Assessment of Balassa-Samuelson Effect in Croatia by Josip Funda, Gorana Lukinić, Igor Ljubaj Discussant: K. Žigić Prague, Czech Republic

Research questions Assessment of the importance of the Balassa-Samuelson (BS) effect in Croatia and quantify its influence on inflation and the real exchange rate Assessment of the importance of the Balassa-Samuelson (BS) effect in Croatia and quantify its influence on inflation and the real exchange rate

BS effect Domestic versus international BS effect a. Simple Accounting Framework Domestic BS effect: BS d = β 1 (ΔPRODT T − ΔPRODNT NT ) Domestic BS effect: BS d = β 1 (ΔPRODT T − ΔPRODNT NT ) Inflation BS = (1-α) β 1 (ΔPRODT T − ΔPRODNT NT ) Inflation BS = (1-α) β 1 (ΔPRODT T − ΔPRODNT NT ) International BS effect: BS m = Δp − Δp* = β 2 [(1-α) (ΔPRODT T − ΔPRODNT NT ) – (1-α*) (ΔPRODT T * − ΔPRODNT NT * )] Negative BS effect in the period ! (lower share of non-tradables in Croatia versus EU; 41% versus 23% respectively) International BS effect: BS m = Δp − Δp* = β 2 [(1-α) (ΔPRODT T − ΔPRODNT NT ) – (1-α*) (ΔPRODT T * − ΔPRODNT NT * )] Negative BS effect in the period ! (lower share of non-tradables in Croatia versus EU; 41% versus 23% respectively)

b. Econometric Analysis Domestic BS effect: Domestic BS effect: Δ log(CPI NT / CPI T ) t = c + β 0 Δ log(LP NT /LP T ) t + ε i β 0 not significant in any of the two specifications International BS effect: International BS effect: Δ log RER t = c + β 0 Δprod _ dif + ε i Δ log(CPI/ CPI EA ) t = c + β 0 Δprod _dif + β 1 ΔE t +ε i β 0 and β 1 not significant in any of the two specifications!

Comments, suggestions, questions 1) The analysis follows closely the approach and methodology developed by Mihaljek and Klau (2003) but focus on Croatia. (Section 2. pages 5-8, “Theoretical Background” taken almost whole from Mihaljek and Klau (2003)). (Section 2. pages 5-8, “Theoretical Background” taken almost whole from Mihaljek and Klau (2003)). Fine but please acknowledge it!

Comments, suggestions, questions 2) Be more ambitious! Compare the BS effect and real appreciation in Croatia with that of other relevant countries (Slovenia, Hungary, Czech Republic)! Why Croatia (and perhaps) Slovenia are different than the other transition economies? Compare the BS effect and real appreciation in Croatia with that of other relevant countries (Slovenia, Hungary, Czech Republic)! Why Croatia (and perhaps) Slovenia are different than the other transition economies?

Comments, suggestions, questions 3) Explore investment in quality (and product variety) effect that lead to real appreciation! Divergence even in prices of tradables of transition countries vis-à-vis its EU trading partners in PPP terms. Divergence even in prices of tradables of transition countries vis-à-vis its EU trading partners in PPP terms.

Comments, suggestions, questions 4) Review some stylized facts in CEEC countries! * Quality improvements play a role among determinants of real exchange rate appreciation of transition economies; (See Broeck and Slok, 2006, Egert and Lommatzsch, 2004) * Quality improvements play a role among determinants of real exchange rate appreciation of transition economies; (See Broeck and Slok, 2006, Egert and Lommatzsch, 2004) * Quality improvements are not accounted for by the statistical offices in transition economies * Quality improvements are not accounted for by the statistical offices in transition economies *Quality bias of consumer price index! *Quality bias of consumer price index!

Comments, suggestions, questions Point 4) continued For instance, the inflation overstatement as high as 5 percentage points a year in the first decade of economic transformation in the Czech Republic (see for instance Hanousek and Filer, 2004). Quality-unadjusted price indexes might be well responsible for a substantial part of the pace of the real exchange rate development in a transition economy. FDI and real exchange rate appreciation! (FDI are to large extent directed to export oriented industries, which had an effect on improvements in quality of products e.g. due to competition pressures in tradable goods markets worldwide). High correlation of the size of the direct investment inflow with the size of the real appreciation of the local currency

Comments, suggestions, questions 5) Check for terms of trade in Croatia in the period under considerations! (Improvement in terms of trade may mirror the quality improvement, particularly if at the same time a physical volume of export increases)

Comments, suggestions, questions 6) Look at the new international macro literature (NIM) for inspiration! (Typical features of the NIM framework are monopolistic competition, ex post heterogeneity of production entities due to uncertain post- entry productivity, role of sunk costs and self-selection in trade. See Melitz, 2003 and especially Ghironi and Melitz, 2005 and Bruha and Podpiera, 2007). (Typical features of the NIM framework are monopolistic competition, ex post heterogeneity of production entities due to uncertain post- entry productivity, role of sunk costs and self-selection in trade. See Melitz, 2003 and especially Ghironi and Melitz, 2005 and Bruha and Podpiera, 2007).

Comments, suggestions, questions Point 6) continued NIM provides a sound micro- foundation for BS effect! In particular the findings from the NIM type model (see Bruha and Podpiera 2007) indicates that quality investment and creation of new varieties might be responsible for the observed significant real exchange rate appreciation, that often remains unexplained by prevailing models. Convergence of countries facilitated by an extensive growth might be compatible with stability of real exchange rate, while countries pursuing intensive growth and convergence exhibit significant real exchange rate appreciation. Implications for the Maastricht criteria (Countries with significant real appreciation will be in conflict in jointly fulfilling the exchange rate and inflation stability criteria.)

References: 1.) Bruha, J and Podpiera, (2007). Bruha, J and Podpiera, (2007). Transition economy convergence in a two-country model – implications for monetary integration, Working Paper Series 740, European Central Bank. 2.) De Broeck, M., T. Slok, (2006). Interpreting Real Exchange Rate Movements in Transition Countries. Journal of International Economics 68, pp ) Egert, B., K. Lommatzsch (2004). Equilibrium Exchange Rates in the Transition: The Tradable Price-based Real Appreciation and Estimation Uncertainty. William Davidson Institute WP ) Ghironi, F., Melitz M. (2005). International Trade and Macroeconomic Dynamics with Heterogeneous Firms. Quarterly Journal of Economics, CXX (August 2005), pp (August 2005), pp ) Hanousek J., R. Filer (2004). Consumers’ Opinion of Inflation Bias Due to Quality Improvements. William Davidson Institute WP ) Melitz, M. (2003). The Impact of Trade on Intra-Industry Reallocation and Aggregate Industry Productivity. Econometrica 71/6, pp ) Mihaljek, D., M. Klau (2003). The Balassa - Samuelson effect in central Europe: a disaggregated analysis, BIS Working Paper 143.