1. Assessment of Balassa-Samuelson Effect in Croatia Gorana Lukinić, Igor Ljubaj and Josip Funda

2. Overview of the Presentation  Introduction  Theoretical Background  Data  Econometric Analysis  Conclusions

3. Theoretical Background  Balassa-Samuelson hypothesis - faster productivity growth in the tradable sector in relation to the nontradable sector in a given economy in comparison to foreign economies will lead to higher growth of domestic prices of nontradables, higher overall inflation and real appreciation of that country’s currency;  Transmission mechanism - productivity growth in the tradable sector will increase wages in that sector and, due to labour mobility between sectors, wages in the nontradable sector will also rise; producers of nontradables must raise the prices of their products to be able to pay higher wages, which in turn leads to an increase in the overall price level in the economy.

4. Balassa-Samuelson Model  Domestic version  International version

5. Empirical Literature on Balassa-Samuelson Effect in Croatia  Mihaljek and Klau (2003) productivity differential between tradable and nontradable sectors contributed to price differential between nontradables and tradables by 2.2 percentage points, and CPI inflation by 1.26 percentage points, international Balassa-Samuelson effect is not statistically significant;  Egert (2005) estimates of contribution of the Balassa-Samuelson effect to average annual CPI inflation in Croatia go from 0 to 0.63 percentage points, depending on whether the estimates are based on productivity data from national accounts or on industrial production data;  Nestić (2004) Balassa-Samuelson effect for Croatia is not directly evaluated, but concludes that the higher price level in Croatia compared to other transition countries can be partially explained by labour productivity differentials in the tradable and nontradable sectors.

6. Data  productivity and price series for Croatia and the Eurozone - from the first quarter of 1998 to the third quarter of 2006;  the selection of the period is constrained by the availability of officially published data;  the series were constructed as base indices with 1998 as the base year and seasonally adjusted using the X-12 ARIMA method;

7. Data (cont.)  productivity tradable sector – manufacturing, mining and querying (first set), additionally hotels and restaurants (second set); nontradable sector – residual (agriculture excluded)  prices tradables – goods prices index and weighted implicit deflator index of specific branches; nontradables – services prices index and weighted implicit deflator index of specific branches;  real HRK/EUR exchange rate nominal exchange rate multiplied by the ratio of foreign and domestic prices (HICP, implicit deflators and PPI).

8. Labour Productivity in Croatia, 1998=100 Sources: CBS, authors' calculations

9. Labour Productivity and Real Wages in Tradable Sector in Croatia, 1998=100 Sources: CBS, authors' calculations

10. Nominal Wages in Croatia, 1998=100 Sources: CBS, authors' calculations

11. Prices of Tradables and Nontradables in Croatia, 1998=100 Sources: CBS, authors' calculations

12. Relative Productivity in Croatia and the Eurozone, 1998=100 Sources: CBS, Eurostat, authors' calculations

13. Inflation in Croatia and the Eurozone, 1998=100 Sources: CBS, Eurostat

14. Real Exchange Rate (1998=100) Sources: CBS, Eurostat, CNB, authors' calculations

15. Econometric Analysis “It’s my experience that “economy-tricks” is usually nothing more than a justification of what the author believed before the research was begun.”

16. Estimated Coefficients and Accompanying t-statistics for Domestic Balassa-Samuelson Effect ***, **, * indicates rejection of the null hypothesis at significance levels of 1%, 5% and 10%.

17. Estimated Coefficients and Accompanying t-statistics for International Balassa-Samuelson Effect ***, **, * indicates rejection of the null hypothesis at significance levels of 1%, 5% and 10%.

18. Conclusion  presence of the BS effect in Croatia is obviously less marked than in similar countries;  its influence on inflation and real exchange rates should not constitute a barrier to meeting convergence criteria;  possible other econometric techniques for estimating BS effect.