1. Sultanija Bojceva Terzijan, MSc. National Bank of the Republic of Macedonia 30.05.2008, Skopje Conference “Competitiveness of the South Eastern European Countries and Challenges on the Road to EU “ REAL EXCHANGE RATE DYNAMICS IN REPUBLIC OF MACEDONIA: OLD WISDOMS AND NEW INSIGHTS

2. Outline: Republic of Macedonia road to EU  Real convergence  Nominal convergence Competitiveness and real exchange rate dynamics in RM  Estimation of the equilibrium real exchange rate (REER) for Macedonian Denar

3. Republic of Macedonia road to EU  Stabilization and Association Agreement with EU, April 2001  Interim Agreement on Trade and Trade Issues -into force from June 1 st 2001  Submission of the membership application, March 2004  Submitted Questionnaire to the Government of RM, October 1 st 2004  Positive opinion from European Commission for RM candidacy, November 2005  RM was granted candidate status, December 17 th 2005

4. Real Convergence  Slow real convergence  Absence of FDI, new technology and know-how  Negative external and domestic shocks  Intensified in 2007  Real GDP growth rate of 5,1%

5. Real Convergence – continues Contribution of the production factors to GDP growth Contribution of the production factors to GDP growth  Total factor productivity dominates as in all SEE countries Source: IMF Article IV, 2005

6.  Stylized fact: the absolute price level of less developed countries is bellow the euro area average  Macedonia fits this pattern as well  Lower absolute levels of price parities towards Germany, Italy, Slovenia Nominal Convergence

7. Nominal Convergence - continues Price level convergence (EU 27=100)

8. Potential sources of upward inflation pressures  Balassa-Samuelson effect from the supply side  Adjustment in regulated prices  Cost-push factors from non-tradable intermediates (distribution sector, business services sector, rents)  Higher quality and reputation of domestically produced goods

9. Real exchange rate dynamics in RM Analysis based on a paper “Real exchange rate dynamics in Macedonia: Old wisdoms and new insights” Motivation:  Explain reason for depreciation of MK REER  Try to link it to productivity developments – the B-S effect

10. Balassa-Samuelson effect in Macedonia  Starting point: productivity differential bears a link to the relative prices – domestic concept  Prices increased due to other factors than the B-S effect change in administrative prices since 2000

11. B-S effect in Macedonia – continues B-S effect in Macedonia – continues  If potentially there is a link from productivity to relative prices the share of non-tradables in the CPI basket is crucial (Engel’s law)

12. B-S effect in Macedonia – continues B-S effect in Macedonia – continues  Fairly limited contribution to total CPI  The steady rise of services from 2000 have negligible influence on the CPI  The CPI index has strong co-movement with goods price inflation Tradable, non-tradable and overall price inflation in Macedonia

13. B-S effect in Macedonia – continues B-S effect in Macedonia – continues Balassa-Samuelson effect bleeds from two wounds:  Rises in service prices were not connected to developments in the productivity differential in Macedonia from 1997 to 2005  Service price inflation has potentially little impact on headline inflation - modest weight of services in final household expenditures  Empirical evidence indicates non existence of domestic B-S effect

14. Real exchange rate dynamics in RM Real exchange rate dynamics in RM REER - official series; REER1_EU5 - with MK CPI weights, REER2_EU5 - with average EU 5 CPI weights  “Composition puzzle” solved and new REER series were constructed  Low goods price inflation and high service price inflation in foreign benchmark overestimates the depreciation of REER

15. Real exchange rate dynamics in RM Real exchange rate dynamics in RM  Continual decline of the MK productivity relative to the foreign trade partners  Slow catching-up process, contrary to the most transition countries – increase of productivity gap relative to abroad

16. Real exchange rate dynamics in RM Real exchange rate dynamics in RM  Co-movement of the new REER series and the productivity differentials Possible explanations:  The (inverse) quality effect  Non-tradable component of tradable prices

17. Estimation of a behavioral equilibrium exchange rate Estimation of a behavioral equilibrium exchange rate Method:OLS, E-GARDLDOLS Model 1Model 2Model 3Model 1Model 2Model 3Model 4Model 5 ECT -0.5** -0.47** -0.23** -0.30** -0.46** UR -4.86** -6.48** -7.29** -4.24** -4.21** -4.31** -5.44** -5.45** F-test 4.70**5.59**5.89** Const -0.43** 0.37 -3.06** -0.15** -1.96**0.02-0.01 proddiff1 0.12** proddiff20.18** 0.41** 0.14** proddiff3 0.19 0.63** proddiff4 0.09* 0.25** gcon_diff 0.06** 0.14**0.07*0.12**0.25**0.09** open0.04 -0.040.29** 0.18** nfa -0.02** 0.04** rel.prices 0.14**0.13** Notes: * and ** indicate statistical significance at the 10% and 5% levels, respectively  The productivity variable has a positive sign  Increases in public expenditures lead to real appreciation through the relative price of tradable goods.  Rise/fall in openness is reflected in real exchange rate appreciation /depreciation (a surprising finding)  Productivity, government consumption and the openness variables - fairly robust both in terms of sign and size

18. Misalignment of Macedonian REER Misalignment of Macedonian REER According to the three models, there is not significant misalignment of MK Denar

19. Conclusion Conclusion  Macedonia in process of catching up growth  Real convergence might induce risk for meeting nominal criteria  B-S effect has a very limited role in the Macedonian case  The (inverse) quality effect, or the non-tradable component of tradable prices - two possible explanations  REER in line with its fundamentals, absence of significant misalignment of MK Denar

20. Thank you for your attention

21. References References 1.Bogoev, J., Bojceva, T. S., Egert, B. and Petrovska M. (2007), "Real exchange rate dynamics in Macedonia: Old wisdoms and new insights, The Open-Access, Open-Assesment E-Journal, Vol. 2, 2008-12. 2.DeBroeck, M. and T. Slok (2006), "Interpreting real exchange rate movements in transition economies", Journal of International Economics, 68(2), pp. 368-383. 3.Égert, B. and K. Lommatzsch (2004), " Equilibrium Exchange Rates in the Transition: The Tradable Price-Based Real Appreciation and Estimation Uncertainty", William Davidson Institute Working Paper No. 676. 4.Égert, B., Halpern, L. and R. MacDonald (2006) Equilibrium exchange rates in transition economies: Taking stock of the issues, Journal of Economic Surveys, 20(2), 253-324. 5.Gutierrez, E. (2006), "Export Performance and External Competitiveness in the Former Yugoslav Republic of Macedonia", IMF Working Paper No. 261. 6.Loko, B. and A. Tuladhar (2005), "Labor Productivity and Real Exchange Rate: The Balassa-Samuelson Disconnect in the Former Yugoslav Republic of Macedonia", IMF Working Paper No. 113. 7.Mihaljek, D. and M. Klau (2004), "The Balassa-Samuelson Effect in Central Europe: A Disaggregated Analysis", Comparative Economic Studies, 46(1), 63-94.