.32 At any rate, con-sideration should be given to theissue of whether harmonizing thecontribution side would not provefavorable, not least given the sym-bolic importance of such a move,while existing differences between

systems can be balanced out viaother measures.33

— The long parallel-calculation pe-riod and its complicated designare definitely flaws of the new sys-tem. Only in about 40 years� timewill the first pension exclusivelycomputed according to APG rulesbe paid out. In the near future,pension calculations will thereforebe governed by the rather com-plex and opaque transitional pro-visions, which basically under-mines the increased transparencyand determinability of the newnotional account system.34

— As spelled out in this study, thecurrent provisions on the sustaina-bility factor are grossly imprecise.While it is, on the one hand,understandable that the 45-65-80formula is meant to provide a con-sensual anchor for the new sys-tem, it would, on the other hand,also be important to clarify — inparticular with a view to facilitat-ing calculations and planning —how this formula would be modi-fied in the face of demographicchange. The following aspects ofthe sustainability provision areconsidered to be problematic.First, the sustainability factor re-acts only to deviations from pro-jected values and not to demo-graphic movements as such and itis, above all, geared toward lifeexpectancy developments. Sec-ond, there is no automatic adjust-ment, which — already at thedesign level — produces inter-generational inequities. Third, thepostulate of an even adjustmentis not spelled out in detail. Fourth,

32 �Invariance of Incidence Proposition.� See Gruber (1997) and Ooghe et al. (2003).33 See Mayrhuber and Url (2004).34 For an interesting proposal on how to remedy this (by also showing the claims as accrued according to the old

system), see Stefanits et al. (2004), p. 436.





it is doubtful whether evenness is adesired feature in the first placebecause a contribution-based ad-justment makes future generationspay for their parents� reproductivebehavior. And last, but not least,there is the controversial proposalto place more weight on the num-ber of children in calculating pen-sion benefits.A host of important aspects had

to be disregarded in this study. A casein point is the question whether ad-justing existing pensions for the infla-tion rate — as currently envisaged — is

the optimal approach (Knell, 2004).Furthermore, this study did not ex-amine whether the level of the deduc-tions and supplements applicable tothe pension corridor are appropriateand along which lines an adequateoccupation-specific individualizationof the pension system (e.g. provisionfor heavy workers) should be con-structed. These issues as well as theaspects covered in this study deservefurther investigation to help guaranteethat the PAYG system continues toplay a pivotal role in Austria�s pensionscheme.

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Bo‹rsch-Supan, A. 2003. What are NDC Pension Systems? What Do They Bring to Reform Strategies?

MEA Discussion Paper 42.

Bo‹rsch-Supan, A. and C. B. Wilke. 2003. The German Public Pension System: How It Was, How It

Will Be. Mannheim Institute for the Economics of Aging (MEA). Discussion Paper 34.

Bo‹rsch-Supan, A., A. Reil-Held and C. B. Wilke. 2003. How to Make a Defined Benefit System Sus-

tainable: The Sustainability Factor in the German Benefit Indexation Formula. MEA Discussion Paper 37.

Disney, R. 1999. Notional Account-Based Pension Reform Strategies: An Evaluation. University of Not-

tingham and The World Bank.

Disney, R. 2004. Pensions and Employment. In: Economic Policy 39. 267—311.

Fenge, R. and M. Werding. 2003. Ageing and Fiscal Imbalances across Generations: Concepts of

Measurement. CESifo Working Paper 842.

Geanakoplos, J., O. S. Mitchell and S. P. Zeldes. 1999. Social Security Money�s Worth. In: O. S.

Mitchell, R. J. Myers und H. Young (eds.). Prospects for Social Security Reform. University of Pennsyl-

vania Press. 79—151.

Holzmann, R. 2004. Toward a Reformed and Coordinated Pension System in Europe: Rationale and

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Gruber, J. 1997. The Incidence of Payroll Taxation: Evidence from Chile. In: Journal of Labor Economics

15(3). 72—101.

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In: Monetary Policy & the Economy 2. OeNB. 55—71.

Knell, M. 2005a. On the Design of Sustainable and Fair PAYG Pension Systems When Cohort Sizes

Change. OeNB Working Paper 95.

Knell, M. 2005b. High Age — No Kids. Demographic Adjustment Factors for Sustainable PAYG Pension

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Lindbeck, A. and M. Persson. 2003. The Gains from Pension Reform. In: Journal of Economic Literature

41. 72—112.

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paper.





Ooghe, E., E. Schokkaert and J. Flechet. 2003. The Incidence of Social Security Contributions: An

Empirical Analysis. In: Empirica 30(2). 81—106.

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This paper analyzes the efficiency of research and development activities in Austria in comparison withother countries. Public and private R&D spending, which has been increasing steadily for years, isevaluated against a set of performance indicators, such as the number of scientific publications andpatents. The efficiency of Austria�s R&D system is currently rated �average.� This may change in thefuture, given that productivity growth in the Austrian economy is declining despite the continually risingresearch and development ratio. In his conclusions, the author presents suggestions for increasing theefficiency of the system, particularly in the areas of university education and research, in the light ofthe strong interaction with the corporate sector.

Studies on research and develop-ment (R&D) systems often presentinput data separately from outputdata (e.g. comparison of R&D ratiosor of the number of patents). Thispaper thus aims to compare bothinput and performance indicators ofAustria�s R&D/innovation system,which makes it possible to draw con-clusions about the efficiency of thesystem. The first chapter describesR&D expenditure in Austria, whichis then correlated with various outputindicators in the second chapter. Thethird chapter proposes suggestionsfor increasing the efficiency of theR&D system.

In general, statistics on the inputand output of a research systemshould be interpreted cautiously sincethey are subject to significant meas-urement uncertainties, which are fur-ther aggravated in data comparisons atan international or aggregate level, asis the case in this paper. For explana-tions and the general qualifications ofthe data, see, for instance, the Euro-stat Internet database or the relevantOECD publications (e.g. 2003). Atthe time of writing, OECD and Euro-stat were comparing and reconcilingtheir R&D statistics, which will hope-fully lead to improvements, or at leastto a more standardized presentation ofthe data. The situation in Austria is

exacerbated by the five-year intervalof R&D surveys; shorter intervalswould be more effective in terms ofinnovation system management andcontrol.

1 R&D Expenditure(Input Indicators)

1.1 Austria�s R&D Ratio above EU-15Average following Catching-upProcess

In 2003, for the first time since 1998,an R&D census in reference to 2002was carried out among Austrian com-panies, which resulted in a significantupward revision in the estimated R&Dratio (Scholtze, 2004). According tothat census, the R&D ratio for theyear 2003 was 2.19%, and a ratio of2.27% was projected for 2004,1

which means that Austria exceededthe 2002 EU-15 average of 1.99%.Previously, the Austrian R&D ratiohad been slightly below the Europeanaverage. The increase in the AustrianR&D ratio from 1.47% in 1993 to2.27% in 2004 represents one of themost dynamic growth rates amongthe EU-15.

A comparison of present R&Dlevels shows that Austria has nowcaught up with France, while Sweden,Finland and Germany are still wellahead of Austria (chart 1). Reachingthe Lisbon and Barcelona targets of

1 Statistics Austria does not disclose the methods used in the global estimation of R&D expenditure. As a result ofcensuses, both the 1998 and 2003 figures on estimated R&D expenditure were revised considerably. This givessome cause for doubt concerning the quality of the annual global estimates.

Ju‹rgen Janger

Refereed byGernot Hutschenreiter,OECD.


The Research and Development Systemin Austria — Input and Output Indicators

a 3% R&D/GDP ratio will thereforerequire considerable effort (for modelcalculations, see e.g. Schibany andStreicher, 2003, or Hutschenreiter etal., 2001).

1.2 R&D Expenditure by SectorCorporate funding accounts for64.7% of the total R&D expenditurein Austria, which is slightly abovethe EU-15 average of 63.7% but stillbelow the Lisbon target of two-thirdsof total R&D investment. At around22%, the share of foreign funding inAustrian R&D expenditure ranksamong the highest in the world, asshown in chart 1. Only Canada, theUnited Kingdom and Greece postsimilar levels.2 In other words, Austriahas become an international researchlocation, as confirmed by the datapresented in chart 2 (O‹ FTB 2004,chapter 3).

This development, however, alsoimplies a certain degree of vulnera-bility in Austria�s R&D activity, espe-cially since most of the foreign-fundedR&D activities are concentrated ina small circle of major subsidiariesof multinational corporations (e.g. Sie-mens, Infineon, Magna Steyr). Thewithdrawal of only a few of the R&Ddepartments of such corporationswould severely reduce R&D expendi-ture. As a result of an increase in thelevel of the Austrian R&D tax credit,the general conditions for researchactivities have certainly not deterio-rated.3 According to Schibany et al.(2004), there is no significant trendtoward a migration of R&D activities;nevertheless the general conditions forresearch activities must be enhancedfurther, especially by maintaining andimproving the quality of the nationalscience system as a key determinant

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The Research and Development System

in Austria — Input and Output Indicators

of Austria�s attractiveness as a researchsite (Schibany et al., 2004).

The fact that Austria�s corporateR&D expenditure is clearly below theEU average is attributable to structuralfactors rather than a lack of competi-tiveness or of understanding of theimportance of innovation and research.Austria shows a comparatively higherdegree of specialization in less R&D-intensive sectors (Peneder, 2003).

2 R&D Productivity —Output Indicatorsin Relation toR&D Expenditure

The output of R&D activities is moredifficult to measure than their input.A number of R&D activities do notresult in publications or patents, butrather in tacit knowledge, which maybe as important for the national econ-omy. Furthermore, even output evi-denced in writing, e.g. publicationsor patents, may differ widely as to its

scientific and economic impact. Aggre-gated presentations should thereforealways be interpreted with caution.

2.1 Productivity of the PublicResearch System Close to EU-15Average, Below the U.S.A.

Direct output from universities andother public institutions can best bemeasured by publications. Judged bythe number of publications per mil-lion population in relation to R&Dexpenditure, the productivity of pub-lic research institutions and the uni-versity sector in Austria is slightlybelow average. The trend line shownin chart 3 is a simple linear regres-sion line across the country data.Countries with an above-averagenumber of publications relative toR&D expenditure are situated abovethe regression line.4

To factor in the quality or impactof publications, the Relative CitationIndex (RCI) can be used as a measure

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4 The information value of this indicator is reduced by the varying intensity of publication activity in differentscientific disciplines and by divergent national scientific specializations. In addition, R&D expenditure especiallyin the U.S.A. is underestimated (OECD, 2003).




of R&D productivity. The RCI is thecitation rate for national publications(the average frequency of citation ofAustrian publications by other, non-Austrian publications) relative to theshare of national publications in totalpublications. An index greater than1.00 would imply, for example, thatAustrian publications were cited morefrequently than indicated by theirshare in total publications. Austriascores in the average range for indus-trialized nations. It must be noted,however, that the Science Citation In-dex (SCI) mostly covers English-lan-guage publications and is thereforebiased toward English-speaking as wellas smaller countries that do not sharea common language with other coun-tries (e.g. the Scandinavian countries).According to Leeuwen et al. (2001),

the scientific output of Germany andFrance, as measured by the SCI, isunderrated by as much as 10%.5 Inrelation to R&D expenditure, theperformance of the public scientificresearch system in Austria is slightlyabove average.6 The leader in Europeis Switzerland, whose citation indexeven outranks that of the U.S.A. bya substantial margin (chart 4).

Comparing changes, rather thanlevels, is, however, more significant.Austria managed to catch up in the1990s; the improvement in the coun-try�s citation index exceeded the aver-age impact of increased R&D expen-diture (chart 5). Since the mid-1990s,however, the citation index has risenonly slightly or, in the wake of a rapidcatching-up process, has remained flat(Dachs et al., 2003).

5 Not only because the SCI might not take into account non-English language publications, but also because suchpublications are cited less frequently — a fact that does not depend on scientific quality but simply on the researchcommunity�s language proficiency.

6 In this case, the RCI is presented unweighted, i.e. the fact that citation rates vary by scientific disciplines andthat scientific specializations vary across countries is not taken into account.

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2.2 Productivity of CorporateInnovation Efforts Close to EU-15Average

Based on the findings of the Commun-ity Innovation Survey (CIS II and III),the direct research output in relationto R&D funding of Austrian compa-nies can be analyzed and comparedacross EU countries (Falk and Leo,2004). It should be noted, however,that this survey used the more broadlydefined term �innovation,� which alsoincludes, for example, minor improve-ments in existing products. Accordingto the CIS, Austria�s innovation ratioranks fifth within the EU: 43% ofthe Austrian companies included inthe survey stated that they hadlaunched innovations in the past threeyears. At 54%, Germany takes thelead, followed by Belgium, Luxem-bourg and Portugal. In terms of inno-vation output, i.e. the proportion ofinnovations relative to total sales,Austria came in third at 21%, behindGermany (37%) and Finland (27%).As Austria�s corporate innovationexpenditure is in the average range,a positive picture of the �innovationproductivity� in Austrian companiesemerges. The R&D and innovationactivities of foreign subsidiaries inAustria are more productive, how-ever, due to various advantages ofcompanies that have the resources tooperate internationally (Bellak andPfaffermayr, 2002).

2.3 Patent Activity of PublicInstitutions and Private FirmsClose to EU-15 Average

In an EU-15 comparison, the numberof inventions patented by Austrianinstitutions per million population isaverage in terms of filings with the

United States Patent and TrademarkOffice (USPTO) and slightly aboveaverage for filings with the EuropeanPatent Office (EPO), as shown intable 1. The growth rate of the num-ber of applications filed with bothpatent offices is below average.7 Geo-graphical proximity has a relativelystrong effect on the number of filingswith national and regional patentoffices: U.S. inventors submit morepatent applications to the USPTOthan to the EPO, while EU inventorssimilarly tend to favor the EPO.Triadic patents, i.e. patents registeredat all three major patent offices(EPO, USPTO and the JapanesePatent Office), suggest a particularlystrong market potential warrantingthe higher expenditures on applicationfees. In this category, Austria isslightly below average but showssomewhat higher growth rates. GivenAustria�s above-average GDP, thenumber of patents relative to GDPwould be below average in all threecategories.

In this context, it is also importantto take into account the varying de-grees of �patent intensity� in differenteconomic sectors. In some industries,filing large numbers of patents is moreimportant than in others (e.g. thepharmaceutical industry versus theelectronics industry). Empirical evi-dence also indicates that a company�ssize correlates positively with its pro-pensity to file patents (Scholz andSchmalholz, 1984). Another contrib-utory factor is that new products areeasier to patent than new processes.In all three aspects, Austria�s eco-nomic structure has a limiting effecton patent intensity: a low percentageof technology-intensive sectors, a lim-

7 For an analysis of the information value of patent statistics, see e.g. Dachs and Schibany, 2003, and OECD,2001.




ited number of large companies and afocus on process innovation lead to astructurally lower number of patents.8

In relation to R&D expenditure,the innovation productivity of Aus-trian companies is below the EU-15average (table 2). The relatively small

proportion of U.S.-owned triadicpatents and U.S. patents registeredwith the EPO is particularly signifi-cant. The American domestic marketobviously offers sufficient marketingopportunities to make research effortsprofitable. The EU�s improvement is

8 Moreover, the propensity to file patents is positively correlated with GDP growth (Dachs and Schibany, 2003).The sluggish economy between 2001 and 2004 could therefore result in the U.S.A. outperforming the EU.

Table 1

European, U.S. and Triadic Patents (TP)

per million population, growth rate (GR) in %

EPO 2000 GR1991—2000

USPTO2001

GR1992—2001

TP 2000 GR1991—2000

Switzerland 365 5.2 U.S.A. 307 5.9 Switzerland 105 �0.1Germany 262 7.1 Japan 262 4.7 Finland 95 12.8Finland 261 13.6 Switzerland 198 1.8 Japan 93 2.9Sweden 251 9.9 Sweden 196 11.9 Sweden 91 8.1Netherlands 210 9.2 Finland 143 8.4 Germany 70 4.8Denmark 166 9.9 Germany 137 4.9 Netherlands 54 4.0Japan 161 6.0 Canada 116 6.9 U.S.A. 53 3.1Austria 144 6.1 Denmark 91 10.8 Denmark 48 9.9EU-15 131 6.7 Netherlands 83 4.9 EU-15 36 4.3Belgium 121 8.2 Austria 72 5.2 Belgium 35 4.4France 118 3.8 EU-15 72 5.4 France 35 1.6U.S.A. 104 4.6 Belgium 72 9.5 Austria 34 4.9U.K. 97 5.4 France 69 3.3 U.K. 31 3.9Italy 68 5.9 U.K. 66 5.7 Canada 17 6.2Ireland 52 12.3 Ireland 37 11.8 Italy 13 1.5Canada 50 10.8 Italy 30 3.5 Ireland 12 5.1

Source: OECD patent database, Eurostat.

Patent statistics: breakdown by inventor�s country of residence; European Patent Office (EPO): by date of application; U.S. Patent and Trademark Office (USPTO): by date of grant; triadicpatents (TP): by date of application.

Table 2

Number of Patents Relative to Corporate R&D Expenditure from 1992 to 2000

EPO USPTO Triadic Patents

1992—1996 1997—2000 1992—1996 1997—2000 1992—1996 1997—2000

Netherlands 0.57 0.75 Japan 0.56 0.62 Netherlands 0.23 0.23Germany 0.55 0.73 U.S.A. 0.62 0.61 Finland 0.26 0.22Finland 0.59 0.60 Finland 0.54 0.45 Germany 0.19 0.22Italy 0.41 0.60 Germany 0.38 0.44 Japan 0.18 0.20EU-15 0.41 0.54 Netherlands 0.38 0.38 Sweden 0.17 0.17Austria 0.54 0.54 Denmark 0.36 0.34 EU-15 0.15 0.16Denmark 0.45 0.49 EU-15 0.30 0.34 Denmark 0.16 0.16France 0.34 0.44 Sweden 0.33 0.33 France 0.12 0.14Sweden 0.36 0.41 Italy 0.24 0.31 Austria 0.15 0.14Belgium 0.34 0.41 Austria 0.33 0.30 Belgium 0.14 0.13U.K. 0.28 0.38 U.K. 0.25 0.29 U.K. 0.11 0.13Japan 0.24 0.29 France 0.24 0.27 Italy 0.10 0.13Ireland 0.19 0.26 Belgium 0.27 0.25 U.S.A. 0.10 0.10Spain 0.17 0.24 Ireland 0.19 0.22 Ireland 0.06 0.07U.S.A. 0.17 0.18 Spain 0.10 0.11 Spain 0.04 0.04

Source: OECD patent database, Eurostat.

R&D expenditure by economic sector ; constant prices based on 1995 data by purchasing power standard.




attributable to subdued R&D expen-diture growth coupled with averagegrowth in the number of patents; thedecline in Austria — especially in theperiod between 1997 and 2000 — wascaused by a sharp increase in R&Dexpenditure in the business sector.

2.4 Indirect Output — A New Paradox?Indirect output can be described asthe contribution of R&D activities toeconomic and productivity growth.It should therefore be considered themost important indicator of a researchsystem�s productivity.

At the aggregate level, R&D andinnovation activities, along with theaccumulation of human capital, aregenerally recognized to be the mostimportant engines of economicgrowth (Temple, 1999). Empiricalgrowth literature reports that R&Dactivities result in a total economicreturn of more than 50% (Jones andWilliams,1998). In the medium term,the 0.3 percentage point increase inthe R&D ratio from an average of1.85% between 1995 and 1999 to anaverage of 2.14% between 2000 and2004 would thus entail an increaseof 0.15 percentage point in the long-term growth rate.

As demonstrated by Coe andHelpman (1995), international R&Dspillovers are especially importantfor small, open economies. Accordingto their estimates, Austria�s totalfactor productivity (TFP) is highlyresponsive to the development ofGermany�s R&D capital stock. In thesame period as indicated above forAustria, the German R&D ratio rosefrom 2.31% to 2.51%. In this con-text, it must be taken into account

that a country�s R&D activities notonly increase productivity through in-novations, but are also an essentialprerequisite for absorbing interna-tional research findings in the firstplace (Griffith et al., 2004a). In addi-tion, corporate R&D expenditure in-fluences productivity growth moredirectly than university R&D expen-diture, since companies tend to con-centrate on applied research whileuniversities primarily engage in basicresearch. According to these studies,the increase in national and inter-national R&D expenditure can beexpected to boost productivity growthin Austria.

At the national level, however,there are no findings on whetherAustria�s R&D activities lead to com-paratively more or less productivitygrowth than those of other countries.9

The combination of low R&D ratiosand high productivity growth rates inAustria was dubbed a �structure-per-formance paradox� (Peneder, 2001)in the past. At least, this did not indi-cate a low-efficiency research system.A new paradox — not so much in com-parison with other countries, butrather in comparison with the empiri-cal findings mentioned above — wouldbe presented by the opposite situa-tion, i.e. a sustained decline in pro-ductivity growth combined with asteadily rising R&D ratio (chart 6).In Austria, total factor productivity —a measure of efficiency that is signifi-cantly influenced by R&D activities —is dropping rather sharply.10

Given that TFP is very difficult tocalculate and that short-term move-ments in TFP growth are not particu-larly significant, it would be advisable

9 A study by Pottelsberghe (1998), although not related to Austria, concludes that the total economic return fromR&D expenditure in Japan is much higher than in the U.S.A.

10 For an overview of the empirically confirmed determinants of total factor productivity, see Gnan, Janger andScharler (2004).




to wait and see how the trend evolvesover the next few years before makinga final assessment. In addition, struc-tural TFP determinants such as R&Dexpenditure have a delayed effect,even though the R&D ratio has beenuptrending rather clearly for morethan ten years. If this trend continues

and is confirmed by new figures,the question arises of whether theadditional research funding is beingused inefficiently or whether thedeterioration in productivity growthis the result of contrary developmentsaffecting other TFP determinants.11

3 Means to Improve theProductivity of the R&DSystem

In terms of patent activity, the pro-ductivity of Austria�s R&D system isequivalent to that of the U.S.A. andlags behind that of the EU-15. In thefield of scientific publications, theU.S.A. and Switzerland set the stand-ards for the quality of the scientificresearch system as measured by thecitation count; Austria scores in theaverage range within the EU-15.12

As regards innovations, there is nosurvey in the U.S.A. comparable with

the Community Innovation Survey;benchmarked against the rest ofEurope, Austria ranks above average.Assessing the relative impact of R&Dactivities on productivity growth,i.e. indirect output, will require a lon-ger observation period and in-depthstudies. All in all, the productivity ofthe Austrian research system — orrather innovation system — may becharacterized as �average.�

So what are the possible startingpoints to enhance the efficiency ofthe system, i.e. where can we findpotential for quality improvements?

11 See Pottelsberghe (1998, p. 234): �. . . although R&D activities seem to be a necessary (but not sufficient)condition for productivity growth, they might be a sufficient condition against a productivity deterioration.�

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12 It should be noted that these figures do not, or only to a very limited extent, reflect the impact of the 2002university reform and the Dienstrechtsgesetz (Employment Act) of 2001. As has already been pointed out,the disadvantage of German as a publication language should not be underestimated.




In the following sections, we willaddress government-funded research,corporate R&D, and university re-search and education.

In the past, criticism was leveledagainst the Austrian system of re-search promotion because of theexcessive number of underfundedprograms and the resulting highadministrative costs, which were outof proportion to the net value ofthe funds distributed (Aiginger andKramer, 2003). This situation, whichis partially caused by the division oftechnology policy responsibilitiesamong several different ministries,has improved significantly followingthe creation of the Austrian ResearchPromotion Agency (FFG), which isdedicated to business R&D promo-tion. It now remains to be seenwhether or not the new structureswill prove effective.

In Austria (Austrian Science Fund,FFF), as in the U.S.A. (NationalScience Foundation), the system ofpromoting research for scientific oruniversity projects is based on thepeer review principle, i.e. the assess-ment of research quality by scientistsof equivalent standing. At the EUlevel, the distribution of funds by theR&D Framework Programmes is notyet subject to such strict evaluationcriteria. A corresponding reorganiza-tion of structures and procedures(the report by Sapir et al., 2003, callsfor a European Agency for Scienceand Research) might also provide apositive impetus for Austria.

To determine the optimal mix ofhigher education and governmentresearch and research institutes, theCouncil for Research and Technologi-cal Development currently pursues a

strategy of promoting the governmentsector. According to the estimation ofGuellec and Pottelsberghe (2004),however, research performed by thehigher education sector has a higherimpact on productivity — a phenom-enon which may be attributable to anumber of causes, for instance, thedifferent funding systems employed(global funding versus project fund-ing). More in-depth studies are neces-sary to validate this interpretation.

The research productivity of com-panies domiciled in Austria can bedescribed as average because of therelatively sharp hike in R&D expendi-ture and the above-mentioned struc-tural disadvantages of the Austrianeconomy. As has already been dis-cussed elsewhere in this paper, theR&D performance of foreign sub-sidiaries is higher, owing to the advan-tages inherent in major companies.Technology and economic policy islimited, therefore, to a small set ofdirect measures; instead, an effort canbe made to optimize the conditionsnecessary to strengthen corporatetechnology absorption capacities.13

Considering that reforms in theresearch promotion system havealready been implemented and thatcorporate research productivity isdifficult to influence directly, reor-ganization efforts should focus onthe potential for change in tertiaryeducation and university research,which strongly interact with corpo-rate research productivity in a numberof ways.

First, analyses of the CommunityInnovation Surveys (Falk and Leo,2004) show that companies with ahigher percentage of university-edu-cated employees initiate product or

13 To quote Griffith et al. (2004b, p. 56): �The best policy towards spreading technology is more likely to be improvingthe environment for firms through better skills and greater competition rather than in an R&D policy per se.�




process innovations more frequently,not least because such employeesremain in contact with their formerschools or can easily get back in touch,which in turn facilitates the transfer ofknowledge between science and indus-try. A company�s own research activi-ties become more productive becausethey entail lower search costs.

The capacity of Austrian compa-nies for technological absorption andinnovation could soon peak out be-cause of the relatively small numberof tertiary-level graduates with sci-ence and technology degrees. Accord-ing to Eurostat, in 2003, there wereonly 8.3 graduates with science andtechnology degrees per 1,000 popula-tion between 20 and 29 years of agein Austria, versus an EU-15 average(in 2001) of 11.9 (U.S.A.: 10.9).14

By contrast, graduates with scienceand technology degrees account for alarge share of total graduates, whichmeans that the low figure of 8.3 re-sults from the small number of totalgraduates (OECD, 2004b). Accord-ingly, the cause of the problem seemsnot to be a lack of enthusiasm for sci-ence and technology, but rather thestructurally small number of univer-sity graduates overall. In Austria, thenumber of women graduating fromsuch fields is particularly low (3.5 ver-sus an EU-15 average of 7.3).

Second, the quality of the scien-tific research system is a basic factor

influencing a company�s choice oflocation for its R&D activities (seealso chapter 1). Knowledge transferbetween research institutes, universi-ties and companies is favored by geo-graphical proximity (local R&D spill-overs, see Keller, 2002).15 Researchby Schibany et al. (2004) shows thataccording to multinational corpora-tions specific advantages in certainscientific disciplines in Austria arenot the reason for choosing Austriaas a location for sizable subsidiarieswith a high degree of R&D activities.As the integration of foreign R&Dactivities into the Austrian innovationsystem works relatively well (Schibanyet al., 2004), improvements in thequality of the scientific research sys-tem can be expected to stimulatethe entire national economy.16 Thepromotion of new generations ofscientists and the accumulation ofknowledge attracts more companies,which in turn boosts productivitygrowth and employment. Structuralchange toward more technology-intensive sectors is accelerated bythe formation of new technology-ori-ented companies, and the potentialfor starting up such companies is like-wise increased by improvements inthe system of tertiary education andresearch.17

So what are the possible startingpoints to improve university educa-tion and research?

14 The EU average would be reached if the graduates of secondary technical and vocational colleges (HTLs) weretaken into account.

15 Jaffe (1989, p. 968) summarizes the results of his estimates as follows: �. . . it appears that university researchcauses industry R&D and not vice versa. Thus, a state that improves its university research system will increaselocal innovation both by attracting industrial R&D and augmenting its productivity.� Acs et al. (1992) confirmhis findings.

16 To facilitate the transfer of knowledge between industry and universities, the Uni:Invent program was establishedlast year. Experts referred to as �innovation scouts� assist universities in optimally utilizing patenting and licens-ing potentials.

17 See, for example, the study by Zucker et al. (1998), which describes the relationship between scientists, the prox-imity to universities and startups (limited, however, to the biotechnology sector, which is known to be closelyrelated to science).




Scheibelhofer (2003) investigatesthe motivation of Austrian scientistsnow working in the U.S.A. In thecourse of her qualitative interviewswith the respondents it becameapparent that the working conditionsat U.S. universities constituted amajor reason for the scientists� deci-sion to emigrate, with an emphasison employment law and the broadresearch latitude (as confirmed byAllmendinger and Eickmeier, 2003).Another decisive factor was the lackof basic research in Austria, whilesalary levels or the reputation ofAmerican universities played only asecondary role. One reason that thesescientists do not return to Austriais that the qualifications they haveacquired in the U.S.A. are often insuf-ficiently recognized in Austria.

Universities in the U.S.A. offerresearchers a long-term career planthrough the tenure track system: aftera probationary period of several years,there is the possibility of obtaining afixed contract if the candidate meetsthe eligibility criteria. Research andteaching continue to be evaluatedeven after tenure is granted. Thereare no such prospects of a researchcareer at Austrian universities. Theposition of an assistant professorin the U.S.A. differs considerablyfrom that of a Universita‹tsassistent inAustria; in the U.S.A., there is sig-nificantly more leeway to developone�s own research program. Thedepartment head acts only in thecapacity of a coordinator or facilitator,which means that (research) hierar-chies are flatter. The Austrian Univer-sita‹tsgesetz (University Act) of 2002and the Dienstrechtsgesetz (Employ-

ment Act) of 2001 contain no suchtenure provisions. The collectiveagreements currently under negotia-tion may offer an opportunity forimprovement for academic personnel(Pechar, 2004).

Other studies (Allmendinger andEickmeier, 2003; Mayr, 2003) focus-ing on Germany stress the importanceof structured (postgraduate) educa-tion for scientific research. In Austria,it is left to the individual school to de-cide what kind of support doctoralstudents should get or whether theyshould be employed in other activi-ties. Establishing graduate schools orstructured, more directive doctoralprograms could be an important steptoward improving the quality of futuregenerations of scientists.

Based on the figures mentionedabove, one way to increase the num-ber of graduates from scientific andtechnological programs could be toexpand the total number of universitygraduates (i.e. by making systemicchanges that would encourage takingadvantage of the tertiary educationsystem), while at the same time in-creasing the number of female stu-dents in scientific and technologicaldisciplines. Both approaches requiremore in-depth studies and evaluationsof existing promotional projects.18

Schneeberger (2004) addresses theneed for expanding and diversifyingthe choice of accelerated degree pro-grams, which would reduce universitydrop-out rates and at the same timeeffectively prepare students for thejob market. Another alternative wouldbe to expand the range of institution-alized options for working studentsat universities, as offered in other

18 See, for example, Leuthold (2000) for an investigation of the possible strategies for motivating women to take upscientific and technological subjects and an overview of the existing measures for promoting female development.The Austrian Report on Research and Technology (O‹FTB) for 2005 will also address the issue of women inscience and technology.




countries. It might also prove effectiveto think about ways to improve thepercentage of students qualifying foruniversity entrance, which is rela-tively low in Austria (36%) as com-pared to other countries (e.g. Sweden:71%).

Finally, in the light of its interna-tional success, it seems advisable toexamine the functional structures ofthe Swiss university research systemin greater detail. Austria�s researchinstitutions are probably more closelyaligned with the Swiss structures andprocedures than with the U.S. system.

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The goal of this study is to identify factors which can explain the substantial appreciation of theEUR/USD exchange rate in the period from 2002 to 2003. Our analysis has shown that both funda-mental and nonfundamental factors seem to have played a role. Regarding fundamental factors, anaccommodating U.S. monetary policy in light of a weak labor market as well as the rising U.S. currentaccount deficit contributed to weakening the U.S. dollar and thus strengthening the euro. The Bank ofJapan�s large intervention purchases of U.S. dollars, which have been widely considered important in theeconomic policy debate, do not appear to have had a significant impact on the EUR/USD exchange rate;however, they seem to have weakened the Japanese yen both vis-a‘-vis the U.S. dollar and the euro. Inaddition to these factors, the accounting scandals in the U.S. stock markets as well as fears of war andterrorism had a dampening effect on market sentiment, thus adding to the strain on the U.S. dollar.Measurement problems render it difficult to assess the role of euro area monetary policy and of Euro-pean economic data. With a view to nonfundamental factors, we discuss the role of the trend-followingbehavior of agents in the foreign exchange market on the basis of a technical foreign exchange tradingsystem used in practice. The buy and sell recommendations of such systems may also help explain theappreciation of the euro in the period in question. All in all, these fundamental and nonfundamentalfactors may explain the direction to which the EUR/USD exchange rate moved, but not the extent ofthis movement or the relative significance of these factors in determining the EUR/USD exchange ratein the period in question.

1 IntroductionThe EUR/USD exchange rate is oneof the most important relative pricesin the global economy and in theglobal monetary system. Fluctuationsof this rate have an effect on the com-petitiveness and purchasing power aswell as on the value of accumulatedassets of internationally diversifiedinvestors. Under the current regimeof flexible exchange rates, theUSD/EUR exchange rate fluctuatesfreely and is therefore determinedby demand and supply in the foreignexchange market.

The EUR/USD exchange rate hasbeen fluctuating considerably since thebeginning of Economic and MonetaryUnion (EMU) in early 1999. Thus,the euro went down by around 26%against the U.S. dollar in the periodup to the fourth quarter of 2000,which eventually led to coordinatedinterventions of the G-7 central banksand to unilateral interventions of theEurosystem in the EUR/USD market.

This case study focuses on theperiod from early 2002 to end-2003,when the euro fully regained its lossesvis-a‘-vis the U.S. dollar und appreci-ated up to a value of USD 1.26, whichcorresponds to a nominal appreciationof some 36%. By historical standards,this has been the second sharpest ex-change rate increase over a two-yearperiod since 1970.1 This movementsurprised many observers, since afterthe global downturn in 2001 the econ-omy had been recovering notablyfaster in the U.S.A. than in theEU-12 and productivity growth inthe U.S.A. continued to clearly sur-pass EU-12 figures.

This study aims to identify factorsthat influenced the EUR/USD marketin 2002 and 2003 and which maytherefore serve to explain at leastthe direction of these exchange ratemovements. A differentiation is madebetween fundamental and nonfunda-mental factors that determine theexchange rate.

1 The sharpest EUR/USD (synthetic) exchange rate increase occurred between 1985 and 1987.

Hannes Haushofer,Gabriel Moser,Franz Schardax,Renate Unger

Refereed byMichael Ehrmann, ECB.


Fundamental and Nonfundamental Factorsin the Euro/U.S. Dollar Market

in 2002 and 2003

Chapter 2 examines the role offundamentals such as the monetarypolicy of the Federal Reserve System(Fed), the Bank of Japan�s interven-tions in the USD/JPY market as wellas macroeconomic data in the U.S.A.and the EU-12. Furthermore, it pro-vides an overview of important one-time events and other general factorsmarket participants deemed signifi-cant in the period under review.

Chapter 3 examines nonfunda-mental factors, which exclusively re-sult from market-inherent dynamics,using a concrete example of a techni-cal foreign exchange trading system.

2 Fundamental FactorsIt is a particular challenge to empiri-cally illustrate the correlation betweenexchange rates and economic funda-mentals such as economic growth,productivity, inflation rates, the cur-rent account or monetary and fiscalpolicy measures. In their frequentlyquoted paper, Meese and Rogoff(1983) find that fundamental varia-bles, which are considered relevantby simple macroeconomic theories

on exchange rate determination, usu-ally cannot explain exchange ratemovements. Another example thatshows how difficult it is to explainexchange rate movements is therepeated rejection of the theory ofuncovered interest parity in empiricalstudies (Froot and Thaler, 1990).Only fairly recent works, e.g. Chinnand Meridith (2002), find an em-pirical correlation between exchangerates and long-term interest rateswhich is consistent with uncoveredinterest parity.

In the past few years, however, anew kind of literature has emergedwhich makes use of a new, moremarket-based approach and has founda number of interesting empiricalcorrelations between fundamentalsand exchange rates. Before presentingthis approach, we provide a simplemacroeconomic theoretical modelthat explains the role demand andsupply play in the foreign exchangemarket when it comes to exchangerate determination (see box �A SimpleModel of Exchange Rate Determina-tion�).

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in 2002 and 2003

A Simple Model of Exchange Rate Determination

How do fundamental factors determine nominal exchange rates? Our rationale is based on a simplemacroeconomic textbook model of an open economy according to Mankiw (2004). This model focuseson the money, credit and foreign exchange markets. Important macroeconomic factors influencingthe nominal exchange rate are domestic and foreign interest rate and employment levels (reflectingdifferences in business cycles) in the short run and domestic and foreign price levels in the long run.In the short run, the central bank is capable of controlling the interest rate level vis-a‘-vis other countriesby changing the money supply or the money market interest rate. The �Money Market� chart showsthat, for example, an expansion of money supply creates a money supply surplus versus money demand.With interest rates still on a high level, this surplus reflects higher opportunity costs for holding money. Inthis situation, economic agents tend to shift their financial assets out of money balances to less liquid,higher-yielding financial instruments. Banks and security issuers respond to the higher demand forhigher-yielding financial instruments by reducing interest rates. This, in turn, gives rise to an increaseddemand for holding money in the nonbank sector, because the holding of (non-interest bearing) moneybalances becomes less costly again. This process lasts until a new, lower equilibrium interest rate isestablished in the money market. The �Credit Market� chart, which explains how interest rate move-ments influence saving and investment decisions, shows that a decrease in interest rate causes ashort-term increase in the employment level by pushing up consumption (which means savings go down)and investment. The higher employment level also corresponds to a business cycle acceleration vis-a‘-visother countries, which triggers a virtuous circle of imports; as a result, net exports decline.1 Dependingon the starting point, this either causes a decline in the current account surplus or a rise in the currentaccount deficit.

The following chart shows how the above-mentioned interest rate reduction directly affects creditmarket behavior and indirectly affects foreign exchange market behavior. Credit market: A lower interestrate first leads to a decline in savings deposits and thus in credit supply. Savings that were used to provideloans go down, as their yields fall. Given the higher interest rates abroad, savers rather opt for transferingpart of their funds abroad; as a consequence, net capital outflows rise. Furthermore, the demand forloans to finance domestic investment goes up. The employment level rises, resulting in the above-men-tioned virtuous circle of imports. Net exports decline.1 In the short term, it is not relevant to differentiate between nominal and real interest and/or exchange rates, as price levels adjust only

very slowly. In the long run, however, price levels developments do have an effect. Therefore, from a long-term perspective, the effect ofmonetary policy has to be assessed differently: The domestic price level rises in comparison to that of foreign countries. The moneysupply curve moves back to its original position. The impact on the interest rate level is neutralized, i.e. in the long run, monetary policyhas no effect on interest rates.

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This brief illustration already defines the two principal determinants of the exchange rate. Thesupply of domestic currency in the foreign exchange market corresponds to the net capital outflow, whichincreases after a domestic interest rate cut. This capital outflow is part of the domestic currency savingsused for foreign portfolio investment and direct investment and is thus supplied for exchange into foreigncurrency. At first this supply does not depend on the exchange rate but on the interest rate (i.e. on theinterest rate differential vis-a‘-vis the foreign economy). If the net capital outflow increases, the exchangerate for the domestic currency will go down.

The second determinant for the exchange rate is the demand for domestic currency in the foreignexchange market, i.e. the domestic money foreign entities need to finance net exports. Net exports haveto be financed in domestic currency. In exchange for domestic currency, foreign investors supply foreigncurrency; in other words: they demand the currency of the export country.

In this example, therefore, the exchange rate drops for two reasons: first, because higher net capitaloutflows raise the supply of domestic currency on the foreign exchange market (the supply curve shiftsto the right) and second, because a stronger virtuous circle of imports causes a decline in net exports.This, in turn, corresponds to a lower demand for domestic currency on the foreign exchange market.

A method which has increasinglybeen used — especially over the pastfew years — to empirically illustratethe correlation between fundamentaldata and financial market prices isthe event study approach.2 It investi-gates the response of the exchange

rate to an event the market partici-pants did not anticipate (the so-calledsurprise event). In this context, sur-veys among market participants orfutures prices may be used as indica-tors for expectations regarding possi-ble events. The following univariate

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2 As alternatives to an empirical description of the correlation between exchange rates and economic fundamentals,structural macroeconomic models or structural VaR models can be used. VaR models are often used to describe theempirical correlation between monetary policy and exchange rates (Faust and Rogers, 2003).




in 2002 and 2003

linear regression is then used to esti-mate the reaction of the exchangerate:

�yt ¼ �þ �xt þ "t:�yt indicates the percentage

change of the EUR/USD exchangerate in a narrow observation windowaround the time market participantslearn about the surprise event xt.Many event studies estimate the cor-relation with daily data, which allowfor a 24-hour observation interval.More recent works increasingly useintraday data with observation inter-vals of around 30 minutes. Dependingon the type of event, this study usesboth daily data and intraday data.The parameter �, estimated by apply-ing the ordinary least squares (OLS)method, measures the reaction ofthe exchange rate.3 The error term"t represents other factors which de-termine the price but do not correlatewith the exogenous variables.

Furthermore, this equation is alsoestimated for interest rates in themoney and capital markets, whichenables the determination of thesimultaneous reaction of interest andexchange rates to an event. By meas-uring these simultaneous reactionswe arrive at a more accurate pictureof the way in which financial marketparticipants interpret an event and,consequently, which exchange ratedetermination model they use for ori-entation (Hardouvelis, 1988). Faustet al. (2003) also emphasize this roleof interpretation and/or the subjec-tive element contained in marketreactions. Event studies measure notonly the correlation between an eventand the subsequent price changes, butalso the way in which financial marketagents interpret an event.

The selection of events for thisanalysis was based on the literature,which quotes a number of macroeco-nomic data releases as well as themonetary policy of the U.S. Fed asrelevant factors for the EUR/USDexchange rate. With regard to macro-economic data releases, this studyfocuses mainly on the role of employ-ment figures (nonfarm payrolls) andthe U.S. trade balance (as an indicatorfor the current account). The limitedfocus on these factors was chosen,among other things, because marketparticipants deemed them particularlysignificant for the period under review.In addition, this study investigates thesignificance of a number of Europeandata releases. Another factor whichwas considered relevant especially byEuropean economic policy makerswas the exchange rate policy of anumber of Asian countries. Giventhe limited availability of interventiondata, this study only analyzes inter-ventions by the Bank of Japan (BoJ)on the USD/JPY market which mayhave had an indirect influence onthe EUR/USD exchange rate in theperiod under observation. The tablein the annex shows the events andthe observation interval used tomeasure the exchange and interestrate changes.

2.1 The Monetary Policy of theFederal Reserve System

To investigate the market reaction tothe Fed�s interest rate moves we applyKuttner�s (2001) approach to meas-uring the surprise component of achange in the Fed�s monetary instru-ment, the Fed funds target. Thisapproach uses federal funds futuresto determine the expectations of

3 If only the event is regressed on the exchange rate and its surprise component is not, this leads to an attenuationbias in estimating the coefficient and subsequently to an underestimation of the impact of the event.




in 2002 and 2003

changes in the Fed funds target. It usesthe unanticipated change or mainte-nance of the Fed funds target on daysof Federal Open Market Committee(FOMC) meetings, computed byGu‹rkaynak et al. (2004), as an exoge-nous variable.4 The estimate includesthe reaction of both the EUR/USD

exchange rate and the U.S. and euroarea yield curves in the period afterthe start of Monetary Union in1999. A Chow test is carried out todetermine the structural stability ofcorrelations for the period from2002 to 2003, which is of particularinterest for this study.

Table 1 shows that the Fed�s inter-est rate moves have a significant simul-taneous effect on the EUR/USD ex-change rate and on interest rates inthe U.S.A. and the euro area. In orderto illustrate this assertion we discussthe relevant case of an interest ratecut in the period from 2002 to 2003.

If the Fed cuts interest rates by100 basis points, the EUR/USDexchange rate goes up 3.1% accord-ing to this estimate, i.e. the euroappreciates. At 1.6%, Ehrmann andFrantzscher (2004) find a less strongreaction of the EUR/USD exchangerate.5

The Fed�s interest rate cut causesU.S. interest rates to drop across theentire maturity spectrum, with theeffect on the money market, whereinterest rates fall by 94 basis points,being clearly stronger than at the longend of the bond market, where ratesdecline by a mere 19 basis points.The response of yields of inflation-protected bonds suggests that in theU.S.A. both nominal and real interestrates reacted to the Fed�s rate cut.

Furthermore, the effect spills overto interest rates in the euro area,causing them to drop as well. Theextent to which euro area interest

4 The interest rate cut of January 3, 2001, which started the cycle of interest rate cuts in 2001, was removed fromthe sample because it is an observation atypical of the period in question, as U.S. bond markets responded to thiskey interest rate cut with rising nominal interest rates and real yields and inflation risk premiums. If thisobservation is taken into account, the effect on the exchange rate is weaker, but still significant.

Table 1

Reaction of the EUR/USD Exchange Rate and U.S. and Euro Area

Interest Rates to an Unanticipated 100 Basis-Point Change in theFed Funds Target from 1999 to 2003

Reaction Standard deviation R^2 Chow test

U.S.A. EU-12 U.S.A. EU-12 U.S.A. EU-12 U.S.A. EU-12

Basis points

3 months 94.1** 20.8** 6.5 5.2 0.82 0.26 0.84 0.532 years 41.2** 26.7** 10.7 11.5 0.20 0.12 0.78 0.3310 years 18.7** 18.2 8.8 15.8 0.06 0.08 0.46 0.05Real yield 18.2** 4.9 5.3 10.5 0.13 0.02 0.89 0.01

%

EUR/USD �3.10** 0.84 0.13 0.92

Source: OeNB.

** indicates significance at the 5% level. R^2 indicates the coefficient of determination. The columns for the Chow testindicate the p-value of the null hypothesis of structural stability. The real yield is the yield on inflation-indexed governmentbonds with a residual maturity of 10 years.

5 The result of Ehrmann and Fratzscher�s (2004) estimate for the period from January 1993 to February 2003falls within the 95% confidence interval of this estimate.




in 2002 and 2003

rates react does not seem to dependon maturities; therefore, the yieldcurve reaction in the euro area maybe described as a downward parallelshift. The effect at the long end(10 years), however, is significant nei-ther for nominal nor for real interestrates.

All in all, these estimates suggestthat a relaxation of monetary policyin the U.S.A. ceteris paribus causesshort- and long-term nominal and realinterest rates in the U.S.A. to dropfaster than those in the EU-12, withthis effect being most obvious in themoney market. The structural stabil-ity test of the correlation shows thatthe Fed�s monetary policy affectedthe EUR/USD exchange rate and theinterest rates in the years 2002 to2003 as well.

Within the scope of our simplemodel, this effect of monetary policycan be interpreted as triggering achange in investment incentives forinternational investors, thus causingnet capital flows, which in turn leadto a change in the exchange rate.

These estimates serve to prove thesimultaneous effects of the Fed�s mon-etary policy measures (i.e. decisionsto change the Fed funds target or tokeep it unchanged) on exchange ratesand interest rates. Fatum and Scholnik(2003), however, have shown thatrevised expectations of future mone-tary policy measures also influencethe EUR/USD exchange rate. Suchrevisions can be triggered by the re-lease of certain new economic datainforming the financial markets aboutthe current state and the expectedfuture developments of the U.S. econ-omy. As the Fed reacts to economicdevelopments in its monetary policydecisions, such data releases act asleading indicators for future monetarypolicy decisions. This, however, is not

necessarily true for all economic data.Some economic data may have aneffect on the exchange rate withoutat the same time causing a change inthe expectations of future monetarypolicy decisions.

2.2 U.S. Macroeconomic Data:Labor Market and CurrentAccount Deficit

From the literature on the correla-tion of unanticipated releases of U.S.macroeconomic indicators and onthe EUR/USD exchange rate, a num-ber of systematic correlations havebeen documented. In this context,the U.S. dollar is strengthened by bet-ter-than-expected economic data suchas for industrial output, retail trade,orders for durable goods and con-sumer confidence but also by better-than-expected labor market statisticsand U.S. trade balance data. Interest-ingly, unexpectedly high, or low,U.S. inflation rates often have nosignificant impact on the EUR/USDexchange rate (Faust et al., 2003,and Andersen et al., 2002).

In general, such estimates presup-pose that the structural relationshipbetween certain economic data andthe exchange rate remain constantover time. This assumption, however,is not justified in all instances. In a sur-vey among foreign exchange tradersCheung and Chin (1999) found thatthe relevance of specific economicdata for the market may change con-siderably over time, i.e. that economicdata that drive the market at one pointmay be irrelevant at a different pointin time. As the markets� focus iscontinuously shifting between variousaspects of the set of economic data,the obvious course of action is tonarrow any detailed analysis down tothe effect of those macroeconomicindicators that are considered particu-




in 2002 and 2003

larly important in the market debatein the period under observation. In2003 in particular, these were newdata on the U.S. labor market and cur-rent account.

In the following, we estimate thecorrelation between nonfarm payrolls(as the prime indicator for the U.S.

labor market situation) and the U.S.balance of trade (as an indicator forthe current account) on the one handand the EUR/USD exchange rate andU.S. and euro area yield curves on theother hand (sample period: 2002 to2003). Table 2 shows the results ofthis estimation:6

To illustrate the results pertainingto the reaction to U.S. employmentdata we use the case of an unexpect-edly low number of newly createdjobs, or an unexpectedly strong de-cline in jobs, respectively, which wasrelevant in the observation period. Itbecomes evident that such negativenews about the U.S. labor marketweakens the U.S. dollar while at thesame time driving up the price ofmoney market papers and bonds, withthe impact on the bond market beingstronger. As there is an inverse rela-tionship between prices and interestrates, this means that bad news fromthe U.S. labor market drives downinterest rates in the U.S.A. Spillovereffects then cause interest rates in

the euro area to drop as well, but lessthan in the U.S.A. (the effect on theeuro money market is insignificant).As a result, the relative prices ofU.S. bonds, or money market papers,respectively, go up, thus causing U.S.interest rates to decline more sharply.These results are in line with those inFaust et al. (2003).

The reaction in U.S. money andbond markets can be interpreted asa �policy anticipation effect.� Themarkets are aware of the Fed�s mone-tary policy reaction function, wherechanges in the employment level playa prominent role because of theirimportance for price stability andsustainable economic growth. Conse-quently, a worse-than-expected labor

6 Other than in the sections dealing with the Fed�s monetary policy, the euro area economic data and the Bank ofJapan�s exchange rate policy, in this section we use the price change of front-end foreign exchange or interest ratefutures contracts as an endogenous variable. These data are available in intraday frequency, which allows fornarrower observation intervals and thus more precise estimates.

Table 2

Reaction of Prices in the Money, Bond and Foreign Exchange Markets to

Unanticipated U.S. Employment and Trade Balance Data from 2002 to 2003%

Reaction Standard deviation R^2

U.S.A. EU-12 U.S.A. EU-12 U.S.A. EU-12

Employment3 months �0.0128** �0.0034 0.0029 0.0021 0.24 0.092 years �0.0487** �0.0181** 0.0205 0.0078 0.30 0.215 years �0.1190** �0.0411** 0.0503 0.0200 0.30 0.18EUR/USD �0.132** 0.0553 0.34

Trade balance3 months �0.0011 0.0001 0.0017 0.0028 0.01 0.002 years �0.0067 0.0065 0.0080 0.0077 0.03 0.035 years �0.0268 0.0145 0.0201 0.0209 0.04 0.02EUR/USD �0.0786* 0.0441 0.12

Source: OeNB.

* and ** indicate significance at the 10% and 5% level. R^2 indicates the coefficient of determination.




in 2002 and 2003

market report leads to a revision ofexpectations of future monetary pol-icy; i.e. key interest rates are ex-pected to fall or remain unchangedfor longer than previously expected.

Expectations regarding the Fed�sfuture monetary policy played an im-portant role especially in the secondhalf of 2003, as the Fed signaled dur-ing that period that, given the risk ofan undesired further decline in infla-

tion, it would keep its key interestrates low �for a considerable period.�This move aimed to counter this riskand, at the same time, close the out-put gap more quickly. Anderson andThornton (2004) assume that this�unconventional policy� was respon-sible for the decline in long-termreal interest rates in this period (seechart 2).7

The estimates of the effects ofnegative labor market data and ofthe Fed�s monetary policy suggest thatthese two factors together contributedto a decrease in short- and long-termreal interest rates in the U.S.A. Thesimple model of exchange rate deter-mination presented in this studyshowed that ceteris paribus thisdecline of interest rates leads toincreased net capital outflows and

subsequently to a weaker exchangerate.

The second factor we investigatedmore closely was the U.S. currentaccount deficit. Market debates haveregularly pointed out that the existingdeficit reflects an imbalance that canonly be evened out if U.S. importsgo down or exports go up. This, inturn, requires a weaker U.S. dollaras a prerequisite. The estimates indi-

7 Measured by the break-even inflation rates computed from inflation-indexed bonds, inflation expectations in theU.S.A. also went up (more strongly than in the euro area), which generally also indicates a weaker U.S. dollar.

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cate that in fact, in the period in ques-tion the U.S. dollar regularly reactedto unexpectedly high deficits in theU.S. trade balance by depreciatingagainst the euro (see table 2). Table 3shows the bilateral trade balances asthe most important subaccount ofthe current account balance.

In the period from 2002 to 2003,the U.S. trade balance deterioratedboth vis-a‘-vis the euro area and Japan(as well as against many other coun-tries, including China), with theabsolute increase of USD 9.6 billionand USD 4.6 billion, respectively, atan annualized basis being relativelysmall.8 Based on the model describedin the box �A Simple Model ofExchange Rate Determination,� thechange in the U.S. net trade balancecan be interpreted as additional de-mand for foreign goods, which resultsin additional demand for foreign cur-rency by U.S. residents. This, in turn,weakens the U.S. dollar. According tothis model, in such a case there shouldbe no simultaneous reaction of U.S.interest rates — an assumption whichis in line with our estimates.

In this context, it is important tonote that this study measures the mar-ket reaction to the release of newtrade balance data rather than thereaction of the exchange rate to the

trade balance and/or the subsequentdemand for foreign currency. Usinga theoretical model, Bachetta andVan Wincoop (2004) demonstratethat markets use fundamentals thatare not directly observable and whichshow large imbalances as a �scapegoat�for exchange rate movements, whichmeans that not only the effect of thefundamentals themselves, but alsotheir subjective perception by the eco-nomic agents has an impact on themarket.

By way of a summary, two funda-mental factors are identified as beingresponsible for the weak U.S. dollar:the supportive U.S. monetary policyin conjunction with slow employmentgrowth, and the high current accountdeficit, which triggers market con-cern. These two factors are comple-mentary when explaining exchangerate developments by using funda-mentals. Depending on the perspec-tive, in the period under review theU.S. current account deficit waseither too high or U.S. interest rateswere too low for the U.S. dollar tobe more stable. These results, how-ever, do not allow for a relative orabsolute weighting of these two fac-tors when it comes to explaining theexchange rate changes in the periodunder observation.

Table 3

Bilateral Trade Balances of the EU-12, Japan and the U.S.A.

USD billion

U.S.A./EU-12 U.S.A./Japan EU-12/Japan

2002 2003 2002 2003 2002 2003

�13.1 �17.9 �35.4 �37.7 �12.9 �17.7

Source: Eurostat, IMF (Directions of trade).Values for 2002 and 2003 are the total of Q4 01 and Q1 02 data, and of Q4 03 and Q1 04 data, respectively.

8 The U.S. net investment position (foreign claims against the U.S.A. less U.S. claims against the rest of the world)came to USD —2,430 billion or some 24% of GDP at purchasing power parities in 2003.




in 2002 and 2003

2.3 Monetary Policy andMacroeconomic Data Releasesin the Euro Area

In sections 2.1 and 2.2 we used theevent study approach to analyze spe-cific fundamental factors in the U.S.A.which are relevant for price dynamics.The effects we found may help explainthe direction of exchange rate changesand are consistent with those of thesimple model of exchange rate deter-mination we introduced. Basically,this empirical approach may also beused to measure market reactions tomonetary policy measures and to therelease of macroeconomic data in theeuro area, which would also helpdemonstrate the significance of euroarea factors in determining theEUR/USD exchange rate. However,a number of measurement problemsexist in this context.

Up to now, relatively few empiri-cal studies have been available forthe euro area. Galati and Ho (2001)and Ehrmann and Fratzscher (2004)find that individual economic datafrom the euro area or from Germany(with the exception of the ifo businessclimate index) exert no significantinfluence on the EUR/USD exchangerate. These results are in line with thewidely shared view in the foreignexchange market that the release ofindividual economic data from theU.S.A. plays a much more substantialrole than that of euro area data. Table4 shows the results of the estimatesregarding the effects of certain macro-economic data from the euro area(inflation rates of consumer and pro-ducer prices), from France (INSEEbusiness climate) from Germany (ifobusiness climate index).

These results confirm earlier stud-ies, in part, as well as the marketopinion, which says that Europeaneconomic data, as a rule, have no sig-nificant influence on the exchangerate. The ifo business climate index,which other studies estimate as beingsignificant, could not be estimated asbeing significant in the present study.A possible explanation for the minorsignificance of European economicdata for the foreign exchange marketmay be the fact that they are releasedlater than U.S. economic data. Since alot of U.S. economic data act as lead-

ing indicators for European economicdata, agents in the foreign exchangemarket might increasingly turn to U.S.figures for guidance, which wouldreduce the news value and thus theexchange rate relevance of Europeaneconomic data.

Concerning the monetary policyof the European Central Bank (ECB),one option would be to proceed alongthe lines of the analysis presented insection 2.2, i.e. by measuring theeffects of unanticipated interest ratemoves on U.S. and euro area interestrates as well as on the EUR/USD

Table 4

Reaction of the EUR/USD Exchange Rate to Unanticipated Euro Area

Economic Data from 2002 to 2003%


HICP (EU-12) 0.1371 0.0877 0.02PPI (EU-12) 0.4509 0.4996 0.08INSEE-BC 0.0424 0.0986 0.01ifo index �0.2857 0.1874 0.04

Source: OeNB.

* and ** indicate significance at the 10% and 5% level. R^2 indicates the coefficient of determination.




in 2002 and 2003

exchange rate. However, in the periodfrom 2002 to 2003, markets for themost part anticipated the monetarypolicy decisions of the GoverningCouncil of the ECB, i.e. they antici-pated whether the Governing Councilwould change the main refinancingrate or leave it unchanged. Therefore,within the scope of this study it is notpossible to determine unanticipatedmonetary policy events and to assignthem to a specific point in time. Con-sequently, this analysis of the relativelyshort period from 2002 to 2003,which focuses on the event studyapproach, cannot make any statementon the effects of the ECB�s monetarypolicy on the EUR/USD exchangerate.

Ehrmann and Fratzscher (2004)estimate the correlation between theUSD/DEM exchange rate (andEUR/USD exchange rate, respec-tively) and interest rate moves of theDeutsche Bundesbank and the ECBin the period from 1993 to February2003 and find that interest rate hikeshave a nonsignificant, positive effecton the exchange rate, i.e. higher keyinterest rates of the Deutsche Bundes-bank or the ECB strengthened theDeutsche mark (and the euro, respec-tively) against the U.S. dollar.

2.4 Interventions by the Bank of JapanThe large-scale purchases of U.S. dol-lars in the course of interventions onthe foreign exchange market by anumber of Asian central banks wereanother possible determinant for the

external value of the euro that wasdiscussed by in particular by Europeaneconomic policy makers (see e.g. theinterview with W. Duisenberg, Han-delsblatt, September 22, 2003).

In this context, the unilateral inter-ventions by the Bank of Japan (BoJ)stood out in particular. On behalf ofthe Japanese Ministry of Finance, theBoJ sold a total amount of aroundJPY 24,000 billion for U.S. dollarsin the period under review.9 Interven-tions on the foreign exchange market,inter alia, have been recommended asan effective instrument to combatdeflation in Japan against the back-ground of a zero-interest environmenton the money market (Coenen andWieland, 2004).10 Given the availabil-ity of intervention data at a daily fre-quency, the effects of these interven-tions on the USD/JPY and theEUR/JPY exchange rates — and thuson the EUR/USD exchange rate —can be estimated using the event studyapproach (Ito, 2002). Table 5 presentsthe results of a regression of BoJ inter-ventions on the three exchange ratesas well as on bond yields in Japanand the U.S.A.

As table 5 shows, the sale of JPY1,000 billion for U.S. dollars causesa depreciation of the Japanese yenagainst the U.S. dollar and the euroby 0.84% and 0.75%, respectively.The estimate of the effect on theUSD/JPY exchange rate confirmsSpiegel�s (2003) assessment that theinterventions successfully counteredan appreciation of the Japanese yen

9 In the period from 2002 to 2003, neither the Eurosystem nor the Fed intervened on the foreign exchange marketby purchasing or selling foreign exchange. However, there were a number of statements, most notably by indi-vidual members of the Governing Council of the ECB, that had an effect on the markets. Fratzscher (2004)provides an econometric analysis of such �verbal interventions.�

10 The accumulation of reserves by the Chinese central bank was also a relevant factor. A higher preference for U.S.dollar-denominated reserves, prompted by the Asian crisis, seems to have been one of the factors to play a role forthe other Asian central banks (Aizenman and Marion, 2002).




in 2002 and 2003

against the U.S. dollar (�leaningagainst the wind�).11 Bond yields inJapan did not react to the interven-tions.

A crucial finding with regard tothe main focus of this study is the factthat the BoJ intervention purchases ofU.S. dollars hardly supported the U.S.dollar against the euro, if at all. Themeasured effect has the right sign

but is not significant, which meansthat the interventions do not seemto have had a substantial influence onthe EUR/USD exchange rate. Thisfact may be attributable to the depthand/or elasticity of U.S. money andbond markets (Bernanke, 2004). Theresults for U.S. bond yields, whichdid not react to the interventions,suggest the same.

One-Time Events and Market Sentiment

Regardless of the factors analyzed so far, such as monetary policy decisions or the release of the latesteconomic indicators, there are other factors which are more difficult to quantify and less easily explicablein economic terms and which may also influence the foreign exchange market at least in the short term.These are one-time events that may drive the market. The political arena provides most of the examplesfor such events, which include elections or military conflicts. In addition, foreign exchange traders feelthat the market is also driven by a wide range of general economic expectations and by less specificassessments and moods, the so-called market sentiment. These general assessments often create thebackdrop for events analyzed in sections 2.1 and 2.4. To shed some light on these background charac-teristics as well as on certain relevant one-time events, we evaluated a number of sources which reflectthe full spectrum of foreign exchange market activities in real time. For this purpose, reports of variousinvestment banks were used which provide a comprehensive picture of those factors that were partic-ularly important for the market in certain periods.

In 2001, the market increasingly began to doubt in the sustainability of the New Economy inthe U.S.A. The value of the U.S. dollar clearly dropped not only against the euro but also against anumber of other important currencies. In the second half of the 1990s, high productivity growth andthe expectations of higher profitability and better earnings prospects in the U.S.A. were considered

11 The effect on the USD/JPY exchange rate is very close to Ito�s estimate for the period from 1995 to 2001 andslightly stronger than the effects Castren (2004) found for the period from 1999 to 2003 for the JPY/USD,JPY/EUR and USD/EUR exchange rates. As endogenous variables, Castren uses the first four moments of therisk-neutral density derived from foreign currency options. In general, the effects of interventions might tend to bestronger because the market reaction to interventions rather than to the surprise component of interventions isestimated.

Table 5

Reaction of Exchange Rates and Bond Yields to U.S. Dollar Purchases

within the Scope of BoJ Interventions to the Amount of JPY 1,000 Billionfrom 2002 to 2003


%EUR/USD �0.09 0.26 0.00EUR/JPY 0.75** 0.23 0.09USD/JPY 0.84** 0.15 0.25

U.S.A. Japan U.S.A. Japan U.S.A. Japan

Basis points2 years 0.1 �0.8 3.1 0.5 0.00 0.035 years �0.1 �1.0 4.4 1.3 0.00 0.0010 years 0.5 �1.9 3.5 1.7 0.00 0.01

Source: OeNB.

** indicates significance at the 5% level. R^2 is the coefficient of determination.




in 2002 and 2003

major pillars for the expansion of investment activities and the extraordinarily bullish stock markets. Ac-cording to market estimates, this positive environment caused foreign capital inflows and thus raised thevalue of the U.S. dollar. In the course of 2001, the U.S. investment boom started to stagnate, corporateprofits declined considerably and the economy slowed down. The terrorist attacks on the World TradeCenter as well as the bankruptcy of the U.S. energy corporation Enron increased investors� risk aversion,causing them to resort to lower-risk assets.

In early 2002, markets were particularly focusing on the investigations of U.S. supervisory author-ities into further cases of accounting irregularities in U.S. corporations. After the telecommunicationscompany WorldCom had filed for bankruptcy and numerous other bankruptcies and accounting scan-dals had occurred in the U.S. telecom industry, many shareholders and investors suffered considerablelosses. Investors increasingly lost confidence, uncertainty grew; and for the first time in two years the U.S.dollar tested parity with the euro, which markets considered an important barrier. In spite of soundeconomic prospects in the U.S.A., the U.S. dollar failed to recover.

Another political factor which increasingly became the center of market participants� attention wasthe ever clearer indication that a military conflict in Iraq was looming. In November 2002, the UNadopted a resolution to send weapon inspectors to Iraq, and in December it was reported that therewas �solid� information that Iraq had weapons of mass destruction. In that period, the EUR/USDexchange rate climbed to 1.05.

In late 2002/early 2003, the war with Iraq became the markets� dominant issue. In the weeks priorto the release of the first preliminary report of the UN weapons inspectors on January 27, 2003, thevalue of the euro climbed by the day and reached a three-year high of 1.09, as the situation becamemore aggravated. U.S. military action influenced the mood in the financial markets throughout the periodfrom March 20 to May 2, 2003.

Statements by U.S. Secretary of the Treasury John Snow, who succeeded Robert Rubin in January2003, also stirred up the foreign exchange market. He had announced to the public that the market wasto decide on the exchange rate level. A weak U.S. dollar was favorable for exports and thus also for theeconomy, he said. By the end of May 2003, the exchange rate of the U.S. dollar dropped to approxi-mately 1.20 against the euro. Accordingly, the announced continuation of the strong dollar policy becameless and less credible.

A factor that kept coming up in the discussion was the risk of new terrorist attacks in the wake ofSeptember 11, 2001. This risk was considered negative for the U.S. dollar, as negative repercussions onthe U.S. economy were to be expected.

In the second half of 2003, the market focus shifted to international imbalances, and in particularto the U.S. current account deficit. In this context, markets considered the G-7 statement on the impor-tance of exchange rate flexibility as a signal for a further decline of the U.S. dollar. Until the end of thefourth quarter 2003, the euro continued to strengthen and reached levels above 1.25.

When evaluating the various documents describing market opinion and market sentiment, it isremarkable that information about the euro area or about individual euro area countries was of verylimited significance. For example, developments in connection with the Stability and Growth Pact hardlyplayed a role in the markets in the period under observation. By contrast, the general perception wasrather that the European economy was merely following the lead of the U.S. economy, and that thereforeinformation on U.S. developments was more significant.

3 NonfundamentalFactors

In addition to the fundamental factorsidentified in chapter 2, evidence sug-gests that other factors which are re-lated more closely to market dynamicsmay also influence the EUR/USD ex-change rate. The majority of exchange

rate changes, for example, occur atpoints in time when there are noobservable market events. The coeffi-cients of determination of the regres-sions presented in chapter 2 also sug-gest that, next to fundamentals, thereare other factors that come into play.Ehrmann and Fratzscher (2004) find




in 2002 and 2003

that fundamentals may be used to ex-plain the direction of a change of theEUR/USD exchange rate, but not itsextent.

An alternative approach to ex-plaining exchange rate fluctuations isto look at the role of market partici-pants who use so-called technical trad-ing and trend-following systems.12 Inthe 1970s and 1980s, economics liter-ature widely agreed (Fama, 1970) thatfinancial markets (und thus also for-eign exchange markets) were efficientand that price developments followeda random walk. Therefore, analyzingthe history of a financial time serieswould not provide any useful informa-tion on future developments. For thisreason, the use of technical tradingsystems — when taking transactioncosts properly into account — wouldnot able to generate profits and weretherefore useless. In the early 1990s,however, empirical studies raised sus-tained doubts about this conclusion.Brock et al. (1992) found that tradingstrategies that followed relativelysimple rules generated profits whichexceeded those of a buy and holdstrategy.

From the theoretical literatureon nonfundamental exchange ratedeterminants, two approaches shouldbe mentioned in particular, namelythe microstructure approach (Lyons,2001) and the dynamic equilibriumapproach (Brock and Hommes, 1997)with heterogeneous foreign exchangemarket participants.

The first approach explains short-term exchange rate developmentsmainly by analyzing the way partici-pants in the foreign exchange marketaggregate information. Osler (2001)found that foreign exchange limit

orders concentrated around certainpoints (points of support or pointsof resistance), which reinforcedongoing exchange rate movements.De Grauwe and Grimaldi�s (2004)provide an example for the secondapproach. They define a dynamicequilibrium model with a group offoreign exchange traders acting onthe basis of fundamentals and a secondgroup acting on the basis of technicaltrading systems. Depending on theirsuccess (as measured by the generatedrisk-adjusted trading profits), the twogroups� share in the foreign exchangemarket changes. The success of thetechnically oriented traders attractsmore traders who work along theaccording to this pattern, which re-sults in the reinforcement of existingtrends in the foreign exchange mar-kets. In this model, however, the�chartists� never completely dominatethe exchange rate developments.Outside the tolerance band for thefundamental exchange rate, which de-pends on the transaction costs in theinternational commodity markets,�fundamentalists� prevail. Further-more, the growing number of techni-cally oriented traders leads to higherexchange rate volatility, which — viaa risk-adjustment of trading profits —limits the number of new �chartists.�

De Grauwe and Grimaldi�s (2004)model arrives at a number of state-ments which seem to apply to the an-alyzed currency pair (EUR/USD) inthe period from 2002 to 2003: First,the model presupposes that the vola-tility of the exchange rate increasesas the volatility of the fundamentalsdeclines. Although, as demonstratedabove, the development of fundamen-tals may help explain a stronger euro,

12 This study examines the role of automated foreign exchange trading systems. The classic technical analysis (chartanalysis) operates on the same principle: the price history is used to produce a forecast.




in 2002 and 2003

a 36% change of the nominal EUR/USD exchange rate in the periodunder review seems very difficult tocomprehend, given the high stabilityof the two economies (U.S.A. andEU-12) concerned.

Second, technically oriented trad-ers play a major role in this modelif the exchange rate fluctuates arounda fundamentally justified value withina tolerance band determined by trans-action costs in commodity markets.Conversely, the importance of funda-mentally oriented traders increases ifthe exchange rate is outside the limitsof the tolerance band: The trend of theEUR/USD exchange rate reversed in2001—02, when the exchange rateclearly deviated from the purchasingpower parity (PPP) of 1.1113 com-puted by the OECD (2004), and whenthe G-7 central banks (and the Euro-system, respectively) — in view of anexchange rate level of around 0.85EUR/USD in 2001 — signaled thatthe euro was undervalued by perform-ing coordinated and unilateral foreignexchange market interventions. Ac-cordingly, the ensuing exchange ratedevelopment in 2002 could be inter-preted as the euro approaching itsequilibrium exchange rate, where, ac-cording to De Grauwe and Grimaldi�s(2004) model, the technically ori-ented traders were supposed to playa major role. The results of this anal-ysis do not clearly say whether, at arate of 1.26, the valuation of the euroexceeded the transaction cost band atthe end of 2003. If we assume, how-ever, that the exchange rate is based

on purchasing power parity as a funda-mentally justified value, it should benoted that the upward deviation ofthe EUR/USD exchange rate fromthe PPP exchange rate at 13.5% wassignificantly lower than the downwarddeviation of 23% in early 2002. Ac-cordingly, starting from a significantlyundervalued position, the EUR/USDexchange rate in 2002—03 may havefluctuated within a band determinedby the transaction costs in the com-modity markets.

A technical foreign exchange trad-ing system that is used in practiceexemplifies the functioning of such asystem in the period analyzed (CapitalInvest, 2004). The present tradingsystem is a trend-following system,which uses certain indicators (e.g.moving averages, price break-outsout of trading ranges, etc.) to identifyupward and downward trends of theunderlying exchange rate time series.In addition to price history, the systemalso takes exchange rate volatility intoaccount. For example, if a price per-sistently lingers above or below amoving average, the system generatesa buy or sell signal. Usually, severaltechnical indicators are used aftertheir profitability and reliability hasbeen backtested for long price his-tories.

Chart 3 shows that the system pre-sented in this study was very success-ful in the observation period from2002 to 2003. Almost all positionsclosed with a profit (which becomesapparent when comparing buy and sellsignals).14

13 The PPP rates determined by the OECD (2004) for the relation between euro and U.S. dollar are USD 1.12 pereuro for 2002 and USD 1.11 per euro for 2003.

14 For an exact analysis, transaction costs and the interest rate differential would have to be taken into account. TheEUR/USD market is a very liquid market and therefore the transaction costs are very low. Even if the interestrate differential is taken into account, the quality of the result will not change. In part, U.S. dollar interest rateswere even below euro interest rates, which would have increased profits given the fact that the U.S. dollar wasfalling most of the time.




in 2002 and 2003

A large number of other marketparticipants might have applied theseor similar strategies. Based on this as-sumption, the behavior of marketagents who rely solely on the historyof the EUR/USD time series mayhave become a major factor in themarket, which means that conse-quently, this nonfundamental factormay also have contributed to the ap-preciation of the euro.

4 SummaryThis study examines the significanceof fundamental and nonfundamentalfactors for the determination of theEUR/USD exchange rate in the pe-riod from 2002 to 2003 — a periodin which the euro appreciated by some36%. Using an event study approach,we examine the significance of specificU.S.-specific factors such as the Fed�smonetary policy, data on newly cre-ated jobs in the U.S.A. and the U.S.balance of trade as well as the inter-ventions by the BoJ on the USD/JPYmarket. As regards U.S.-specific fac-tors, negative employment and tradebalance data as well as the Fed�s mon-

etary decisions had a weakening effecton the U.S. dollar. The analyzed eco-nomic data on the EU-12 had no sig-nificant influence on the EUR/USDexchange rate. The BoJ�s interven-tions on the foreign exchange marketin favor of the U.S. dollar had no sig-nificant impact on the EUR/USD ex-change rate, either, but they did serveto strengthen the euro against the Jap-anese yen. Important one-timeevents, which market participants es-timated to be extremely significantfor the decline of the U.S. dollar,are the war in Iraq and the U.S. ac-counting scandals, which influencedmarket sentiment to the disadvantageof the U.S. dollar.

With respect to nonfundamentalfactors, which solely originate frommarket dynamics, this study presentsan example of a technical foreign ex-change trading system which providedmostly accurate short-term exchangerate forecasts — and thus trading prof-its — in the period under review. Ifsuch profitable trading strategies wereemployed by a large enough numberof market participants, this might ex-

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in 2002 and 2003

plain the weaker U.S. dollar and thestronger euro.

Altogether, both fundamental andnonfundamental factors can be usedto explain the direction of the EUR/

USD exchange rate movement. Thisanalysis, however, does not allow fora weighing of the relative significanceof these factors.

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Going on? NBER Working Paper 9266.

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Working Paper 8959. May.

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St. Lewis. Monetary Trends. February.

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Discussion Paper 4268. February.

Bernanke, B. 2004. International Monetary Reform and Capital Freedom. At the Cato Institute 22nd

Annual Monetary Conference. Washington, D.C.

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1095.

Brock, W. A., J. Lakonishok and B. LeBaron. 1992. Simple Technical Trading Rules and the

Stochastic Properties of Stock Returns. In: The Journal of Finance 47. 1731—1764.

Capital Invest. 2004. Global Trend Bond. Presentation material.

Cheung, M. and M. Chinn. 1999. Macroeconomic Implications of the Beliefs and Behavior of Foreign

Exchange Traders. University of California, Santa Cruz. Working Paper.

Chinn, M. and G. Meridith. 2002. Testing Uncovered Interest Parity at Short and Long Horizons during

the Post Bretton Woods Era. UCSC Center for International Economics Working Paper.

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Rates. In: American Economic Review. Vol. 94(2). May. 80—84.

Castre«n, O. 2004. Do Options Implied RND Functions on G3 Currencies Move around the Times of

Interventions on the JPY/USD Exchange Rate. ECB Working Paper 410. November.

De Grauwe, P. and M. Grimaldi. 2004. Exchange Rate Puzzles: ATale of Switching Attractors. Sveriges

Riksbank. Working Paper Series 163. May.

Ehrmann, M. and M. Fratzscher. 2004. Exchange Rates and Fundamentals: New Evidence from Real-

Time Data. In: Journal of International Money and Finance (forthcoming). ECB Working Paper 365.

Fama, E. F. 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. In: Journal of Finance

25. 383—417.

Fatum, R. and B. Scholnick. 2003. Do Exchange Rates Respond to Day-to-Day Changes in Monetary

Policy Expectations? Evidence from the Federal Funds Futures Market. University of Copenhagen. Insti-

tute of Economics. EPRU Working Paper. 2003—2018.

Faust, J. and J. H. Rogers. 2003. Monetary Policy�s Role in Exchange Rate Behavior. In: Journal of

Monetary Economics 50. 1403—1424.

Faust, J., J. Rogers, S. Wang and J. Wright. 2003. The High-Frequency Response of Exchange Rates

and Interest Rates to Macroeconomic Announcements. Board of Governors of the Federal Reserve

System (USA). International Finance Discussion Papers 784.

Fratzscher, M. 2004. Communication and Exchange Rate Policy. ECB Working Paper 363.




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Froot, K. and R. Thaler. 1990. Anomalies: Foreign Exchange. In: Journal of Economic Perspectives 4(3).

179—192.

Galati, G. and C. Ho. 2001. Macroeconomic News and the Euro/Dollar Exchange Rate. BIS Working

Paper 105.

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the Response of Asset Prices to Monetary Policy Actions and Statements. Board of Governors of the

Federal Reserve System. Working Paper. September.

Handelsblatt. 2003. Interview with W. Duisenberg. September 22.

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Money and Finance 7. 23—35.

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Paper 8914.

Kuttner, K. 2001. Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures

Market. In: Journal of Monetary Economics 47. 523—544.

Lyons, R. 2001. The Microstructure Approach to Exchange Rates. MIT Press. Cambridge. Massachusetts.

Mankiw, N. 2004. Grundzu‹ge der Volkswirtschaftslehre. Stuttgart: Scha‹ffer-Poeschel.

Meese, R. and K. Rogoff. 1983a. Empirical Exchange Rate Models of the Seventies. Do They Fit Out of

Sample? In: Journal of International Economics 14. 3—24.

Spiegel, M. 2003. Japanese Foreign Exchange Intervention. FRBSF Economic Letter. December. 2003—

2036.

OECD. 2004.Purchasing Power Parities statistics. http://www.oecd.org/dataoecd/61/54/18598754.pdf

Osler, C. L. 2001. Currency Orders and Exchange Rate Dynamics: Explaining the Success of Technical

Analysis. Federal Reserve Bank of New York. Working Paper. March.

Annex: Data Used for the Event Study

Overview of Times of Events and Observation Intervals (GMT)

Event Source Usual timeof event

Observation interval Obser-vations

Instrument Source/Market

From To

FOMC meeting Gu‹rkaynak et al.(2004)

19:00 23:00(t-1) 23:00 41 Bonds Bloomberg17:00 10:30(t+1) EUR/USD BIS, Fed h1010:30 10:30(t+1) Money market portfolios BIS

Nonfarm payrolls Bloomberg 13:30 13:20 13:40 24 EUR/USD — future Tickdata/CMEEURIBOR, treasury, BOBL — futures Tickdata/EUX, LIF

Eurodollar, TRN 2-year, 5-year — futures Tickdata/CME, CBTTrade balance Bloomberg 13:30 13:20 13:40 24 EUR/USD — future Tickdata/CME

EURIBOR, treasury, BOBL — futures Tickdata/EUX, LIFEurodollar, TRN 2-year, 5-year — futures Tickdata/CME, CBT

HICP (EU-12) Bloomberg 10:00 23:00(t-1) 10:30 24 EUR/USD BIS, BloombergPPI (EU-12) Bloomberg 10:00 23:00(t-1) 10:30 22 EUR/USD BIS, BloombergInsee index Bloomberg 06:45 23:00(t-1) 10:30 20 EUR/USD BIS, Bloombergifo index Bloomberg 08:00 23:00(t-1) 10:30 23 EUR/USD BIS, BloombergBoJ intervention www.mof.go.jp 23:00—23:00 23:00(t-1) 23:00 88 USD/JPY, EUR/USD, bonds Bloomberg

Source: OeNB.




in 2002 and 2003

In 2002, the International Monetary Fund added the Balance Sheet Approach to its set of instrumentsfor monitoring member countries as well as the international financial system and for preventing andresolving financial crises.

In this approach, which was predominantly conceived for emerging market economies, the IMFassumes that a country�s vulnerability to financial crises depends in part on the financial structureof its sectoral balance sheets. With this instrument, the IMF analyzes the size and the composition offinancial assets and liabilities in a country�s aggregate balance sheet and its most important sectoralbalance sheets (government, banks, corporations and households as well as the rest of the world).The IMF finds indicators of a country�s vulnerability to crises by detecting imbalances in its maturityand currency matching, capital structure and solvency. This makes a valuable contribution to crisisprevention and helps to determine the necessary economic policy measures and external financingneeds once a financial crisis has emerged.

The IMF already employs this approach in its analyses and also plans to use it routinely in futureArticle IV consultations.1

1 IntroductionThe tasks of the International Mone-tary Fund (IMF) include promotingand securing economic growth andinternational trade as well as monitor-ing the world monetary system. Inthis context, the IMF is responsible,on the one hand, for the surveillanceof its member countries and theinternational financial system in orderto prevent financial crises and, on theother hand, for crisis resolution byproviding finance subject to economicpolicy requirements.

In order to perform its functionsmore effectively, the IMF has at itsdisposal a wide array of instrumentsfor monitoring its members andresolving financial crises (Table 1). InDecember 2002, the IMF expandedthis set of surveillance instruments toinclude the Balance Sheet Approach(BSA).

The BSA provides early warningsigns which allow for the preventionand resolution of financial crises andis among the new developments aris-ing from the IMF�s Surveillance andCrisis Prevention and Crisis Resolutionstrategies. The IMF already uses thisapproach in its analyses and also plans

to use it routinely in future Article IVconsultations.

This instrument is particularlyhelpful in the case of emerging marketeconomies (e.g. Brazil, Turkey, Mex-ico), especially as such countries havebecome increasingly active in inter-national capital markets and have beenissuing international bonds denomi-nated in foreign currency since theearly 1980s. The corporate sector inthese countries has also taken onexternal debt in foreign currency.Similarly, banks in emerging marketcountries have refinanced themselvesexternally in foreign currency, whiletheir revenues have largely remainedin local currency.

As a result, financial markets havebecome increasingly integrated overthe last 20 years. In many countries,foreign borrowing made it possibleto finance higher investment volumesthan would have been possible withdomestic savings capital alone. How-ever, especially in emerging markets,this opening of capital markets andthe high volatility of private capitalflows have led to major financial crisesin a number of emerging marketeconomies (Allen et al., 2002, p. 4).2

1 Annual review of a country�s economy.2 See the Mexican crises of 1982 and 1994—95 as well as the Asian crisis of 1997—98.

Andrea Hofer

Refereed by:Aurel Schubert.


The International Monetary Fund�sBalance Sheet Approach to

Financial Crisis Prevention and Resolution

Table 1

IMF Instruments for Monitoring Member Countries and Resolving Financial Crises

Surveillance and Crisis Prevention

Instrument Abbrevia-tion

Explanation

Financial Sector Assessment Program FSAP Assessment of a country�s financial system (including banks, insurance companies, pensionfunds, financial market supervision).

Country surveillance:Article IV consultations Art. IV Annual review of a country�s economy as a whole (including the government, financial

sector, corporations, private households), especially monetary policy, fiscal policy, eco-nomic policy, international trade, retail demand, investment activity, short-term forecasts.

Regional surveillance Assessment of monetary unions in particular (e.g. euro area, East Caribbean CurrencyUnion, West African Currency Union, East African Currency Union).

Multilateral surveillance, especially:World Economic Outlook WEO Assessment of economic development and risks to the world economy.Global Financial Stability Report GFSR Outlook and risks for the worldwide financial system.

Report on the Observance of Standards andCodes

ROSC Review of whether countries are adhering to best practices in the development ofstandards and codes (mainly for fiscal policy).

Special Data Dissemination Standard SDDS Worldwide collection and preparation of national economic indicators.

Debt Sustainability Analysis DSA Analysis of the potential effects of a GDP, currency or interest rate shock on debtsustainability, that is whether debts can still be serviced.

Balance Sheet Approach BSA Assessment of a country�s vulnerability to crises and crisis prevention through thedetection of currency and maturity mismatches on the country�s aggregate and sectoralbalance sheets.

Technical Assistance andRegional Institutes

TA andRegionalInstitutes

Technical assistance in the establishment of systems relevant to economic and monetarypolicy (e.g. central bank, payment system, statistics).Regional institutions such as the Joint Vienna Institute (JVI) in Vienna serve as educationalfacilities for experts from emerging and developing economies.

Crisis ResolutionIMF loans Capital inflows under an IMF program to mitigate balance of payments crises.Includes special IMF facilities(e.g. Poverty Reduction and Growth Facility)

PRGF Special facility for developing countries.

Principle: IMF has preferred creditor status The funds made available by the IMF are to be repaid first (even before national loans);currently common practice.

Rollovers1 Banks do not demand repayment of loans but extend their terms.

General bond exchange1 One or more bonds are exchanged for a new bond, usually with a longer maturity.

Capital outflow controls1 Capital outflows are stopped or subjected to restrictions.

Payment suspension or debt moratorium1 Temporary suspension of payment obligations.Payment suspension: unilateral.Debt moratorium: multilateral agreement.

Heavily Indebted Poor Countries Initiative HIPCInitiative

Debt relief for the poorest developing countries.

Collective Action Clauses CACs Clauses in foreign currency bonds (usually in U.S. dollars) which facilitate debt restruc-turing by changing issuing terms (e.g. interest rates, maturities).Initiated after the failure of SDRMs.Available to emerging market economies since 2002.

Balance Sheet Approach BSA Assessment of the necessary economic policy measures and external financing needsafter the eruption of a crisis due to currency and maturity mismatches on the country�saggregate and sectoral balance sheets.

Sovereign Debt Restructuring Mechanism SDRM Bankruptcy procedure for sovereigns.Discussed from 2001 to April 2003, not currently under active discussion.

Principles for Stable Capital Flows and FairDebt Restructuring in Emerging Markets

Principles Agreement between private industry and emerging market economies regarding rulesof conduct for information, consultation and adherence to agreements, and that areexpected of the lender and borrower in the event of a debt crisis.(formerly: Code of Good Conduct)

Private Sector Involvement PSI Involvement of the private sector in the financing of crisis prevention programs.

Source: OeNB.1 Instruments employed jointly with other sectors with the participation of the IMF.


The International Monetary Fund�s

Balance Sheet Approach to


In principle, financial crises canoriginate in all three main sectors ofthe economy (government, banks orcorporations). One of the main sourcesof financial crises is the financialbalance sheet structure in emergingmarket economies. A country�s balancesheet reveals financial risks which canmaterialize quickly. Although thereare significant differences betweenemerging market economies in termsof their financial balance sheet struc-ture, their overall vulnerability to cri-ses is far higher than that of maturemarket economies.

The IMF document (Allen et al.,2002) underlying substantial parts ofthis study provides a systematic setof analytical instruments for the pur-pose of examining whether a coun-try�s balance sheet contains weak-nesses, whether such vulnerabilitiescan trigger or exacerbate financial cri-ses and which measures can be takenin each case.

2 The IMF�s Balance SheetApproach

2.1 DefinitionThe IMF�s Balance Sheet Approach isan instrument for the detection, preven-tion and resolution of financial crises.The BSA allows the IMF to analyzethe size and composition of the assetsand liabilities on a country�s aggregatefinancial balance sheet as well as thefinancial balance sheets of its most im-portant sectors.

The BSA is not based on a balancesheet in the conventional sense of theterm, that is, the accounts of an eco-nomic entity (usually a company) fora business year in the form of a com-parison of financial and nonfinancialbalance sheet positions on the assets

and liabilities sides as of a certainaccounting date (Betriebswirtschaft-licher Verlag Dr. Th. Gabler GmbH,1984, p. 748). The Balance SheetApproach in the IMF model is merelya comparison of financial assets andliabilities as of a certain accountingdate, which means that nonfinancialbalance sheet positions are omitted.Moreover, the IMF does not draw upsuch balance sheets for individual eco-nomic entities but in aggregate formfor the overall economy and for itsmost important sectors.

In this context, the IMF assumesthat the resilience of an economy tovarious shocks, including financialcrises, depends in part on the struc-ture of the country�s financial balancesheet. From this perspective, a finan-cial crisis typically emerges in caseswhere demand for domestic financialassets plunges in one or more sectors(1. government sector, 2. financial sec-tor, 3. nonfinancial sector, 4. externalsector). Creditors lose confidence inthe government�s ability to serviceits debt, in the banking system�s abilityto meet deposit outflows, in the cor-porate sector�s ability to repay bankloans and other debt, or in the coun-try�s ability to earn sufficient foreignexchange in order to meet its externalobligations. This leads to the sale oflocal assets by nonresidents or to asurge in demand among residents forforeign assets and/or assets denomi-nated in foreign currency. The resultsare massive capital outflows, a sharpdecline in the exchange rate (in aflexible exchange rate regime) or anoutflow of reserves (in a fixed ex-change rate regime) along with otherpotential negative economic and socialeffects (Allen et al., 2002, p. 5).





2.2 Concept of the Balance SheetApproach

2.2.1 The Balance Sheet Approach —A Third-Generation Model forExplaining Currency Crises

Economics literature provides threemodel theory-based approaches forthe explanation of currency crises:

Until the mid-1990s, the standardfirst-generation model explained cur-rency crises as a consequence of mone-tized fiscal deficits leading to losses incurrency reserves and eventually to anabandonment of the exchange rate peg(Krugman, 1979; Flood and Garber,1984).

Second-generation models weredeveloped after the European Mone-tary System�s exchange rate mecha-nism crisis in 1992 and the Mexicancrisis of 1994 to 1995. These modelswere based on fundamental weak-nesses (e.g. an overvalued currency,an unsustainable current account def-icit), but for the first time they alsoincluded the potential consequencesof maturity and currency mismatcheson the balance sheet (Obstfeld, 1994;Drazen and Masson, 1994, etc.).

Third-generation models were de-veloped on the basis of experiencefrom the Asian crisis of 1997 to1998, in which weaknesses in the pri-vate sector played a more importantrole than fiscal imbalances. Thesemodels are based explicitly on theanalysis of financial balance sheets.They point out additional vulnerabili-ties in the financial and corporatesectors as causes of currency crisesand show that currency crises oftenbring about banking crises (twin cri-ses) (Kaminsky et al., 1997; Calvo,1998; Kaminsky, 1999; Krugman,1999; Dornbusch, 2001, etc.) (IMF,2003, pp. 3—4).

2.2.2 The Balance Sheet Approach —A Stock Concept

The IMF�s traditional financial pro-gramming approach basically buildson the examination of flow variablessuch as the current account or capitalaccount. Those analyses focus on thegradual accumulation of unsustainabledeficits in the respective areas.

While the traditional analysis offinancial crises relies on the examina-tion of flow variables over a certainperiod of time, the BSA focuses onexamining stock variables on a coun-try�s financial balance sheet and onthe balance sheets of key sectors (i.e.their assets and liabilities) at a certainpoint in time. Therefore, the BSAconstitutes an enhancement and ex-tension of the set of instrumentsavailable for analyzing capital accountcrises. Especially in the wake of thecapital account crises of the 1990s,academics and policymakers are nowattributing greater importance to thecontinued development of these tools(IMF, 2003, pp. 1—2).

2.2.3 Compiling a Country�s Inter-sectoral Balance Sheet byConsolidating its SectoralFinancial Balance Sheets

In the BSA, an economy is analyzed asa system of sectoral balance sheets, witha distinction being made between thefollowing sectors:1. Government sector (including the

central bank);2. Financial sector (mainly banks);3. Nonfinancial sector (corporations

and households);4. External sector (nonresidents, i.e.

rest of the world).The first three sectors listed above

each have claims and receivables vis-a‘-vis one another and the rest of theworld.





When the first three sectoral bal-ance sheets are consolidated to yielda country�s aggregate balance sheet,the assets and liabilities held byresidents are netted out, and whatremains is the external balance sheet

vis-a‘-vis the rest of the world (i.e.nonresidents).

Chart 1 gives a simplified over-view of the system of sectoral andaggregate balance sheets; nonfinancialassets and liabilities are omitted.

A country�s aggregate financialbalance sheet can reveal the potentialextent of its vulnerability to changesin external financial flows, but it israrely suited for examining the causesbehind such changes. Sectoral finan-cial balance sheets provide importantinformation which is not visible inthe aggregate financial balance sheet.One conspicuous example is foreigncurrency-denominated debt betweenresidents, which is netted out in theaggregate balance sheet. Weaknessesin a sectoral balance sheet can contrib-ute to the development of a nation-wide balance of payments crisis with-out even appearing on a country�saggregate balance sheet.

The risk of problems in one sectorspilling over into other healthy sectorsis exacerbated in countries which haveliberalized their capital flows if exter-nal investors only take country riskinto account and do not necessarilydifferentiate between sectors (Allenet al., 2002, pp. 13—15).

2.2.4 Four Types of Risk in the Analysisof Financial Balance Sheet Mis-matches

The four most important risk typesincluded in the analysis of balancesheet mismatches are as follows:— Maturity mismatch risk

This type of risk typically ariseswhen assets are long-term and

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mainly illiquid, while liabilities areshort-term. Maturity mismatchescreate rollover risk, that is the riskthat it will not be possible to refi-nance maturing debts and thatdebtors will have to meet theirobligations with liquid assets. Mis-matched maturities also constitutean interest rate risk for the debtor,that is the risk that the level and/or structure of interest rates onthe outstanding debt will change.Maturity mismatches can arise inboth domestic and foreign cur-rency.For example, debtors may haveshort-term liabilities in foreigncurrency which exceed theirshort-term liquid assets in foreigncurrency, even though their totalassets in foreign currency areequal to their total liabilities inforeign currency.This risk has consistently played akey role in recent financial crises.Maturity mismatches in foreigncurrencies often led to a rollovercrisis because short-term liabilitiesin foreign currency exceededliquid assets. In some countries,financial pressure arose due toshort-term government debt(e.g. Mexico, Russia, Turkey, Ar-gentina), while in other countries(e.g. Korea, Thailand, Brazil) itwas triggered by the short-termliabilities of the banking system.In other cases, (e.g. Russia,Turkey,Brazil, Argentina), short-term in-terest rates on government debtrose substantially even before thefinancial crisis struck.

— Currency mismatch riskThis risk arises when assets andliabilities are denominated in dif-ferent currencies. If assets are heldin domestic currency but liabilities

are denominated in foreign cur-rency, substantial losses may resultif the domestic currency depreci-ates sharply in an exchange rateshock. Currency mismatches tendto be more prevalent in emergingmarkets than in mature marketeconomies. This is because finan-cial intermediaries in emergingmarkets are often unable to bor-row long-term capital in local cur-rency domestically. As a result, itis often only possible to obtaincapital for investment purposesby assuming currency risk. Hedg-ing this currency exposure domes-tically merely transfers it to an-other sector within the country.If, for example, banks in anemerging market economy takeon liabilities in U.S. dollars, a cur-rency risk results. If the banks passthose liabilities on to corporationsin the form of U.S. dollar-denomi-nated loans, the banks� currencyexposure declines again, whilethat of the corporations increases.If the corporations are not majornet exporters, the risk that theywill not be able to repay theirforeign-denominated liabilities in-creases as well.Currency mismatches can alsotrigger capital flows, which inturn create pressure on a country�scurrency reserves.This risk has also played a signifi-cant role in nearly all recent crises.Currency mismatches were verypronounced in the governmentsector (e.g. in Mexico, Brazil, Ar-gentina), in the banking sector(e.g. in Korea, Thailand, Indone-sia, Brazil) and in the corporateand household sector (e.g. in Ko-rea, Thailand, Indonesia, Turkey,Argentina, Brazil).





— Capital structure mismatch riskThis risk results from excessive reli-ance on debt financing instead ofequity. The absence of an �equitybuffer� can lead to a financial crisiswhen a sector encounters a shock.While profits slacken in economi-cally bad times, interest paymentson debt generally remain un-changed. Excessive debt financingis usually accompanied by exces-sive short-term borrowing, andthus not only leads to capitalstructure mismatches but also tomaturity mismatches. The reasonsfor excessive debt financing caninclude poor corporate gover-nance as well as tax and regulatorydistortions.In this context, Korea and Thai-land can be mentioned as exam-ples of countries in which exces-sive debt financing has been afactor. The Korean governmentimposed severe restrictions onforeign direct investment until1997 and encouraged inflows ofexternal capital in the form ofdebt. In Thailand, the tax regimefavored corporate debt over equityfinancing. The resulting debt-to-equity ratio in each country�s cor-porate sector was therefore veryhigh at the onset of the crisis(1997: Korea, 320%; Thailand,200%; as compared to USA,110%). In addition, the capitalstructure of the banking and finan-cial sector was also poorly bal-anced, as banks and financial insti-tutions were undercapitalized. Inmany crisis countries, the bankswere leveraged excessively andoften showed capital adequacyindicators far below internationalstandards. Therefore, when liq-uidity and currency shocks hitthe financial institutions� balance

sheets, the �equity buffer� wasnot sufficient to absorb them.

— Solvency riskThis risk emerges when a sector�sfinancial assets no longer coverits financial liabilities. Solvency riskis closely linked to maturity mis-match risk, currency mismatchrisk and capital structure mis-match risk. These three types ofrisk can all increase the risk of in-solvency in the wake of a negativeshock.The concept of solvency is easy toexplain for private sector balancesheets: A private firm can be con-sidered solvent when its financialassets exceed its financial liabili-ties. The government sector isconsidered to have sufficient coverwhen the present value of allfuture revenues (mainly taxes) ishigher than the current stock ofnet government debt on its sec-toral balance sheet. Likewise, acountry as a whole will remainsolvent as long as the present valueof all future current account bal-ances is higher than the currentstock of net external debt.In order to assess solvency, gov-ernment debt is often comparedto flow figures such as gross do-mestic product (GDP) or govern-ment revenues, and a country�saggregate debt is usually comparedto GDP or exports.Solvency risk varied widely in thecountries most recently affected bycrises. In Mexico, Korea and Thai-land, the government appeared tobe solvent despite some macro-economic, structural and financialweaknesses. In other cases, highratios of debt to GDP and/or gov-ernment revenues already signaledthe risk of a government liquidityand/or solvency crisis. In many





other cases (and especially inRussia and Argentina), stable ex-change rates prior to the crisesimproved the ratio of foreign cur-rency debt to GDP. Once the cri-sis had erupted, however, drasticdeclines in exchange rates gaverise to a sharp increase in govern-ment debt relative to GDP. Insome cases, this shock was furtheramplified by the high fiscal costsof recapitalizing domestic banks(and, indirectly, the cash-strappedcorporate sector), by a drasticincrease in real interest rates andby a slump in economic growth.All of the risk types discussed

above are closely interrelated andcan generate credit risk, that is the riskthat debtors will no longer be able torepay their debts. Solvency risk forthe debtor is equivalent to credit riskfor the creditor. Due to its specificfunctions, the banking system is espe-cially susceptible to credit risk, whichitself can lead to a run on deposits. Onthe other hand, solvency problemsin another sector can also trigger arun on the banks and thus quicklybring about payment difficulties inthe economy as a whole.

In its analyses, the IMF examineswhether the risks mentioned aboveare found on the financial balancesheets of the main sectors of theeconomy in question and how suchproblems in one sector might spillover into other sectors, possibly caus-ing a balance of payments crisis. How-ever, balance sheet weaknesses canpersist for years without triggering acrisis as long as investor confidenceremains unbroken (Allen et al., 2002,pp. 15—20).

2.2.5 Potential Course of aFinancial Crisis in an Economywith Sectoral Balance SheetMismatches

An economy which shows mismatcheson its sectoral financial balance sheets(i.e. those of the government, banks,corporations and households) willtend to be more vulnerable tofinancial as well as real economicshocks.

A financial crisis in an economywith sectoral financial imbalances typ-ically takes the following course:

Shocks (e.g. a plunge in demandor prices for an important exportproduct, deterioration of governmentrevenues or corporate earnings, orworse-than-expected economic data)can trigger a loss of confidence in theeconomy.

This can affect a country�s capitalflows, in particular bringing aboutcapital outflows (especially portfolioinvestment but also foreign direct in-vestment), which in turn put pressureon the exchange rate. In the case of amanaged float or an exchange ratepeg, the country�s government willattempt to stabilize its exchange rate,usually by raising interest rates.

This loss of confidence can triggerthree effects:— Rollover shock, that is banks will

demand repayment of their claims.— An exchange rate shock, that is cor-

porations which have foreign-de-nominated liabilities and earn thebulk of their revenues in domesticcurrency will have to make highercapital repayments on their for-eign-denominated liabilities.

— An interest rate shock, that is refi-nancing costs will rise along withinterest rates.These three effects have implica-

tions for the overall economy. In thecase of financial mismatches on a sec-





toral balance sheet, the problems canspill over into other sectors and snow-ball very quickly.— Corporations and households

experience economic problems,which in turn affect

— banks. When the banks find them-selves in a problem situation, theyturn to the

— ministry of finance or the centralbank (due to guarantees, contin-gent liabilities, etc.).

Once the entire country ends upwith a financing problem, corpora-tions and households have to providefinancing (e.g. by means of tax in-creases and interest rate hikes).

Mismatches on a country�s aggre-gate balance sheet or sectoral balancesheets can lead to a loss of confidence,thus triggering the course of eventsand effects described above. If the lossof confidence is caused by exogenousfactors, any existing sectoral imbalan-ces can exacerbate these effects.

2.2.6 Characteristics of FinancialCrises under the Balance SheetApproach

The following characteristics of finan-cial crises can be derived from theIMF�s experience in recent years:— Exchange rate pegs have played an

important role in recent financialcrises. In each balance of paymentscrisis in the 1990s, the countriesin question maintained some formof exchange rate peg. In manycases, the nominal stability of theexchange rate led to a real appre-

ciation of the local currency,which reduced the real costs offoreign currency borrowing. Ineffect, this strategy led to anaccumulation of severe currencymismatches. By contrast, countrieswith floating exchange rate regimeswere often better equipped towithstand external shocks.

— Sectoral financial balance sheetproblems spilled over into othersectors and snowballed, with thebanking sector often playing akey role in the transmission proc-

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ess. In all cases, sectoral financialbalance sheet problems led to twincrises, that is currency and bankingcrises. The depreciation of thecurrency weakened the financialasset side of the banks� balancesheet, even in cases where thebanking sector was formallymatched in terms of currenciesat the onset of the crisis. The ap-preciation of the foreign currencyled to an increase in credit de-faults, while foreign-denominatedliabilities persisted.

— Problems on both the sectoral andaggregate financial balance sheetsof a country showed the potentialof developing into balance of pay-ments crises.

— Weaknesses in the private sector�sfinancial balance sheet oftenbrought about problems in thebanking sector due to implicit andexplicit guarantees provided by thebanks and ultimately encumberedthe government sector�s financialbalance sheet due to contingentliabilities. In Indonesia, for exam-ple, these liabilities amounted to50% of GDP in 1997.

— Sectoral financial balance sheetproblems led to a more severeslowdown in economic growth thanexpected. Corporate expenditurecuts as well as the required restric-tions on bank lending exceededthe immediate positive effect oncompetitiveness triggered by thedepreciation of the domestic cur-rency.

— It was difficult to determine thescale of external financing needsbecause information on the sizeand maturity of financial assetsand liabilities was incomplete (orcompletely missing) on the bal-ance sheets of banks and especiallyof the private sector. Moreover,

the rollover rate and the extentof the exchange rate adjustmentcould not have been anticipated.Short-term external financing needscan be extremely high; in 1997, theyreached 43% of GDP in Indonesiaand 31% of GDP in Thailand(Allen et al., 2002, pp. 20—23;IMF, 2003, pp.3—5).

2.3 Objectives of the Balance SheetApproach

2.3.1 Crisis Prevention ObjectivesFinancial crises and subsequent bal-ance of payments crises do not ariseby pure coincidence. As long as acountry�s aggregate and sectoral finan-cial balance sheets do not show severemismatches, economic entities in thecountry can borrow in order to sus-tain imports (and thus consumptionand investment), for example. How-ever, persistent deficits can translateinto balance sheet problems. There-fore, one important objective of theIMF is to develop the data sources nec-essary to create transparency regard-ing financial asset and liability posi-tions and in order to monitor themeffectively.

Information about sectoral finan-cial balance sheets is very useful whenit is available in due time, as it enablespolicymakers to identify and correctweaknesses before these trigger financialdifficulties. In practice, however, thisinformation is often only available inpart or with significant time lags,meaning that its utility is frequentlylimited to ex post analysis.

In addition to the development ofdata sources necessary for monitor-ing, government economic policiesin emerging market economies canalso have a significant influence onthe strength of their national balancesheets.





Information about sectoral finan-cial balance sheets can also be usefulin evaluating the tradeoffs betweenvarious economic policy goals; suchtradeoffs arise as soon as sectoralproblems spill over into other sectorsand thus pose a systemic danger tothe economic and financial system.Finally, the BSA makes it possible toassess whether and to what extentfinancial intervention by the govern-ment is warranted.

The BSA thus focuses on measuresto reduce sectoral financial vulnera-bilities (especially those which areaffected by changes in key financialvariables), specifically:— First, sound debt management in

the public sector (a reasonablelevel of public debt, insulation ofliabilities against shocks, a gradualshift from foreign currency-de-nominated liabilities to long-termdebt in local currency, limitationof contingent liabilities).

— Second, the creation of incentivesfor the private sector to limit itsexposure to balance sheet risks(mismatches), especially the ex-plosive combination of currencyand maturity mismatches, bymeans of sufficient equity buffer-ing and hedging.

— Third, the need to maintain suffi-cient foreign currency reserves(as exchange rate risk is largelynot covered in emerging marketswith high levels of foreign cur-rency-denominated debt (i.e. highliability dollarization); Allen et al.,2002, pp. 24—29, and IMF, 2003,pp. 5—6).

2.3.2 Crisis Resolution ObjectivesThe BSA not only provides guidancein estimating a country�s vulnerabilityand in preventing crises through suit-able economic policy measures, it also

serves to support crisis resolutiononce a financial crisis has erupted.Specifically, it is useful in determiningthe required economic policy meas-ures and external financing needs.

Common economic policy measuresfor crisis resolution include exchangerate policy, monetary policy, capitaloutflow controls and fiscal policy.These instruments not only serve toaddress specific macroeconomic andstructural problems, they are also in-tended to renew confidence in theeconomy in order to prevent abroader financial crisis.

If financial imbalances in the sec-toral balance sheets can be offsetbefore they spill over into other sec-tors, it is possible to avoid a largerfinancial and economic crisis. TheBSA can help determine when officialexternal financing is warranted. Bal-ance sheet problems in private firmstend to pose less risk of spilling overinto other sectors and leading to abroader crisis. However, there arecases in which the need to resolve afinancial crisis in the private sectorjustifies intervention on the part ofthe national government in order toprevent the crisis from spilling overinto other areas of the economy (e.g.the banking sector). By contrast,financial problems in the governmentsector usually harbor a high risk oftriggering a broader financial crisis,as government debt is often the bank-ing sector�s most important financialasset. The BSA can also help in assess-ing sectoral demand for foreign cur-rency liquidity, although the calcula-tion of financing needs should notprejudice the appropriate level of IMFsupport. However, the BSA providesa series of tests which enable policy-makers to judge how strong the casefor official external financing is.





In general, official financing is bestsuited for financing needs created bymaturity mismatches. It is then possi-ble to make additional capital availa-ble, either in foreign currency (inthe form of preferred IMF loans) orin local currency through expansivemonetary policy measures. The otherimbalances (currency mismatch, capi-tal structure mismatch and solvencyrisk) cannot be alleviated by officialexternal financing measures. By defi-nition, external capital inflows willaugment a country�s external debtin foreign currency and thus also

exacerbate currency mismatches orshift them from one sector to another.Official external financing would onlyimprove poor capital structure match-ing if it were extended as a grant. Inpractice, however, official financingfor emerging market economies isalmost always provided in the formof low-interest loans. Additional loansdo not help either in cases where acountry requires substantial debtrestructuring in order to regain itssolvency and to be able to serviceits debts sustainably (Allen et al.,pp. 29—41).

Practical Application of the Balance Sheet Approach

by the IMF — Case Study: ThailandThe information necessary for crisis prevention and resolution can be presented in a matrix of a country�sintersectoral financial assets and liabilities which highlights intersectoral financial linkages as well ascurrency and maturity mismatches.1

The example below analyzes Thailand�s sectoral financial balance sheets at the outset of its 1997crisis and illustrates the scope for and severe limitations of forecasting external financing gaps. Thailandwas selected as an example for various reasons: First, Thailand�s crisis is better documented statisticallycompared to other countries. Second, the financial crisis originated in the private sector, which madesectoral analysis especially useful. Finally, the size of capital account adjustment and the scale of poten-tial financing needs were substantially underestimated; in fact the IMF�s projection error in the case ofThailand was by far the largest among all crisis countries.

If we look at Thailand�s intersectoral financial assets and liabilities as of the end of 1996, we cansee the existing stock positions and the related financial vulnerabilities which continued to accumulatethrough the end of June 1997 and led to the financial crisis starting on July 2, 1997, when the bahtwas floated. The financial balance sheet only helps to highlight the vulnerabilities themselves, notto reveal the causes behind these weaknesses (in Thailand�s case, the quality of investments). InThailand, the weaknesses were the high short-term foreign-denominated liabilities of banks (nearlyUSD 29 billion in 1996) and of the nonfinancial sector, that is, corporations and households (almostUSD 19 billion in 1996), making for a total of some USD 48 billion in short-term foreign currency debt.On the assets side, the Bank of Thailand (BOT) held almost USD 39 billion in foreign currencyreserves, thus showing a potential financing gap of some USD 10 billion.

The sectoral financial balance sheet for commercial banks showed extremely severe maturity andcurrency mismatches. Under the pessimistic assumption that no short-term debt would be rolled overand in light of its liquid assets in foreign currency (USD 2.6 billion), the banking sector showed ashort-term financing need of USD 26 billion.

Although no information was available on the short-term assets held by the nonbank sector, wecan assume that the balance sheet mismatches were even larger among corporations and householdsthan in the case of banks. Any calculation of an external financing gap is highly sensitive to behavioralassumptions, in particular the willingness to roll over short-term debt. Aside from possible financinggaps, the matrix also shows a capital structure mismatch in the nonfinancial private sector. A com-parison of the private sector�s total liabilities (approximately USD 269 billion) and its equity (approxi-mately USD 137 billion) implies a debt-to-equity ratio of almost 200% as of the end of 1996.Ultimately, it was possible to detect a significant level of solvency risk at the aggregate country level,





as the external foreign-denominated debt of the private and public sectors came to a total externaldebt of USD 115 billion, that is, more than 60% of GDP and over 200% of exports (Allen et al.,2002, pp. 50—59).

The Thai example shows that a country can have extremely high external financing needs if it hasa large stock of short-term liabilities in foreign currency which cannot be refinanced.1 See Allen et al., 2002, p. 44. The liabilities in each line are divided among the columns depending on which sector used the relevant

instrument. As the liabilities are already consolidated data, the matrix diagonal (representing intrasectoral liabilities, e.g. the level of thefinancial sector�s liabilities to the financial sector) is blank.In practice, the lack of data in many IMF member countries poses an obstacle to the complete numerical application of the BSA. Thereasons for this are the lack of resources for data preparation and misgivings with regard to data confidentiality. In the future, suchinformation should be more readily available as soon as more countries subscribe to the Special Data Dissemination Standard (SDDS)for the worldwide collection and preparation of economic indicators. Some of the data can be derived from other sources, for examplenational authorities, the country pages in the IMF�s monthly International Financial Statistics (IFS), and the international bankingstatistics published by the Bank for International Settlements (BIS). IFS und BIS data provide information on the assets and liabilitiesof the public sector and on the aggregate external debt of a country. However, information on the residual maturity of individual sectors�external liabilities as well as data on financial assets and liabilities in the nonfinancial private sector (including corporations) are generallyscarce.

Matrix of Thailand�s Intersectoral Assets and Liabilities

(End of December 1996)USD million (1 USD = 25,6 baht)

Debtor Creditor Total

Generalgovern-ment andcentralbank(BOT)

Com-mercialbanks

Nonbanksector

Rest oftheworld

General government andcentral bank (BOT)Domestic currency 2,394.0 11,885.0 14,279.0Total other liabilities 5,555.0 5,152.0 10,707.0a) short-term 3,616.0 34.0 3,650.0

in foreign currencyin domestic currency 3,616.0

b) medium and long-term 1,939.0 5,118.0 7,057.0in foreign currencyin domestic currency 1,939.0

Commercial banks (incl. BIBF)Total liabilities 10,327.0 139,299.0 48,790.0 198,417.0a) deposits and other short-term liabilities 9,366.0 131,866.0 28,858.0 170,090.0

in foreign currency 448.2 28,189.0 28,637.0in domestic currency 9,366.0 131,417.0 669.0 141,453.0

b) medium and long-term 961.0 7,434.0 19,932.0 28,327.0in foreign currencyin domestic currency 7,433.7

Equity (capital) 23,439.0

Nonbank sectorTotal liabilities 206,715.0 61,701.0 268,416.0a) short-term 18,831.0 18,831.0

in foreign currency 18,831.0in domestic currency 555.2

b) medium and long-term 42,870.0 42,870.0in foreign currency 31,542.0 42,870.0 42,870.0in domestic currency

Equity (capital) 4,745.0 136,252.0

Rest of the worldTotal liabilities 38,694.0 7,029.0 45,723.0Currency and short-term liabilities 38,694.0 2,580.0 41,274.0Medium and long-term liabilities 4,449.0 4,449.0Equity (capital) 481.0

Source: Allen et al.. 2002. p. 51.BOT— Bank of Thailand, BIBF — Bangkok International Banking Facility.





3 Evaluation of theBalance Sheet Approach

3.1 General RemarksThe BSA is primarily useful for emerg-ing market economies, as these haverecently begun to issue foreign cur-rency-denominated bonds on inter-national capital markets, have experi-enced major financial crises in con-nection with the opening of capitalmarkets in recent years and tend tobe more susceptible to crises thanmature market economies.

If the information contained insectoral balance sheets is available indue time, it can allow economic poli-cymakers to identify and correctweaknesses before these give rise tofinancial difficulties, provided themeasures are politically and economi-cally feasible. In practice, balancesheet data are often only available inpart or with significant time lags,meaning that this instrument is mainlysuited for ex post analysis. For exam-ple, Austria, like all other EU MemberStates, is required to provide Eurostatwith its financial accounts data withinsix to twelve months, while somecountries are exempt from this re-quirement. Due to these delays in datapublication, this approach will at bestmake it possible to detect emergingstructural problems.

3.2 Evaluation in Comparison to the1995 European System of NationalAccounts (ESA 95)

In Austria, sectoral financial corporatebalance sheet data can be derived fromfinancial accounts data compiled inaccordance with the 1995 EuropeanSystem of National Accounts (ESA 95),which itself is based on the inter-national System of National Accounts(SNA). In effect, the BSA constitutesa different type of financial accounts.

The BSA�s classification of curren-cies as domestic and foreign is notprovided for in the ESA 95, can onlybe calculated with considerable effort,and usually bears little significance inhighly mature market economies suchas Austria. The classification of cur-rencies is mainly relevant in caseswhere capital only flows into a coun-try in foreign currency (as is the casein emerging market economies, e.g.Thailand), and not in domestic cur-rency as well (as is the case in coun-tries belonging to a currency zone,e.g. Austria).

For those countries which belongto a monetary union (e.g. the euroarea), the currency question is en-tirely different than for a country withits own currency, as the bulk of theirfinancial claims and liabilities are de-nominated in this common currency.However, foreign currency-denomi-nated debt (i.e. debt which is notdenominated in the common cur-rency) still poses an individual cur-rency risk. Therefore, it is not thenational currency reserves indicatedon the balance sheet which are rele-vant in the case of a financial crisis,but rather the total currency reservesof the entire monetary union.

Moreover, the BSA only includesconsolidated data, which means thatintrasectoral claims and liabilities arenetted out among the various sectorsof the economy. The IMF approachonly makes it possible to detectstructural shifts over time, as actualtransactions cannot be derived. Thetable values show net stocks and netyear-on-year changes therein, that is,the values include exchange ratefluctuations, reclassifications, inflowsand outflows. Accordingly, the IMFapproach contributes little to reveal-ing the causes of vulnerabilities in a





country, but it does make it possibleto detect the weaknesses themselves.

3.3 Applicability of theBalance Sheet Approach toMature Market Economies

In principle, this approach can be ap-plied to emerging markets as well asmature market economies.

While missing or insufficient datahamper the BSA�s application inemerging markets, most of the coun-tries in which financial accounts areobligatory (i.e. most mature marketeconomies) can already provide datamaterial which is nearly sufficient forthe BSA. Thus the BSA can be appliedas an additional analysis tool with areasonable level of effort. The IMFconsiders it wise to apply the BSA tomature market economies as well,even if those countries are not subjectto the same types of risk (e.g. rolloverrisk, foreign currency exposure in thecorporate sector) as emerging mar-kets.

3.4 Applicability of theBalance Sheet Approach in theIMF�s Practical Work

In general, the IMF�s view is that theBSA is a useful analytical tool foridentifying currency mismatches andother vulnerabilities of an economyand its most important sectors ascauses of financial crises and for thepurpose of supporting the IMF inmaking economic policy recommen-dations.

For some time now, the approachhas already been in use as a supple-ment to traditional flow-based analysis(IMF, 2004a, p. 1), and many of its el-ements are applied in the practicalwork of the IMF in (country) analyses,e.g. Article IV consultations, fiscal andexternal sustainability, liquidity anddebt management, debt sustainability

analysis (DSA), quarterly externalvulnerability exercise or the FinancialSector Assessment Program (FSAP).

The BSA already serves as a sys-tematic framework for IMF super-vision in mature market economies.For example, selected sectors wereanalyzed in the course of Article IVconsultations in 2003. In the consulta-tions for Australia, Ireland, the UnitedKingdom and the U.S.A., the IMFfocused on potential changes in realestate prices and the implications formortgage lending and household debt.The international linkages of thebanking and insurance sector wereexamined in selected issues papersfor Germany and Spain.

In the case of Austria, IMF staffscrutinized currency mismatcheswhich had arisen due to rapidly in-creasing foreign-denominated loans tohouseholds.

Comprehensive intersectoral bal-ance sheet analysis is highly data inten-sive; however, some countries (e.g.the United Kingdom) have alreadymade great advances in this area. InArticle IV consultations for selectedemerging market economies (e.g.Thailand, Peru) the IMF has alreadyintegrated several sectors and theirinterlinkages into its balance sheetanalysis.

In some cases, the analysis of indi-vidual sectoral balance sheets, in par-ticular those of the financial sector,is useful for detecting weaknesseswhich could spill over into other sec-tors. For example, the IMF routinelyapplies the BSA to the financial sectorin the course of FSAP reviews of indi-vidual countries and includes somesectoral data on corporations andhouseholds in stress tests. Some stud-ies (e.g. for Ecuador, Uruguay) haveexamined fiscal policy on the basis ofpublic-sector balance sheet analysis.





Article IV reports on some emergingmarket economies (e.g. Malaysia,Mexico, South Africa) have focusedon the corporate sector (IMF, 2004a,p. 3). In the Global Financial StabilityReport (GFSR), the IMF analyzedstructural developments in selectedsectors in mature market economiesover a quarter as well as a longerperiod and aggregated these devel-opments for the euro area (IMF,2004b, pp. 64—66).

The IMF�s debt sustainabilityanalysis (DSA) examines the potentialimpact of shocks (e.g. changes inexchange rates, interest rates, etc.)on a country�s debt level with regardto solvency.

The quarterly external vulnerabil-ity exercise quantifies potential short-term financing needs in the case ofreduced rollover rates as well as theextent to which currency reservesmay serve as liquidity buffers.

FSAP reviews reflect the conclusionthat the banking sector�s financialbalance sheet plays a key role in acountry�s resilience to crises.

Efforts to integrate the BSA intothe ongoing work of the IMF havebeen supported by statistical andtransparency initiatives. The require-ments of the Special Data Dissemina-tion Standard (SDDS), the CoordinatedPortfolio Investment Survey and thenew Government Finance StatisticsManual (GFSM) have improved theavailability, accuracy and comparabil-ity of important balance sheet stockfigures (IMF, 2003, pp. 6—7).

3.5 Future Use of the Balance SheetApproach at the IMF

Recent experience with the practicalapplication of the BSA has highlightedthe paramount importance of highdata quality. In emerging and maturemarket economies alike, the necessary

data are often not available (or not inthe proper formats). The develop-ment of sound databases requires agreat deal of time and effort on thepart of a country�s authorities andthe IMF. Thus it will still take sometime before the IMF can routinelyintegrate the BSA into its work.

The analysis of the corporate sec-tor in particular is subject to practicallimitations. The available data oftenonly cover publicly listed corpora-tions, that is a sub-group of firmswhich does not adequately reflectthe complex vulnerabilities of this het-erogeneous sector.

However, even an analysis which isconfined to the banking and govern-ment sectors (where data are morereadily accessible) can provide usefulinformation on a country�s vulnerabil-ity to shocks. As a caveat, however, itis necessary to note that partial analy-ses can provide a misleading picture ofthe risks to an economy.

The IMF plans to examine BSAdata requirements thoroughly for thepurposes of supervision and crisis res-olution. In addition, the IMF is work-ing together with the World Bank todevelop a standardized quarterly stat-istical report on the external debt ofcountries subscribing to the SDDS.The coordinated compilation exercisefor Financial Soundness Indicators(FSIs) will also be useful for BSA-re-lated work (IMF, 2004a, pp. 4—5;IMF, 2003, pp. 8—9). The IMF willalso include the BSA in the guidancenote on the coverage of financial sec-tor issues in Article IV consultationsusing the same macroprudential anal-ysis framework employed in FSAPs.Finally, the IMF is planning broad-based outreach work on the topic ofBSA with numerous analytical papers,publications and expert lectures (IMF2004a, pp. 5—6).





4 ConclusionsIn summary, the IMF�s Balance SheetApproach is an interesting new instru-ment for crisis detection, preventionand resolution.

For some time now, the IMF hasbeen using the BSA as a complementto traditional flow-based analysis,and many BSA elements have alreadybeen applied in the IMF�s practicalwork in country analyses, such asFinancial Sector Assessment Programs(FSAPs), debt sustainability analyses(DSAs), quarterly external vulnerabil-ity exercises, etc. The IMF also usesthe BSA as a supplementary analysistool to examine selected sectors(e.g. the banking and corporate sec-tors) in Article IV consultations formature market economies.

The IMF plans to enhance its workin this area by means of case studies onadditional countries (in the course of

Article IV consultations), countrycomparisons of debt structures andrelevant weaknesses, training semi-nars, etc.

The further integration of sectoralbalance sheet analysis into IMF workcan refine and reinforce existing in-struments such as the DSA, vulnera-bility exercise, etc., by enabling theidentification of existing weaknessesin those balance sheets. The system-atic recording of sectoral weaknessesin an economy will allow the IMF toassess more precisely the type andamount of liquidity required as wellas the need for IMF loans and anyaccompanying debt restructuringmeasures. However, due to incom-plete data and the static nature ofthe approach, the BSA can only beregarded as a useful complementto the other IMF instruments (IMF,2003, pp. 9—10).

ReferencesAllen, M., C. Rosenberg, C. Keller, B. Setser and N. Roubini. 2002. A Balance Sheet Approach to

Financial Crisis. IMF Working Paper 210.

Betriebswirtschaftlicher Verlag Dr. Th. Gabler GmbH. 1984. Gabler-Wirtschafts-Lexikon. Gabler.

Wiesbaden.

Calvo, G. 1998. Capital Flows and Capital-Market Crisis: The Simple Economics of Sudden Stops. In:

Journal of Applied Economics. Vol. 1. November. 35—54.

Calvo, G. A., A. Izquierdo and L.-F. Mejia. 2004. On the Empirics of Sudden Stops: The Relevance

of Balance Sheet Effects. NBER Working Paper 10520.

Dornbusch, R. 2001. A Primer on Emerging Market Crisis.

http://www.mit.edu/~rudi/media/PDFs/crisesprimer.pdf

Drazen, A. and P. Masson. 1994. Credibility of Policies versus Credibility of Policymakers. In: Quarterly

Journal of Economics. Vol. 59. 735—754.

Eichengreen, B., R. Hausmann and U. Panizza. 2003. Currency Mismatches, Debt Intolerance and

Original Sin: Why They Are Not the Same and Why it Matters. NBER Working Paper 10036.

Flood, R. and P. Garber. 1984. Collapsing Exchange Rate Regimes: Some Linear Examples. In: Journal of

International Economics. Vol. 17. 1—13.

IMF. 2003. The Balance Sheet Approach and its Applications at the Fund. Policy Development and Review

Department. IMF Note 63003. 30 June.

IMF. 2004a. Integrating the Balance Sheet Approach into Fund Operations. Policy Development and

Review Department. IMF Note 22304. 23 February.

IMF. 2004b. Global Financial Stability Report Market Developments and Issues. 12 September.





Kaminsky, G., S. Lizondo and C. M. Reinhart. 1997. Leading Indicators of Currency Crisis. IMF

Working Paper 79. 1 July.

Kaminsky, G. 1999. Currency and Banking Crisis — The Early Warnings of Distress. IMF Working Paper

178. 1 December.

Krugman, P. 1979. A Model of Balance of Payments Crises. In: Journal of Money. Credit and Banking.

Vol. 11. 311—325.

Krugman, P. 1999. Balance Sheets, the Transfer Problem and Financial Crises. Mimeo. MIT. January.

http://web.mit.edu/krugman/www/FLOOD.pdf

Milesi-Ferretti, G. M. and K. Moriyama. 2004. Fiscal Adjustment in EU Countries: A Balance Sheet

Approach. IMF Working Paper 143.

Mulder, C., R. Perrelli and M. Rocha. 2002. The Role of Corporate, Legal and Macroeconomic

Balance Sheet Indicators in Crisis Detection and Prevention. IMF Working Paper 59.

Obstfeld, M. 1994. The Logic of Currency Crises. Cahiers Economiques et Monetaires. Bank of France.

Vol. 43. 189-213.

Rosenberg, C. 2003. The Balance Sheet Approach to Financial Crisis. Unpublished speech notes.

October.

Schneider, M. and A. Tornell. 2000. Balance Sheet Effects, Bailout Guarantees and Financial Crisis.

NBER Working Paper 8060.





Highlights

The Oesterreichische Nationalbank (OeNB), the Austrian Institute of Economic Research (WIFO) andthe University of Vienna organized a full-day workshop on �Capital Taxation after EU Enlargement,�which was hosted by the OeNB on January 21, 2005.

Matthias Roche (Ernst&Young Frank-furt/Main) opened the first sessionwith a comprehensive overview ofcompany tax systems and effectivetaxation in the ten new EU MemberStates. Since the accession of the tennew members in May 2005, transna-tional corporations have had to copewith 25 different systems of capital in-come taxation in the EU, and anothertwo systems will be added in 2007,when Bulgaria and Romania are ex-pected to join the EU. The statutorytax rates in the new Member Statesare on average lower than in the EU-15. However, not only the statutorytax rates, but also the national provi-sions for computing the taxable baseare relevant for determining the effec-tive tax burden on enterprises. Therules on computing taxable incomeof all new members allow for the de-preciation of buildings and the amorti-zation of intangibles and tangible fixedassets, whereas setting up contingencyreserves and loss carryback are pro-hibited. Roche used a model invest-ment project based on assumptionsabout the sources of finance and typesof assets to calculate the effective aver-age tax rates (EATRs) for a Germanparent company which operates a sub-sidiary in each of the new MemberStates: At 19.99 percentage points,the spread between the highest EATR(Malta: 32.81%) and the most attrac-tive EATR (Lithuania: 12.82%) is verywide; the EU average stands at19.61%. Compared with the EU-15,the EATRs in all new Member Statesexcept Malta are significantly lower.Tax incentives, such as reduced cor-porate income tax (CIT) rates (offerede.g. by Cyprus and Malta) or CIT re-

bates in special economic zones (e.g.in Latvia and Lithuania) still play animportant role in the new MemberStates. In his conclusions, Rochepointed out that the new MemberStates offer a highly attractive taxenvironment.

Christian Bellak (Vienna Universityof Economics and Business Administra-tion) and Markus Leibrecht (OeNB)presented preliminary results of theirresearch project �Taxation and FDIin Central and East European Coun-tries� (carried out in cooperation withRoman Ro‹misch of the Vienna Insti-tute for International EconomicStudies — WIIW), in which theyinvestigate the implications of com-pany taxation for foreign direct invest-ment (FDI). According to Bellak andLeibrecht, methodological differencesare, among other things, responsiblefor the highly divergent outcomes ofpast empirical analyses closing in onthe influence of the effective corpo-rate tax burden on FDI flows. In addi-tion, the DI tax rate elasticity is sig-nificantly higher in �core countries�than in �periphery countries.� Toobtain valid empirical results on theinterrelationship of these two factors,it is necessary to choose the appropri-ate computation method. First, multi-national DI activity can be determinedon the basis of financial measures (DIflows and stocks) or measures of realactivity (corporate assets and invest-ments in plant, property and equip-ment, gross product of affiliates, num-ber of affiliates); many studies arebased on DI flows since these dataare more readily available. Second,the effective corporate tax burdencan be measured with several indica-

WalpurgaKo‹hler-To‹glhofer(OeNB),Margit Schratzenstaller(Austrian Institute ofEconomic Research —WIFO),Andreas Wagener(University of Vienna)


Company Taxationin an Enlarged European Union

tors (based on different methodologi-cal approaches): the statutory tax rate,backward looking effective tax ratesand forward looking rates. EATRs im-pact on business location decisions;the relevant data for DI are bilateralEATRs, as they account for the taxprovisions of the host country, inter-national tax provisions (e.g. doubletaxation conventions) as well as thecorporate tax provisions applicable inthe home country of the parent com-pany. The bilateral EATRs calculatedby Bellak et al. for seven importanthome countries and five new EUmembers for the period 1996 to 2004show that statutory tax rates arehigher than domestic EATRs, the var-iabilities of statutory tax rates anddomestic EATRs are within a similarrange, and country rankings by statu-tory tax rates and domestic EATRsproduce similar results. BilateralEATRs are usually higher than thestatutory CIT rates of the host coun-try, which is also reflected in thecountry rankings by bilateral EATRs.Using the latter, instead of statutorytax rates, in the empirical determina-tion of DI tax rate elasticity yieldssignificantly higher (negative) tax elas-ticities for the five new EU MemberStates examined. The estimated taxrate elasticities are, however, likelyto decrease when other businesslocation factors (e.g. public infrastruc-ture and agglomeration effects) areincluded.

In his summary of the pros andcons of the existing methodologicalapproaches to computing the effectivecorporate tax burden, Christian Beer(OeNB) emphasized that individualtax burden indicators shed light ondifferent aspects. According to him,the macro backward looking approachshould be used to analyze the burdenof different tax bases (e.g. capital

and labor) or to measure changes ofthe tax burden over time. The microbackward looking approach — whileinappropriate for isolating the influ-ence of the different corporate taxa-tion systems — can be used to computethe effective corporate tax burden onenterprises of different sizes and sec-tors. Beer maintains that the microforward looking approach neglectskey elements of the tax systems andis based on — often rather arbitrarilychosen — restrictive assumptions.

Otto Farny (Vienna Chamber ofLabor) pointed out that the micro for-ward looking approach to computingeffective tax rates, which is based onmodel investment projects and therespective tax laws, disregards the factthat the difference between the no-tional and the actual tax burden maybe significant (especially in the newEU Member States); the backwardlooking approach, on the other hand,uses the actual tax payments.

He furthermore criticized styliz-ing the corporate tax burden as thekey determinant of business locationand investment decisions and calledfor further empirical analyses of theinfluence of wage-based taxes andcharges on DI.

Session 2 revolved around twocentral aspects of corporate and capi-tal taxation.

In his presentation �(Why) Dowe need corporate taxes,� AlfonsWeichenrieder (University of Frank-furt) questioned the need for corpo-rate taxation and underscored therelevance of this issue for small openeconomies. Tax theory suggests that,under specific conditions, the opti-mal solution for small open econo-mies would be not to tax capitalincome. Despite an internationaltrend in recent years to lower CITrates, the GDP share of CIT revenues


Company Taxation

in an Enlarged European Union

remained relatively stable owing toan increase in the number of incor-porated enterprises and to tax basebroadenings coupled with the taxrate reductions. International com-parisons show that EATRs (whichconstitute an important factor in thecompetition of business locations)were lowered to a considerable ex-tent during the last decades. Againstthis backdrop, it is interesting toexamine whether the erosion of cor-porate taxes has any alarming eco-nomic or fiscal effects at all. Analyz-ing the arguments given in the cor-porate finance literature in favor ofthe separate taxation of incorporatedcompanies, Weichenrieder arrived atthe conclusion that neither the classicargument of a benefit tax, i.e. a�quasi fee� for the use of the publicinfrastructure, nor the argument ofa fee for the privilege of the share-holders� limited liability (and limitedrisk) sufficiently justify the separatetaxation of incorporated enterprises.The argument that CIT can be usedas a way to tax foreigners in a systemof liberalized capital transactions isonly valid on condition that thehome country has a tax credit systemin place for taxes paid in the sourcecountry. If, on the other hand, CITis regarded as a prepayment of thepersonal income tax (PIT), precau-tions have to be taken to avoid doubletaxation, e.g. by introducing a share-holder tax or applying a full imputa-tion system of corporate taxes withrespect to the shareholders� PIT(with the latter solution leading toapproximative results). However, fullimputation systems usually applyonly to resident taxpayers and thereis no imputation system for cross-border dividends arising from taxburdens. If PIT on capital income isdesired, a positive CIT rate is essen-

tial according to Weichenrieder. Inthis scenario, CIT is supposed tofunction as a �backstop� to preventshareholders from escaping capitalincome taxation via profit retentionand to reduce the attraction ofdeclaring labor income as capitalincome. However, if CIT is morefavorable than PIT, taxpayers willtry to save money via the corporateshelter, especially if capital gainsare not subject to taxation duringthe retention period. Weichenriederpointed out that the most importantfunction of the corporate income taxis to make sure that the capitalincome of natural persons remainstaxable at all. Empirical evidencesuggests that a reduction of the CITrate below the PIT rate level resultsin a tax-induced shift of savings fromprivate households to enterprises.

Christian Keuschnigg (University ofSt. Gallen) focused on the interrela-tions of capital income taxation andlong-term economic growth on thebasis of his complex proposal for acapital taxation reform in Switzerland(in cooperation with Soren Bo Nielsenund M. D. Dietz). This approach es-sentially aims to eliminate tax-induceddistortions of investment and savingdecisions by combining a specific var-iant of the dual income tax (as imple-mented in northern Europe) with achange in the taxation of equity. Inhis proposal, Keuschnigg recommendsreducing the double taxation of divi-dends while at the same time intro-ducing effective taxation of capitalgains with a view to reducing tax-in-duced distortions adversely affectinginvestment demand (and thus alsothe accumulation of capital) and tax-induced distortions concerning thechoice of both organizational formand type of financing. In addition tothe CIT reform, he advocates leveling


Company Taxation


the tax burden on all types of capitalincome at the personal level by intro-ducing a uniform proportional tax.He claims that this will in all probabil-ity not cause any tax-induced distor-tions to private investors� behaviorand will furthermore result in compa-rable tax burdens on enterprises inde-pendent of their organizational form(equal treatment of equity and debtwith respect to the CIT assessmentbase). In this scenario, only companyrents and excess profits would be sub-ject to taxation which constitutes areduction of the average tax burdenon enterprises and would, in turn,improve the competitive position ofSwitzerland as EATRs play a key rolein multinational enterprises� choiceof business locations. The compara-tively low proportional capital incometax as proposed by Keuschnigg (whichwould cut the current tax burden oninterest and dividend income approx-imately by half) is designed to mitigatethe effects of the double taxation ofsavings. At the same time, a moreeffective taxation of capital incomewould eliminate a tax loophole thatexists in almost all countries andmakes retentions profitable (lock-ineffect). If the tax rate is chosenaccordingly, it will not encourageentrepreneurs to record labor incomeas capital income (tax arbitrage).According to Keuschnigg, the imple-mentation of this reform proposal(computed on the basis of a calibratedgrowth model) would translate intopermanent GDP growth by approxi-mately 2% to 3%. The resulting dropin tax revenues could be canceled outwith a higher VAT on the one hand,and with spending cuts or a tempora-rily higher debt ratio on the otherhand. The first option would entailconsiderable short-term costs becauseof distortions to the labor market, and

the second (debt-financed) optionwould somewhat dampen the impliedlong-term growth effects.

In his presentation, Keuschniggalso touched on the taxation of ven-ture capital (VC)-funded startups.Challenging the current practice ofsubsidizing them, he claimed thatlevying taxes on startups might havea positive impact on their quality,i.e. net worth. The resulting taxreceipts should be used to compen-sate for tax losses arising from thetax reduction on capital gains ofVC-funded enterprises. Curbing notperformance-related subsidies and fa-voring successful startups is supposedto contribute to a more active styleof VC financing.

Anton Rainer (Austrian FederalMinistry of Finance) argued that thesignificance of corporate taxes, andespecially their role in business loca-tion decisions, is generally overesti-mated. Besides, he questioned the re-sults of Keuschnigg�s study challeng-ing the relevance of the assumptionsimplied by dynamic equilibrium mod-els since such models underlying such(quantitative) analyses.

Alex Stomper (Vienna Institute forAdvanced Studies) emphasized theimpact of the perspective (corporatefinance versus tax theory or macro-economics) on the approach to analyz-ing the company tax issue. He, too,questions the practice of deducingfindings from equilibrium modelsgiven their numerous simplifyingassumptions (such as perfect com-petition) and because they fail toaddress several issues. He argues thatKeuschnigg�s proposal of levying taxeson VC-backed startups as an incentive(instead of subsidizing them) woulddiscourage entrepreneurs and trans-late into fewer business startups. In-troducing imperfect competition and


Company Taxation


imperfect markets might have an im-pact on the results of model compu-tations. Furthermore, there is no con-clusive evidence to substantiate theassumption that a tax reform actuallystrengthens the equity base of nonin-corporated firms, and Stomper voiceddoubts about the wisdom of embark-ing on a comprehensive tax reformwhen its outcome is so uncertain.He pointed out that the analyses arebased on highly simplified assump-tions of the financing structure (puredebt or equity financing). In his view,it is most important to find out whichfinancing alternatives are available to acertain type of company in imperfectcapital markets and which financingstructure serves it best, as well as todetermine the impact of the varioustypes of funding on investment deci-sions and the influence of tax provi-sions on the various financing alter-natives.

The leading question for the thirdsession was whether the tax policiesin an economically integrated areashould be coordinated or left to thediscretion of national governments.In the EU, this question is particularlyrelevant for direct taxes since indirecttaxes are, by and large, alreadyharmonized.

Bernd Genser (University of Kon-stanz) outlined the achievements andfailures of the EU in harmonizingcorporate taxation. During the pastfour decades, the EU commissioneda series of reports on the harmoniza-tion of CIT, with the aim of levelingthe playing field within the CommonMarket, abolishing discriminatory taxpractices, and avoiding fiscal external-ities. None of the blueprints includedin these reports was ever imple-mented. Genser stressed that thismust not be interpreted as a failureof coordination policies, since numer-

ous issues tackled in these reportswere actually incorporated into therelevant EU provisions, e.g. theParent-Subsidiary Directive (1990),the Merger Directive (1990) and theCode of Conduct (1997). Neverthe-less, several key issues have yet to beresolved. A case in point are the highlyheterogeneous statutory and effectivemarginal and average CIT rates acrossEurope, which generates distortionsin the allocation of capital and createsmisplaced incentives for national gov-ernments to use their tax instrumentsin a strategic manner. Some of theseproblems are addressed in the Bolke-stein Report of 2001, which proposesvarious approaches to harmonizingthe CIT base for EU-wide operationsof multinationals in combination withan allocation system for the distribu-tion of the tax revenues among theEU Member States. While leavingtax autonomy to the national govern-ments, the proposal aims at substan-tially reducing compliance costs, elim-inating incentives for cross-borderprofit shifting, implementing capitalexport neutrality, and crowding outmany incentives for unfair or strategictax practices. However, as Genserpointed out, the Bolkestein proposalsgive rise to new problems: the Mem-ber States need to agree on a reasona-ble allocation key, the system mightproduce negative fiscal externalities,and the issue of non-EU activitieshas not been addressed at all. How-ever, the Bolkestein proposals deservecredit for demonstrating that CIT har-monization is not necessarily accom-panied by the loss of national taxautonomy; it allows for various waysof CIT/PIT integration along nationaltax traditions.

Lars Feld (University of Marburg)discussed the issue of tax competitionwithin the Common Market, where


Company Taxation


companies can choose to locate mo-bile factors in the country offeringthe most attractive package of taxrules and public services. This fact in-variably leads to competition amongthe EU Member States. According tothe Tiebout hypothesis, such a �votingby feet� would serve as an incentive toimprove the efficiency of public serv-ices. Unfortunately, Feld argues, thiseffect is of academic value only sinceexternalities between the countriesrender decentralized tax policies inef-ficient. Moreover, public services arein many ways not comparable with�normal� goods (non-rivalry in con-sumption, decreasing average produc-tion costs, etc.). Even if a Tieboutworld led to increased efficiency, itwould still be incompatible with thelarge-scale redistribution policies ofthe European welfare states. All theseaspects cast doubt on the viability ordesirability of tax competition. Onthe other hand, tax competition mayappear attractive from a political-economy perspective: the potentialabusive behavior of politicians andgovernments (e.g. failing to imple-ment welfare-enhancing policies, act-ing as selfish rent-seeking agents) willbe limited by taxpayer mobility.Under the pressure of yardstick com-petition in an open economy, best-practice solutions and political re-forms might be adopted more quicklyand effectively. Hence, there is no con-clusive evidence in favor of or againsttax competition from a theoreticalperspective. Therefore, Feld comparesthe actual performance of decentral-ized and centralized tax policies andsummarizes his insights (gained by re-viewing numerous empirical studies)as follows: there is sufficient evidenceto substantiate that fiscal competitionenhances economic efficiency; the as-sumption that decentralization will

lead to a collapse of the welfare stateand put an end to redistribution poli-cies was not sustained. The impact offiscal decentralization on economicgrowth is unclear. Finally, some — ifstill unsystematic — evidence suggeststhat fiscal decentralization will leadto more political innovation and highercitizen satisfaction. On the basis ofthese observations, Feld concludedthat fiscal competition, if appropri-ately controlled by political proce-dures, has some advantages over har-monization.

The discussants basically agreedwith Genser�s and Feld�s analyses butadded some qualifications.

Martin Zagler (Vienna Universityof Economics and Business Administra-tion) questioned whether tax competi-tion is (or will ever be) compatiblewith the welfare state concept. Heargued that harmonized taxes maysimply shift intergovernmental com-petition to other areas, such as publicexpenditures.

Daniele Franco (Banca d�Italia)warned not to take political-economyarguments in favor of tax competitiontoo seriously since democratic sys-tems had a range of built-in mecha-nisms apart from tax competition tocontrol government opportunism.He advocated a gradual approach tothe design of new tax systems as thebenefits and costs of neither tax com-petition nor tax coordination werecertain or quantifiable at this point.

In his presentation �The Future ofCapital Income Taxation in the Euro-pean Union,� Sijbren Cnossen (Univer-sity of Maastricht) gave an overview ofcurrent tax practices and focused onthe question if (and how) capital in-come should be taxed in the future.Levying taxes on economic rents iscommonly accepted as justified. Thequestion if (and to what extent) taxes


Company Taxation


should be levied on normal yieldshinges on efficiency, equity and en-forcement issues. Cnossen specifiesthree relevant models apart from theexisting capital income taxation sys-tems: the dual income tax model,the comprehensive business incometax model and a net wealth tax. Theexisting CIT systems are characterizedby the trend of levying higher taxes onlabor income than on capital incomeand of tax discrimination against divi-dend payouts in favor of debt financ-ing. Cnossen recommends the intro-duction of a dual income tax systemthat includes comprehensive with-holding taxes on interest income andthe approximation of capital incometax rates, but voices doubt over thetax harmonization plans currentlyunder discussion in the EU, especiallywith regard to the introduction of acommon tax base and a harmonizedEuropean corporate tax system. Inhis view, tax coordination is indis-pensable for effective capital incometaxation, but he also underscores theimportance of the subsidiarity princi-ple. In conclusion, Cnossen arguedthat tax coordination has to be a bot-tom-up process that should be realizedin a gradual and largely reversiblemanner.

Ewald Nowotny (Vienna Universityof Economics and Business Administra-tion) observed that the concept ofcomprehensive income taxation is ad-vocated in theory only; it is no longervery relevant in the EU: today, taxeson labor income are generally (in partsignificantly) higher than those oncapital income. He acknowledges theNordic system of dual income taxa-tion favored by Cnossen as an inter-esting solution, but points out that

Norway, Sweden and Finland haveeffective wealth taxation systems. Taxcompetition applies to the taxationof corporate profits, wealth and highlabor incomes; these distributionalaspects need to be considered in eco-nomic policy assessments. Accordingto Nowotny, tax havens pose a realproblem in this context. Tax competi-tion leads to distortions in the tax bur-den for international enterprises andlocal SMEs as a result of the negativeallocative effects.

The workshop �Capital Taxationafter EU Enlargement� covered abroad range of topical issues; theaccession of ten new Member Stateswith ten different tax systems makesthese issues all the more importantfor the future economic developmentwithin the EU and for the design ofthe EU�s economic policies. Due tovarying methodological approaches,however, the analysis of the 25 differ-ent CIT systems based on the effectivetax burden failed to furnish final andconclusive data of their effects onFDI. Aligning a CIT reform (or a com-prehensive capital taxation reform)with the aim of increasing the long-term economic growth potential wasgenerally acknowledged as a highlycomplex challenge both from an eco-nomic and a social perspective. Even ifit is not possible to prove conclusivelywhether tax competition or tax har-monization are more advantageous inthe field of corporate taxation, a cer-tain degree of tax coordination be-tween EU countries seems indispensa-ble. The bottom line of this intensiveworkshop was that more researchwork is clearly needed to create a firmbasis for fiscal policy decisions at theEU level.


Company Taxation


ACH automated clearing houseAPSS Austrian Payment System Services GmbHARTIS Austrian Real Time Interbank Settlement

(the Austrian RTGS system)A-SIT Secure Information Technology Center — AustriaASVG Allgemeines Sozialversicherungsgesetz — General

Social Security ActA-Trust A-Trust Gesellschaft fu‹r Sicherheitssysteme im

elektronischen Datenverkehr GmbHATM automated teller machineATX Austrian Traded IndexBCBS Basel Committee on Banking Supervision (BIS)BIC Bank Identifier CodeBIS Bank for International SettlementsBOP balance of paymentsBSC Banking Supervision Committee (ESCB)CACs collective action clausesCEBS Committee of European Banking Supervisors (EU)CEE Central and Eastern EuropeCEECs Central and Eastern European countriesCESR Committee of European Securities RegulatorsCIS Commonwealth of Independent StatesCPI consumer price indexEBA Euro Banking AssociationEBRD European Bank for Reconstruction and

DevelopmentEC European CommunityECB European Central BankEcofin Council of Economics and Finance Ministers (EU)EEA European Economic AreaEFC Economic and Financial Committee (EU)EIB European Investment BankEMS European Monetary SystemEMU Economic and Monetary UnionEONIA Euro OverNight Index AverageERM II Exchange Rate Mechanism II (EU)ERP European Recovery ProgramESA European System of AccountsESAF Enhanced Structural Adjustment Facility (IMF)ESCB European System of Central BanksESRI Economic and Social Research InstituteEU European UnionEURIBOR Euro Interbank Offered RateEurostat Statistical Office of the European CommunitiesFATF Financial Action Task Force on Money LaunderingFed Federal Reserve SystemFFF Forschungsfo‹rderungsfonds fu‹r die Gewerbliche

Wirtschaft — Austrian Industrial ResearchPromotion Fund

FMA Financial Market Authority (for Austria)FOMC Federal Open Market Committee (U.S.A.)FSAP Financial Sector Assessment Program (IMF)FWF Fonds zur Fo‹rderung der wirtschaftlichen

Forschung — Austrian Science FundGAB General Arrangements to BorrowGATS General Agreement on Trade in ServicesGDP gross domestic product

GNP gross national productGSA GELDSERVICE AUSTRIA Logistik fu‹r Wert-

gestionierung und Transportkoordination GmbH(Austrian cash services company)

HICP Harmonized Index of Consumer PricesIBAN International Bank Account NumberIBRD International Bank for Reconstruction and

DevelopmentIDB Inter-American Development BankIFES Institut fu‹r empirische Sozialforschung GesmbH

(Institute for Empirical Social Research, Vienna)ifo ifo Institute for Economic Research, MunichIGC Intergovernmental Conference (EU)IHS Institut fu‹r Ho‹here Studien und Wissenschaftliche

Forschung — Institute for Advanced Studies, ViennaIIF Institute of International FinanceIIP international investment positionIMF International Monetary FundIRB internal ratings-basedISO International Organization for StandardizationIWI Industriewissenschaftliches Institut — Austrian

Institute for Industrial ResearchIT information technologyJVI Joint Vienna InstituteLIBOR London Interbank Offered RateM3 broad monetary aggregate M3MFI monetary financial institutionMRO main refinancing operationMO‹ AG Mu‹nze O‹ sterreich AG — Austrian MintMoU memorandum of understandingNCB national central bankO‹ BB O‹ sterreichische Bundesbahnen — Austrian Federal

RailwaysOeBS Oesterreichische Banknoten- und Sicherheitsdruck

GmbH — Austrian Banknote and Security PrintingWorks

OECD Organisation for Economic Co-operation andDevelopment

OeKB Oesterreichische Kontrollbank (Austria�s mainfinancial and information service provider for theexport industry and the capital market)

OeNB Oesterreichische Nationalbank (Austria�s centralbank)

OPEC Organization of the Petroleum Exporting CountriesORF O‹ sterreichischer Rundfunk — Austrian Broadcasting

CorporationO‹ BFA Austrian Federal Financing AgencyO‹ NACE Austrian Statistical Classification of Economic

ActivitiesPE-ACH pan-European automated clearing housePISA Programme for International Student Assessment

(OECD)POS point of salePRGF Poverty Reduction and Growth Facility (IMF)RTGS Real-Time Gross SettlementSDR Special Drawing Right (IMF)SDRM Sovereign Debt Restructuring Mechanism (IMF)SEPA Single Euro Payments Area


Abbreviations

SPF Survey of Professional ForecastersSTEP2 Straight-Through Euro Processing system offered by

the Euro Banking AssociationSTP straight-through processingSTUZZA Studiengesellschaft fu‹r Zusammenarbeit im

Zahlungsverkehr G.m.b.H. — Austrian ResearchAssociation for Payment Cooperation

S.W.I.F.T. Society for Worldwide Interbank FinancialTelecommunication

TARGET Trans-European Automated Real-time Grosssettlement Express Transfer

Treaty refers to the Treaty establishing the EuropeanCommunity

UNCTAD United Nations Conference on Trade andDevelopment

UNO United Nations OrganizationVaR Value at RiskWBI Wiener Bo‹rse IndexWEF World Economic ForumWIFO O‹ sterreichisches Institut fu‹r Wirtschaftsforschung —

Austrian Institute of Economic ResearchWIIW Wiener Institut fu‹r internationale Wirtschafts-

vergleiche — The Vienna Institute for InternationalEconomic Studies

WKO Wirtschaftskammer O‹ sterreich — Austrian FederalEconomic Chamber

WTO World Trade Organization


Abbreviations

x = No data can be indicated technical reasons. . = Data not available at the reporting date0 = The numerical value is zero or smaller than half of the unit indicated

Discrepancies may arise from rounding.


Legend

For further details on the following publications see www.oenb.at

Issue Q1/04Subdued Economic Activity in the Euro Area and Austria DespiteInternational RecoveryGerhard Fenz, Thomas Gruber, Wolfgang Pointner

Determinants of Long-Term Growth in Austria — A Call for a National GrowthStrategyErnest Gnan, Ju‹rgen Janger, Johann Scharler

Inflation Differentials in Europe: Past Experience and Future ProspectsBala«sz E«gert, Doris Ritzberger-Gru‹nwald, Maria Antoinette Silgoner

The International Financial Architecture: Official Proposals on CrisisResolution and the Role of the Private SectorChristian Just

The Impact of ATM Transactions and Cashless Payments on Cash Demandin AustriaHelmut Stix

Issue Q2/04

Global Recovery and Stable Domestic Economic Conditions SupportModerate Upswing — Economic Outlook for Austria from 2004 to 2006(Spring 2004)Gerhard Fenz, Johann Scharler, Martin Schneider

The Impact of Oil Price Changes on Growth and InflationMartin Schneider

Sectoral Specialization in Austria and in the EU-15Ju‹rgen Janger, Karin Wagner

The Role of Revaluation and Adjustment Factors in Pay-As-You-GoPension SystemsMarkus Knell

Financial Market Structure and Economic Growth: A Cross-CountryPerspectiveFriedrich Fritzer

The Role of Bank Lending in Market-Based and Bank-Based Financial SystemsSylvia Kaufmann, Maria Teresa Valderrama

Growth and Stability in the EU: Perspectives from the Lisbon Agenda —Results from the 32nd Economics ConferenceSylvia Kaufmann, Burkhart Raunig, Helene Schuberth


List of StudiesPublished in Monetary Policy & the Economy

Issue Q3/04

Economic Recovery in the Euro Area and in Austria in a Dynamic GlobalEconomic EnvironmentAntje Hildebrandt, Martin Schneider, Maria Antoinette Silgoner

Measures to Improve the Efficiency of the Operational Framework forMonetary PolicyMichael Pfeiffer

Expansionary Fiscal Consolidations? An Appraisal of the Literature onNon-Keynesian Effects of Fiscal Policy and a Case Study for AustriaDoris Prammer

The Draft Treaty Establishing a Constitution for Europe — InstitutionalAspects of Monetary UnionIsabella Lindner, Paul Schmidt

Central and Eastern Europe — The Growth Market for Austrian BanksPeter Breyer

�60 Years of Bretton Woods� — A Summary of the Bretton WoodsConferenceChristian Just, Franz Nauschnigg

Issue Q4/04

Growth Stimulus from Tax Reform in 2005 to Overshadow Weaker GlobalEconomic Momentum — Economic Outlook for Austria from 2004 to 2006(Fall 2004)Gerhard Fenz, Martin Schneider

Determinants of the Household Saving Rate in AustriaWerner Dirschmid, Ernst Glatzer

The Role of Corporate Bonds for Finance in AustriaWalter Waschiczek

Economic Growth in Denmark, Sweden and the United Kingdom since theStart of Monetary UnionGabriel Moser, Wolfgang Pointner, Gerhard Reitschuler

The Political Economy of International Financial GovernanceVanessa Redak, Helene Schuberth, Beat Weber

Macroeconomic Models and Forecasts for AustriaGerhard Fenz, Martin Schneider

A Constitutional Treaty for an Enlarged Europe: Institutional and EconomicImplications for Economic and Monetary UnionPaul Schmidt

Longer Working Hours? More Flexible Work Schedules?Do Austrian Economic Policymakers Need to Act?Alfred Stiglbauer


List of Studies

Published in Monetary Policy & the Economy

Issue Q1/05

Slowdown in Global Economic MomentumAsia and the U.S.A. To Remain Growth Drivers of World Economy in 2005Johann Elsinger, Gerhard Fenz, Ingrid Haar-Sto‹hr, Antje Hildebrandt,Thomas Reininger, Gerhard Reitschuler

Demographic Fluctuations, Sustainability Factors and IntergenerationalFairness — An Assesment of Austria�s New Pension SystemMarkus Knell

The Research and Development System in Austria —Input and Output IndicatorsJu‹rgen Janger

Fundamental and Nonfundamental Factors in the Euro/U.S. Dollar Marketin 2002 and 2003Hannes Haushofer, Gabriel Moser, Franz Schardax, Renate Unger

The International Monetary Fund�s Balance Sheet Approach toFinancial Crisis Prevention and ResolutionAndrea Hofer

Company Taxation in an Enlarged European UnionWalpurga Ko‹hler-To‹glhofer, Margit Schratzenstaller, Andreas Wagener


List of Studies

Published in Monetary Policy & the Economy

For further details on the following publications see www.oenb.at

Statistiken — Daten & Analysen quarterly

This publication contains reports and analyses focusing on Austrian financialinstitutions, cross-border transactions and positions as well as financial flows.The contributions are in German, with executive summaries of the analysesin English. The statistical part covers tables and explanatory notes on a widerange of macroeconomic, financial and monetary indicators. The tables includ-ing additional information and data are also available on the OeNB�s website inboth German and English. This series also includes special issues on selectedstatistics topics that will be published at irregular intervals.

Monetary Policy & the Economy quarterly

This quarterly publication, issued both in German and English, offers analyses ofcyclical developments, medium-term macroeconomic forecasts and studies oncentral banking and economic policy topics. This publication also summarizesthe findings of macroeconomic workshops and conferences organized by theOeNB.

Financial Stability Report semiannual

The Financial Stability Report, issued both in German and English, containsfirst, a regular analysis of Austrian and international developments with animpact on financial stability and second, studies designed to provide in-depthinsights into specific topics related to financial market stability.

Focus on European Economic Integration semiannual

Focus on European Economic Integration, the successor publication to the Focuson Transition (published up to issue 2/2003), contains a wide range of materialon Central and Eastern European countries (CEECs), beginning with a topicaleconomic analysis of selected CEECs. The main part of the publication com-prises studies, on occasion several studies focusing on a special topic. The finalsection provides information about the OeNB�s CEEC-related activities andconferences as well as a statistical annex.

Annual Report annual

The Annual Report of the OeNB provides a broad review of Austrian monetarypolicy, economic conditions, new developments on the financial markets ingeneral and the financial market supervision in particular, the changing respon-sibilities of the OeNB and the role of the OeNB as an international partner incooperation and dialogue. It also contains the financial statements of the OeNB.

Economics Conference (Conference Proceedings) annual

The Economics Conference hosted by the OeNB represents an important inter-national platform for exchanging views on monetary and economic policy as wellas financial market issues. It convenes central bank representatives, economicpolicy decision makers, financial market players, academics and researchers.The conference proceedings comprise papers of conference participants, mostof them in English.


Periodical Publicationsof the Oesterreichische Nationalbank

The Austrian Financial Markets annualThe publication The Austrian Financial Markets provides easy access to contin-uously updated information on the Austrian capital markets to the internationalinvestment community. The brochure is jointly edited by the OeNB and theOesterreichische Kontrollbank AG (OeKB).

Proceedings of OeNB Workshops recurrent

The proceeding of OeNB Workshops were introduced in 2004 and typically com-prise papers presented at OeNB workshops at which national and internationalexperts, including economists, researchers, politicians and journalists, discussmonetary and economic policy issues. Workshop proceedings are available inEnglish only.

Working Papers recurrent

The Working Paper series of the OeNB is designed to disseminate and provide aplatform for discussing findings of OeNB economists or outside contributors ontopics which are of special interest to the OeNB. To ensure the high quality oftheir content, the contributions are subjected to an international refereeingprocess. The opinions are strictly those of the authors and in no way committhe OeNB.

Conference on European Economic Integration(Conference Proceedings) annual

(formerly East-West Conference)This series, published by a renowned international publishing house, reflects pre-sentations made at the OeNB�s annual central banking conference on Central,Eastern and Southeastern European issues and the ongoing EU enlargementprocess.For further details see ceec.oenb.at

Newsletter of the Economic Analysisand Research Section quarterlyThe English-language Newsletter of the Economic Analysis and Research Section isonly published on the Internet and informs an international readership aboutselected findings, research topics and activities of the Economic Analysis andResearch Section of the OeNB. This publication addresses colleagues from othercentral banks or international institutions, economic policy researchers, deci-sion makers and anyone with an interest in macroeconomics. Furthermore,the Newsletter offers information on publications, studies or working papersas well as events (conferences, lectures and workshops).

For further details see hvw-newsletter.oenb.at


Periodical Publications

of the Oesterreichische Nationalbank

Postal address Telephone Telex

Head OfficeOtto-Wagner-Platz 3 PO Box 61 (+43-1) 404 20-0 (1) 114669 natbk

AT 1090 Vienna AT 1011 Vienna Fax: (+43-1) 404 20-2398 (1) 114778 natbk

Internet: www.oenb.at

Branch Offices

Western Austria Branch Office

InnsbruckAdamgasse 2

AT 6020 Innsbruck

Adamgasse 2

AT 6020 Innsbruck

(+43-512) 594 73-0

Fax: (+43-512) 594 73-99

Southern Austria Branch Office

GrazBrockmanngasse 84

AT 8018 Graz

PO Box 8

AT 8018 Graz

(+43-316) 81 81 81-0

Fax: (+43-316) 81 81 81-99

Klagenfurt10.-Oktober-Stra§e 13

AT 9010 Klagenfurt

PO Box 526

AT 9010 Klagenfurt

(+43-463) 576 88-0

Fax: (+43-463) 576 88-99

Northern Austria Branch Office

LinzCoulinstra§e 28

AT 4021 Linz

PO Box 346

AT 4021 Linz

(+43-732) 65 26 11-0

Fax: (+43-732) 65 26 11-99

SalzburgFranz-Josef-Stra§e 18

AT 5027 Salzburg

PO Box 18

AT 5027 Salzburg

(+43-662) 87 12 01-0

Fax: (+43-662) 87 12 01-99

Representative Offices

Oesterreichische Nationalbank (+44-20) 7623-6446

London Representative Office Fax: (+44-20) 7623-6447

Gracechurch Street 48, 5th floor

GB EC3V 0EJ London

Oesterreichische Nationalbank (+1-212) 888-2334 (212) 422509 natb ny

New York Representative Office (+1-212) 888-2335

745 Fifth Avenue, Suite 2005 Fax: (+1-212) 888-2515

US 10151 New York

Permanent Representation of Austria to the EU (+32-2) 285 48-41, 42, 43

Avenue de Cortenbergh 30 Fax: (+32-2) 285 48-48

BE 1040 Brussels

Permanent Representation of Austria to the OECD (+33-1) 53 92 23-39

Rue Albe«ric-Magnard 3 (+33-1) 53 92 23-44

FR 75116 Paris Fax: (+33-1) 45 24 42-49


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