1. The Academy of Economic Studies The Faculty of Finance, Insurance, Banking and Stock Exchange Doctoral School of Finance and Banking Dissertation paper Real Exchange Rate Misalignments and Trade Competitiveness. The Case of Romania MSc Student Zmeu Oleg Coordinator Professor Moisă Altăr Bucharest 2010

2. I. The aims of the paper 1. Choosing the variables that determine the behavior of the real equilibrium exchange rate (REER) 2. Estimating the equilibrium exchange rate (the BEER model) 3. Calculating the real exchange misalignments (RERM) 4. Choosing the proxies of trade competitiveness 5. Determining the impact of RERM on trade competitiveness – a VAR approach

3. Importance of real exchange rate misalignments Could be used to predict future shifts of the exchange rate (Aguirre, Calderon, (2005)); Could be used to predict future shifts of the exchange rate (Aguirre, Calderon, (2005)); May underline the need to adjust the exchange rate; May underline the need to adjust the exchange rate; A likely prelude to financial crisis (Krugman (1979), Kaminsky and Reinhart (1999)); A likely prelude to financial crisis (Krugman (1979), Kaminsky and Reinhart (1999)); May affect economic growth (Edwards (1989)); May affect economic growth (Edwards (1989)); May boost the economic growth, as was the case of Japan and Germany and more recently, China (Dooley et al. (2003)). May boost the economic growth, as was the case of Japan and Germany and more recently, China (Dooley et al. (2003)).

4. II. Literature review The relationship between real exchange rate misalignments and trade competitiveness was predominantly conducted on countries that record great share of exports in GDP; The relationship between real exchange rate misalignments and trade competitiveness was predominantly conducted on countries that record great share of exports in GDP; Balassa (1990) explores the relationships between RERM and the exports of four African countries (Tanzania, Kenya, Ghana and Ivory Cost) during 1974 – 1981. He finds that exports are highly responsive to RERM; Balassa (1990) explores the relationships between RERM and the exports of four African countries (Tanzania, Kenya, Ghana and Ivory Cost) during 1974 – 1981. He finds that exports are highly responsive to RERM; Ghura and Grennes (1993) run regression between RERM and other macroeconomic indicators (saving, exports, investments). The result of their study confirm the economic theory. The exchange rate – an important variable in measuring the relations with abroad. Ghura and Grennes (1993) run regression between RERM and other macroeconomic indicators (saving, exports, investments). The result of their study confirm the economic theory. The exchange rate – an important variable in measuring the relations with abroad. Söderling (2000) proves that overvalued currency of Cameroon in the 1980s were responsible for a worsening in total exports by 30 – 50%. Söderling (2000) proves that overvalued currency of Cameroon in the 1980s were responsible for a worsening in total exports by 30 – 50%. Sekkat and Varoudakis (2000) demonstrated that inconsistent macroeconomic policies and RERM are responsible for overvaluation. Sekkat and Varoudakis (2000) demonstrated that inconsistent macroeconomic policies and RERM are responsible for overvaluation. Fukunishi (2004) explores the relationships between real exchange rate misalignments and exports competitiveness. He proves that most currencies of Sub-Saharan countries were largely overvalued since their independence in early 1960s. Overvalued currencies discouraged exports and accounted for a peak of 90% misalignment of exchange rate during 1980s. Fukunishi (2004) explores the relationships between real exchange rate misalignments and exports competitiveness. He proves that most currencies of Sub-Saharan countries were largely overvalued since their independence in early 1960s. Overvalued currencies discouraged exports and accounted for a peak of 90% misalignment of exchange rate during 1980s.

5. Data Quarterly data used were obtained from Eurostat. The missing time series were obtained from the site of National Bank of Romania (www.bnr.ro). Quarterly data used were obtained from Eurostat. The missing time series were obtained from the site of National Bank of Romania (www.bnr.ro). The period covered is Q1 2000 – Q4 2009. The period covered is Q1 2000 – Q4 2009. All time series were seasonally adjusted using Census X12 method developed by U.S Census Bureau and implemented in EViews 6. The price indexes (CPI, export unit value, import unit value) have fixed base 2000 = 100. All time series were seasonally adjusted using Census X12 method developed by U.S Census Bureau and implemented in EViews 6. The price indexes (CPI, export unit value, import unit value) have fixed base 2000 = 100. The stock and flow variables (imports, exports, net foreign assets, final consumption expenditure of households) are normalized to GDP. The stock and flow variables (imports, exports, net foreign assets, final consumption expenditure of households) are normalized to GDP. Exchange rate RON/EUR is expressed as units of domestic currency per unit of foreign currency. Exchange rate RON/EUR is expressed as units of domestic currency per unit of foreign currency. Choosing the “fundamentals” The stationarity of the determinants factors was checked. Productivity differential – stationary (not included) Productivity differential – stationary (not included) Final Government consumption expenditure – stationary (not included) Final Government consumption expenditure – stationary (not included) Real interest rate differential – stationary (not included) Real interest rate differential – stationary (not included)

6. ADF and PP unit root tests on fundamentals Choosing the VAR lengthVAR stability ADF and PP unit root tests

7. Series Number of coint. relationsEigenval.Trace test statistic Maximum eigenvalue test statistic Computed val. 5% critical val.p-val. Computed val. 5% critical val.p-val. l_rer open tot cons None0.614058.872247.85130.003336.177827.58440.003 At most 10.298322.692429.79070.261313.461621.13120.410 At most 20.16919.237715.49710.34417.039914.26460.484 At most 30.05612.19993.84160.13842.19593.84160.138 Johansen Cointegration Test and Vector Error Correction Estimates The Johansen Cointegration Test demonstrates that there are only one cointegration relations between the variables included in the test – the null hypothesis of the existence of at most one cointegration relation cannot be rejected at the 5% significance level.

8. The fundamentals The long-run equilibrium of the determinants was captured using the Hodrick-Prescott filter.

9. After adjusting the cointegration vector with respect to real exchange rate, the following expression is obtained: All the coefficients are statistically significant. All the coefficients are statistically significant. The increase of the terms of trade is translated into an appreciation of the real exchange rate. The increase of the terms of trade is translated into an appreciation of the real exchange rate. The degree of openness is positively related wit real exchange rate – an increase of openness determines the depreciation of domestic currency. The degree of openness is positively related wit real exchange rate – an increase of openness determines the depreciation of domestic currency. A hike of final consumption expenditures of households appreciates the domestic currency. A hike of final consumption expenditures of households appreciates the domestic currency. The RERM are calculated according to the formula: The RERM are calculated according to the formula:

10. Table 5 - real exchange rate (RER) and equilibrium exchange rate (REER) Periods of overvaluation: 2000 – 2002, middle of 2004 – first quarter of 2008 Periods of overvaluation: 2000 – 2002, middle of 2004 – first quarter of 2008 Periods of undervaluation: 2002 – middle of 2004, first quarter of 2008 – last quarter of 2009 Periods of undervaluation: 2002 – middle of 2004, first quarter of 2008 – last quarter of 2009 The positive values (values above the red line) represent overvaluation. The positive values (values above the red line) represent overvaluation. Table 6 – real exchange rate misalignments

11. Measures of competitiveness Real exchange rate Real exchange rate - An increase of the RER (a depreciation) is associated with an improvement of a nation’s competitiveness, as the domestic product prices expressed in foreign currency decrease; - On the other hand, a decrease of the RER (an appreciation) may not necessarily imply that domestic competitiveness worsened. It may reflect a convergence process. Export growth and market share Export growth and market share Drawbacks: Drawbacks: - International trade is not a zero-sum game; - The exports could be increased through devaluation and keeping wages at low levels (Porter, 1990). Current account balance (criticized by Krygman, 1994): Current account balance (criticized by Krygman, 1994): - Prior posting large trade deficits, many countries have run trade surplus in order to regain investors’ confidence (case of Mexico in the early 90s); Production cost (cost of labour, with the well known ULC); Production cost (cost of labour, with the well known ULC); Global Competitiveness Index Global Competitiveness Index

12. Merchandise export and ULC growth The ULC has decreased constantly since 2000, pointing towards an improvement of domestic competitiveness. The ULC has decreased constantly since 2000, pointing towards an improvement of domestic competitiveness. On the other hand, the merchandise exports share in GDP remained stable during this period at approximately 26% of GDP. On the other hand, the merchandise exports share in GDP remained stable during this period at approximately 26% of GDP.

13. The VAR stability Choosing the VAR lengthVAR estimates The variables included are merchandise exports deviations and the real exchange rate misalignments. The VAR length is 1 lag and the stability condition is fulfilled.

14. The impulse-response function of exports merchandise deviations to shock in real exchange rate misalignments Impulse-response function and forecast variance decompositions - important ways of assessing the relative importance of a shock in real exchange rate in accounting for variation in trade competitiveness at various time horizons. The impulse-response function shows that a positive shock in real exchange rate misalignments, perceived as an appreciation process induces an increase of merchandise exports deviations (translated into a fall of merchandise exports). A maximum 1.8% impact of real exchange rate misalignments on merchandise exports deviations is recorded on short-run (up to 4 quarters). Also, the impact is significant on short- run. On medium and long-run the impact is decaying away, but the result is not statistically significant.

15. Variance of merchandise export deviations due to RER misalignments (%) The real exchange rate misalignments appear to be responsible for 40% of merchandise exports’ variance on long-run. Even if considered with the short-run significance of the impulse-response, the real exchange rate misalignments determine around 20% of the variance of the merchandise exports deviations.

16. I have encountered some special issues related to ULC. I have encountered some special issues related to ULC. Even if the results obtained running the VAR approach were inconclusive, if a Johansen cointegration were run, a cointegration relation between the variables included would results. Even if the results obtained running the VAR approach were inconclusive, if a Johansen cointegration were run, a cointegration relation between the variables included would results. The ULC deviations have no unit root The Johansen cointegration test between ULC deviations and real exchange rate misalignments

17. The impulse-response function of the cointegrated VAR The shock on real exchange rate misalignments and the ULC deviations’ response confirm the results obtained earlier: a positive shock in real exchange rate misalignments (an appreciation) determines a fall of ULC deviations (perceived as a decrease of ULC and improvement of competitiveness).

18. Concluding remarks The signs of the determinants are in line with economic theory and the coefficients are statistically significant. The signs of the determinants are in line with economic theory and the coefficients are statistically significant. In the covered period, the real exchange rate was well misaligned compared to its long-run value. In the covered period, the real exchange rate was well misaligned compared to its long-run value. The real exchange rate was misaligned by 4% during 2009. The real exchange rate was misaligned by 4% during 2009. Competitiveness is positively related to a depreciation currency. Competitiveness is positively related to a depreciation currency. The exports should not be encouraged through currency depreciation. Increasing productivity and quality, becoming more competitive through prices and costs is a more appropriate strategy. It could also serve as the fundament for a sustained economic development. The exports should not be encouraged through currency depreciation. Increasing productivity and quality, becoming more competitive through prices and costs is a more appropriate strategy. It could also serve as the fundament for a sustained economic development. The real exchange rate should stay as close as possible to its equilibrium level in order to avoid the economic distortions. The real exchange rate should stay as close as possible to its equilibrium level in order to avoid the economic distortions.

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