The stock-flow approach to the real exchangerate of CEE transition economies

Balázs Égert Oesterreichische Nationalbank, UPX, WDI

Amina Lahrèche-RévilCEPII Paris

Kirsten LommatzschDIW Berlin

Motivation

Transition countries economies have been on a path of real appreciation since the initial macroeconomicstabilisation was achieved.

What are its causes?

- equilibrium appreciation related to catch-up process

- unsustainable imbalances

- correction of undervaluation in the early years of the transition

Real exchange rates, CPI based, towards Germany

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1

Bulgaria

Croatia

Czech Republic

Estonia

Hungary

Latvia

Lithuania

Poland

Slovak Republic

Slovenia

Romania

Problem

How to test for determinants of the real exchange rates and for causes of the appreciation in transition economies?

- short time series, methods may yield unreliable results

- early transition period could bias the overall results

If currencies had been undervalued in the planned era + the early years of the transition as suggested e.g. by Halpern/Wyplosz (1997), then a problem of a biased constant would arise(Maeso-Fernandez et al. 2004, 2005)equilibrium appreciation would be over-estimated

Motivation

panel estimates to correct for low number of observations

problem of biased constants remains

Maeso-Fernandez et al. : derive equilibrium rates with relationships determined

in out of sample panels

But: what if the initial undervaluation does not explainthe steady real appreciation in any significant way?

what if the relationships and the parameters differ between the panel of reference countries (e.g. OECD) and the transition economies?

what if short to medium term determinants dominate in the transition economies?

Aim of the paper is therefore to

- investigate determinants of the real exchange rate based on a stock-flow model

- compare in-sample and out-of-sample estimations

Model based on macroeconomic balance and adjustmentof stock of foreign assets

(Aglietta et al. 1997, Faruqee 1995)

odstradablego-non

of price relative foreign the todomestic theof ratio

/**

rate exchange real Internal

sector tradablethefor rate exchange real

* 11( TNTTNTTT ppppppeq

Equilibrium exchange rate prevails at simultaneous internaland external equilibrium (macroeconomic balance); abstraction from short-term fluctuations

Internal equilibrium can be related to a cleared market fornon-tradables (e.g. Balassa-Samuelson model)and is reflected in the prices of non-tradables

External equilibrium requires sustainability of the current account

related to desired capital flows (capital account)

income payments from stock of assets

determinants of the trade balance (real exchange rate, non-price competitiveness)

According to stock-flow models, countries have a desired stock of capital F; adjustment to it is partial

tt fFca

In all periods, the “equilibrium“ current account will be equal to this capital flow (= capital account dominates).

it can also be interpreted as a path of savings and investment in line with long-term income and consumption patterns

The transition economies have run large current account deficits; the debts and the income payments have grown.

Czech Republic: balance of payments positions in per cent of GDP

-2.5

-6.7-6.3

-2.1-2.5

-4.9

-5.4-5.6

-6.3

-5.2

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

balance of goods and services balance of income current account

Hungary: balance of payments positions in per cent of GDP

-3.7-4.0

-4.5

-7.2

-7.8

-8.7

-6.2

-7.1

-8.9 -8.8

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

balance of goods and services balance of income current account

Estonia: balance of payments positions in per cent of GDP

-4.2

-8.6

-11.4

-8.6

-4.4

-5.5 -5.6

-10.2

-12.2

-12.9

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

balance of goods and services balance of income current account

The determinants of the current account have to yield the position given by the adjustment of the stock of foreign assets.

- income flows due to existing stock of foreign assets

- real exchange rate based on traded goods pricesin standard elasticities models: higher growth requiresdepreciation to sustain trade balance

- non-price competitiveness factors imply a reduction in the price elasticity of demand for

exports (and for imports)

tttTtt zfiqca *

non-price competitiveness in the transition economies

Main idea:

In the planned era and the early years of the transition

- domestic supply was of low quality and low technologicalcontent compared with more developed economies

- domestic supply lacked competitiveness in domestic and foreignmarkets

- devaluations at the time of the trade liberalisations reflected the competitiveness problem

Catch-up process means

- increasing capacity of the countries to produce goods of higher quality (= higher productivity)

- the composition of the goods produced changes towardshigher technology goods (e.g. due to FDI)

- upgraded supply can be interpreted as an improvement in the non-price competitiveness

- it shifts demand both of domestic and foreign consumerstowards the goods of the country in the catch-up process

Consumers demand domestic and foreign goods based on e.g.

1 1

1 1

1 1ln (1 ln

1 1ln (1 ln

D D

F F

td ndD D D

j iD Dj i

nf tfF F F

k nF Fk n

U c c

U c c

Crucial assumption

( )f td td

positive

the same applies to the foreign economy

( )f tf tf

negative

If (by assumption) only the domestic economy grows (by the number of available goods varieties), the share of income devoted to the goods of the country catching up increases in both countries.

Demand shifts towards the goods of the country catching up.

It can be shown that under certain conditions

a real appreciation will follow growth in varieties, if the demand shift effect dominates the importgrowth due to the higher income.

Higher non-price competitiveness should be reflectedin productivity growth in industry and the prices of industrial goods (or tradables)

In other papers (as in Aglietta et al 1997), non-pricecompetitiveness is measured by R&D expenditures.

But the catch-up process of the CEE transition countries isnot primarily based on shifts of the technologicalfrontier, but the gradual introduction of more state of the art technology.

Labour productivity growth is taken as indicator of increasingnon-price competitiveness.

Labour productivity in industry – a measure of non-price competitiveness?

- If labour productivity gains lead to production increases with no quality improvement, the relative price of domestic tradable goods should be stable or decreasing. (the price-elasticity of demand is unchanged, higher production level leads to a stability (small country) or even decrease (large country) in the relative price of the tradable goods)

- But if labour productivity is associated to quality improvements, or a better product differentiation, the relative price of tradable goods can increase, because demand becomes less price-elastic.

Czech Republic: Real exchange rate towards Germany

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.00

1.05

1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 2001M1 2002M1 2003M1 2004M1

czde_rer_cpi czde_rer_ppi Linear (czde_rer_ppi)

0.65

0.75

0.85

0.95

1.05

1.15

1.25

1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 2001M1 2002M1 2003M1 2004M1

hude_rer_cpi hude_rer_ppi Linear (hude_rer_ppi)

Hungary: Real exchange rate towards Germany

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 2001M1 2002M1 2003M1 2004M1

plde_rer_cpi plde_rer_ppi Linear (plde_rer_ppi)

Poland: real exchange rate towards Germany

Empirical testing

Reduced form equations

),(/

NFAPRODfQCPI ),(/

NFARELfQCPI

),(//

NFAPRODfQPPI

),,(//

NFARELPRODfQCPI

Productivity gains

RealExchangeRate

Real exchange rate in the open sector(non-price competitivenenss)

CPI-to-PPIratio

Balassa-Samuelson effect

-Demand-side pressure-indirect taxes-regulated prices-quality changes in services

Data

3 country sets

- transition economies (Bulgaria, Croatia, Czech Republic, Estonia,Hungary, Latvia, Lithuania, Romania, Slovakia, Slovenia)

- OECD countries (Austria, Australia, Belgium, Denmark, Netherlands, Sweden, Canada, Finland, Greece, Ireland, Portugal, Spain, New Zealand, South Africa, South Korea)

- emerging countries (Brazil, Chile, Mexico, Indonesia, Malaysia, Singapore. Thailand, Turkey).

Time period:

Transition countries 1992/1993 – 2002OECD countries 1970 – 2002Emerging countries 1980/1990 - 2002

Data

Real exchange rates : “effective“ weighted average of the real exchange rate towardseuro area core (proxied by Germany and France) and towards the USAdecline in RER = appreciation

Productivity is measured as productivity in industry(industrial production divided by employment)

Relative price ratio CPI / PPI

Net foreign assets as per cent of GDPcumulated current accounts over nominal GDP

Econometrics

1) Fixed effect OLS

2) Mean group of individual dynamic OLS estimates

3) Mean group of individual estimates based on ECM in ARDL

4) Pooled mean group estimator based on ARDL

DOLS DOLS_AIC DOLS_SIC MGE MGE_AIC MGE_SIC No. OBS

OECD

COINT -0.043*** -0.041*** -0.042*** 1554

PROD -0.165*** -0.166*** -0.160*** 0.083 -0.140 0.124

NFA -0.076*** -0.075*** -0.074*** -0.224*** -0.236*** -0.235***

COINT -0.054*** -0.051*** -0.052*** 1590

REL -0.745*** -0.760*** -0.763*** -1.132*** -1.214*** -0.744***

NFA 0.037 0.035 0.035 -0.495 -0.513* -0.088

CPI based real exchange rate

CEEC11

COINT -0.138*** -0.148*** -0.148*** 423

PROD -0.455*** -0.471*** -0.437*** -0.045* -0.017*** -0.024***

NFA 0.627*** 0.631*** 0.569*** 0.343*** 0.379*** 0.540***

COINT -0.103*** -0.086*** -0.088*** 427

REL -1.479*** -1.656*** -1.663*** -1.161*** -0.476*** -0.510***

NFA 0.437*** 0.374*** 0.376*** 0.202*** 0.294*** 0.243***

CPI based real exchange rate

DOLS DOLS_AIC DOLS_SIC MGE MGE_AIC MGE_SIC No. OBS

OECD

COINT -0.063*** -0.061*** -0.061*** 1534

PROD 0.015*** 0.021*** 0.013*** 0.013*** 0.043*** 0.023***

NFA -0.124*** -0.125*** -0.120*** -0.203*** -0.207*** -0.194***

COINT -0.054*** -0.052*** -0.053*** 1590

REL 0.253*** 0.239*** 0.234*** 0.057*** 0.541*** 0.012***

NFA -0.030 -0.028 -0.028 -0.226 -0.771** -0.217*

PPI based real exchange rate

CEEC11

COINT -0.138*** -0.151*** -0.150*** 423

PROD -0.350*** -0.358*** -0.319*** -0.028*** -0.373*** -0.354***

NFA 0.456*** 0.460*** 0.408*** 0.300*** 0.258** 0.410***

COINT -0.102*** -0.102*** -0.104*** 427

REL -0.478*** -0.656*** -0.662*** -0.007 -0.056 -0.218

NFA 0.438*** 0.375*** 0.377*** 0.092*** 0.180*** 0.387***

PPI based real exchange rate

Extended specification CPI- RERDOLS DOLS_AIC DOLS_SIC MGE MGE_AIC MGE_SIC No. OBS

OECD

COINT -0.073*** -0.070*** -0.070*** 1534

PROD 0.016*** 0.011*** 0.016*** 0.105 0.103 0.064

REL -0.811*** -0.811*** -0.803*** -0.501*** -0.584*** -0.610***

NFA -0.012 -0.019* -0.020* -0.184 -0.198** -0.124*

CEEC11

COINT -0.106*** -0.143*** -0.112*** 423

PROD -0.514*** -0.488*** -0.486*** -0.124 -0.077*** -0.007*

REL -1.502*** -1.657*** -1.652*** -1.241 -0.795** -0.904

NFA 0.276*** 0.179*** 0.190*** 0.192*** 0.184*** 0.046***

Summary of results

1) Transition economies seem to have some distinct featureswhich cannot be accounted for in out-of-sample estimations

2) Productivity growth in the transition economies reflectsthe nature of the catch-up process: they grow byadopting higher technology and by producinggoods of higher quality (shift in the composition of GDP)

3) Time period matters for the impact of NFA: in the short tomedium term, for the transition countries the inflowand debt creation dominated the income paymentseffect