The stock-flow approach to the real exchange rate of CEE transition economies Balázs Égert Oesterreichische Nationalbank, UPX, WDI Amina Lahrèche-Révil CEPII Paris Kirsten Lommatzsch DIW Berlin

Motivation Transition countries economies have been on a path of real appreciation since the initial macroeconomic stabilisation 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

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 explain the 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 adjustment of stock of foreign assets (Aglietta et al. 1997, Faruqee 1995) Equilibrium exchange rate prevails at simultaneous internal and external equilibrium (macroeconomic balance); abstraction from short-term fluctuations

Internal equilibrium can be related to a cleared market for non-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 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.

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 prices in standard elasticities models: higher growth requires depreciation to sustain trade balance - non-price competitiveness factors imply a reduction in the price elasticity of demand for exports (and for imports)

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 technological content compared with more developed economies - domestic supply lacked competitiveness in domestic and foreign markets - 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 towards higher 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 consumers towards the goods of the country in the catch-up process

Consumers demand domestic and foreign goods based on e.g. Crucial assumption positive the same applies to the foreign economy 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 import growth due to the higher income.

Higher non-price competitiveness should be reflected in productivity growth in industry and the prices of industrial goods (or tradables) In other papers (as in Aglietta et al 1997), non-price competitiveness is measured by R&D expenditures. But the catch-up process of the CEE transition countries is not primarily based on shifts of the technological frontier, but the gradual introduction of more state of the art technology. Labour productivity growth is taken as indicator of increasing non-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

Hungary: Real exchange rate towards Germany

Poland: real exchange rate towards Germany

Empirical testing Reduced form equations

Productivity gains Real Exchange Rate Real exchange rate in the open sector (non-price competitivenenss) CPI-to-PPI ratio 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 – 2002 OECD countries 1970 – 2002 Emerging countries 1980/

Data Real exchange rates : effective weighted average of the real exchange rate towards euro area core (proxied by Germany and France) and towards the USA decline 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 GDP cumulated 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

Notes DOLS_SIC are the DOLS estimates obtained on the basis of the Schwarz information criterion. The same applies to the mean group estimators (MGE_SIC). *,*** and *** denote respectively statistical significance at the 10%, 5% and 1% levels. In the row coint under MGE_SIC and PMGE are shown the error correction terms. DOLSDOLS_AICDOLS_SICMGEMGE_AICMGE_SICNo. OBS OECD COINT-0.043***-0.041***-0.042***1554 PROD-0.165***-0.166***-0.160*** 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 * CPI based real exchange rate

CEEC11 COINT-0.138***-0.148*** 423 PROD-0.455***-0.471***-0.437***-0.045*-0.017***-0.024*** NFA0.627***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*** NFA0.437***0.374***0.376***0.202***0.294***0.243*** CPI based real exchange rate

DOLSDOLS_AICDOLS_SICMGEMGE_AICMGE_SICNo. OBS OECD COINT-0.063***-0.061*** 1534 PROD0.015***0.021***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 REL0.253***0.239***0.234***0.057***0.541***0.012*** NFA **-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*** NFA0.456***0.460***0.408***0.300***0.258**0.410*** COINT-0.102*** ***427 REL-0.478***-0.656***-0.662*** NFA0.438***0.375***0.377***0.092***0.180***0.387*** PPI based real exchange rate

Extended specification CPI- RER DOLSDOLS_AICDOLS_SICMGEMGE_AICMGE_SICNo. OBS OECD COINT-0.073***-0.070*** 1534 PROD0.016***0.011***0.016*** REL-0.811*** ***-0.501***-0.584***-0.610*** NFA *-0.020* **-0.124* CEEC11 COINT-0.106***-0.143***-0.112***423 PROD-0.514***-0.488***-0.486*** ***-0.007* REL-1.502***-1.657***-1.652*** ** NFA0.276***0.179***0.190***0.192***0.184***0.046***

Summary of results 1)Transition economies seem to have some distinct features which cannot be accounted for in out-of-sample estimations 2)Productivity growth in the transition economies reflects the nature of the catch-up process: they grow by adopting higher technology and by producing goods of higher quality (shift in the composition of GDP) 3) Time period matters for the impact of NFA: in the short to medium term, for the transition countries the inflow and debt creation dominated the income payments effect