1. 1 Determinant factors for the appreciation of the domestic real exchange rate MSc Student: Daniel Naftali The Academy of Economic Studies Doctoral School of Finance and Banking Coordinator Professor : Moisă Altăr Bucharest, 2007

2. 2 Dissertation paper outline The importance of studying the factors which determine real appreciation of the domestic currency and the relationship with the equilibrium exchange rate The aims of the paper The Balassa-Samuelson model – the mechanisms which lead to real appreciation The Data Testing the HBS model in a trivariate framework - results Testing the HBS model in a bivariate framework – results The contribution of the HBS effect to the real appreciation of the RON The equilibrium real exchange rate and the misalignment using the HBS model The influence of net foreign assets and productivity on the real exchange rate Conclusions References

3. 3 The importance of analyzing the sources of appreciation of the domestic RER the appreciation of the real exchange rate is a phenomenon which almost all Central and Eastern European countries experienced if the real appreciation is not consistent with the equilibrium exchange rate this triggers a worsening of the current account, thus affecting the real convergence (catching-up) process if the real exchange rate is above its equilibrium value (the currency is undervalued) this leads to inflationary pressures affecting the nominal convergence criteria the domestic currency will be prone to speculative attacks and the Central Bank won’t be able to defend the central parity also, in the view of ERM II and EMU accession, the central parity has to be consistent with the equilibrium exchange rate, otherwise the domestic currency will be prone to speculative attacks and the Central Bank won’t be able to defend the central parity Therefore it is necessary to assess which exchange rate might be best suited for entry to ERM II and for the irrevocable conversion rate.

4. 4 The Aims of the Paper To test whether the Balassa – Samuelson effect can explain (at least partially) the appreciation of the domestic currency over the 2000:Q1 – 2007:Q1 period; To quantify the Balassa – Samuelson effect over the sample period; To compare the results when regulated prices are excluded from the analysis To test various channels through which productivity increases in the tradable sector influence the RER To test the influence of increasing foreign liabilities on the domestic RER

5. 5 Trend appreciation of the RER Appreciation via the non-tradables price channel explained by:  The Balassa – Samuelson effect; Appreciation via tradable prices explained by :  Initial undervaluation of the currency at the onset of the systemic transformation process;  Increasing reputation and home bias due to productivity increases and quality improvements in output;  Nominal appreciation of the RER based on expected future productivity gains triggered by capital inflows related to productive FDIs Regulated prices - whose price increases are the highest and not fully related to productivity increases

6. 6 RER Behavior in Transition Economies

7. 7 The Real Exchange Rate Measurement Combines nominal exchange rate (S) with measures of domestic (P) and overseas prices (P*) In a multilateral framework (REER): The definitions of the RER include measures based on:  The consumer price index  The prices of tradables goods or output prices  The ratio of tradables to non-tradables prices

8. 8 The Balassa – Samuelson model Based on a the model of a small economy with two sectors:  a tradables goods sector  a non-tradables goods sector Two major assumptions:  capital is perfectly mobile across countries and across the two sectors of the economy interest rates are exogenous to the model  Labour is perfectly mobile domestically, between the open and closed sector nominal wages are determined in the tradables sectors and due to wage equalisation process, hold for the entire economy; The internal transmission mechanism: The external transmission mechanism:

9. 9 The Data (1) Quarterly data series for the period 2000Q1:2007Q1 Industry (excl. constructions) Industry (excl. constructions) was considered as the open sector, and services as the closed sector, the latter including trade, transport, telecommunication and tourism activities as well as health, education and public administration services. In the model, the Euro Area represents the foreign country. 1.Average Productivities for the open and closed sectors (both domestic and the Euro-Area) was computed as the ratio between the gross value added in constant prices and the average number of employees. 2. Relative prices between tradables and non-tradables were computed based on the Consumer Price Index (CPI). Tradables prices - constructed based on the Food products CPI prices and Non-food products CPI prices (excluding administrated prices) series; Non-tradables prices series was first constructed based on the services prices series (excluding administrated prices for services) and the administrated price series (of both non-food products and services); 3. The quarterly real exchange rates (q) was computed based on the average nominal exchange rate published by the National Bank of Romania (BNR) and considering the corresponding price measures.

10. 10 Relative prices between tradables and non-tradables CPI basket structure

11. 11 The Data (2) REL_PROD_RO is the relative productivity between the open and the closed sector in the domestic economy – seasonally adjusted using Tramo - Seats procedure - I(1); DIF_PROD_REL is the dual productivity differential between Romania and the Euro area – seasonally adjusted using Tramo - Seats procedure - I(1); REL_PRICES_RO - the relative price of non- tradables to that of tradables, seasonally adjusted using Tramo - Seats procedure - I(1) DIF_PRICES_REL - the relative price differential between Romania and the Euro-zone, seasonally adjusted using Tramo - Seats procedure - I(1) Q_CPI – the CPI based real exchange rate – I(1) All the series were taken in logarithm.

12. 12 The Data (3)

13. 13 Testing the pre-requisites of the HBS model 1. Testing PPP in the open sector - ADF test applied to the Tradable Prices Index based real exchange rate - The test shows that we can’t reject the null of a unit root 2. Wage equalisation across the tradables and non-tradables sectors 3.Capital mobility

14. 14 Testing the HBS model The internal transmission mechanism: testing the existence of a cointegration relation between the dual productivity and the relative price of non-tradables in the home country; the relation is tested under the form: The external transmission mechanism: The link between the dual productivity differential and the difference in the home and foreign relative price of non-tradable goods is considered. Then, the relationship between the relative price differential and the real exchange rate was tested. For testing the external transmission mechanism between Romania and the Eurozone over the sample period two methodologies were used: building a VEC model with the following variables: productivity differential, relative price differential, and the real exchange rate; Testing using bivariate VEC models for the existence of cointegrating relations between the dual productivity differential and the relative price differential and between the relative price differential and the real exchange rate.

15. 15 The internal transmission mechanism The estimation of the cointegration vector confirms the positive correlation between the variables predicted by theory. The coefficient is also statistically significant.

16. 16 The external transmission mechanism (1) – Trivariate model According to the Johansen cointegration test, there are two cointegration relations between the domestic and foreign relative prices differential, the dual productivity differential and the real exchange rate. The estimated cointegration equations are consistent with the transmission mechanism predicted by the HBS effect namely:  A positive relation between the relative price differential and the dual productivity differential  A negative relation between the real exchange rate and the relative price differential;

17. 17 The external transmission mechanism (2) – Bivariate models The Johansen cointegration test applied on the bivariate VEC models did not identify a cointegration relation between the real exchange rate (q_cpi) and the relative price differential. However, two separate cointegration relations were identified between the relative price differential and the dual productivity differential on the one hand and on the other hand between the real exchange rate and the dual productivity differential.

18. 18 Quantifying the Balassa-Samuelson effect Based on the cointegration relation determined between the real exchange rate, relative productivity differential and the relative prices differential, we computed the contribution of the HBS effect on the appreciation of the real exchange rate based on the observed dual productivity differential.Year Including Adm. Prices Excluding Adm. Prices 20015.0%1.21% 2002-1.8%-0.4% 20030.4%0.7% 20042.4%0.4% 20050.8%0.14% 20066.7%1.3% Annul average 2.24%0.45%

19. 19 Computing an equilibrium exchange rate based on the cointegration relations The cointegration relations allowed for the determination of an equilibrium exchange rate based on the long – term evolution of the dual productivity differential. Including adm. prices Excluding adm. prices

20. 20 The influence of the productivity in the open sector and of the net foreign assets on the real exchange rate The Balassa- Samuelson effect is not able to explain the entire appreciation of the real exchange rate; Following Egert(2007), a series of reduced-form equations were tested to see the different channels through which productivity increases in the tradable sector influence the real exchange rate. We also tested the influence of increasing foreign liabilities on the domestic real exchange rate. Eq. (1) assesses the effect of productivity improvements on the real exchange rate of the open sector In eq. (2) the CPI-based real exchange rate is regressed on the relative price of non-tradables to that of tradables, which play here the role of a proxy for productivity for the HBS effect. In eq. (3), productivity and relative prices are considered simultaneously in one single specification to see whether the productivity variable and the relative price variable convey a different set of information Eq. (4) aims at testing the existence of a long run relationship between the real exchange rate, the net foreign assets and productivity.

21. 21 Data Description The sample period for which the relations were tested span the period of 2000:Q1 to 2007:Q1. As in the case of the HBS effect, the relative price on non-tradables was approximated by the CPI-based non-tradables to tradables ratio, while for productivity we used the productivity in industry series computed as gross value added in constant prices over the average number of employees. As a proxy for the Net Foreign Asset (liabilities) series, we used Total External Debt as percentage of GDP. All series were tested for stationarity using the ADF test and they were found to be non-stationary in levels, but all series are integrated of order 1. (The NFA series is non stationary in the first difference at both 99% and 95% confidence level. However, according to the Philips – Peron test the series is stationary in difference at 99% confidence level)

22. 22 Estimation Results

23. 23 The sign of foreign debt (NFA) is negative, showing that higher accumulated debt leads to an appreciation of the real exchange rate. Only in the first cointegration relation the sign of productivity in the open sector is negative suggesting a real appreciation of the exchange rate via increasing productivity in the open sector. However, this relation is not statistically significant in light of the associated t- statistic. In equations 3 and 4, contrary to expectations, the sign of the productivity variable is positive suggesting that an increase in the productivity of the open sector leads to the depreciation of the real exchange rate. Egert (2007) suggests that a negative relation between productivity in the open sector and the real exchange rate reflects improvements in the quality and reputation of manufactured goods. Conversely, the positive relation found in Romania’s case could be the cause of a significant lag in the catching up process.

24. 24 - The Balassa-Samuelson effect is present in the Romanian economy, but only partly explains the real appreciation of the Romanian RON; - As expected, the HBS effect is less powerful when we eliminate administered prices; - The Equilibrium exchange rate computed using the HBS estimations shows that the domestic exchange rate is currently overvalued by approximately 18%; - The Johansen cointegration tests show that there is a long term relationship between the real exchange rate and the Net Foreign Assets, so an increase in this variable leads to real appreciation; - The relationship between the real exchange rate and productivity is ambiguous because it appears with different signs in different cointegration relations. Conclusions

25. 25 References Balassa, B. (1964), “The Purchasing-Power-Parity Doctrine: A Reappraisal”, Journal of Political Economy, Vol. 72. No 6., December, pp. 584-596. Brooks, Chris (2002) : Introductory Econometrics for Finance, Cambridge University Press Bulir A. and K. Smidkova (2005): “Exchange Rates in the New EU Accession Countries: What Have We Learned from the Forerunners?” Economic Systems. 29(2). 163-186. Clark, P. and R. Macdonald (1998): “Exchange Rates and Economic Fundamentals: A Methodological Comparison of BEERs and FEERs”, IMF Working Paper 67/98 Clark, P. and R. MacDonald (2004): “Filtering the BEER: A permanent and transitory decomposition”, Global Finance Journal no 15, p. 29-56 Codirlasu, A. (2005): “Modele de determinare a cursului valutar”, DOFIN Working Paper Crespo-Cuaresma, J., J. Fidrmuc and R. MacDonald (2003): “The Monetary Approach to Exchange Rates: Panel Data Evidence for Selected CEECs”, National Bank of Austria Focus on Transition 2/2003 De Broek, M. and T. Slok (2006): “Interpreting real exchange rate movements in transition countries”, Journal of International Economics 68 p. 368-383. Driver, R. and P. Westaway (2004): “Concepts of equilibrium exchange rates”, Bank of England Working Paper no 248 Egert, B. (2002): “Investigating the Balassa-Samuelson hypothesis in transition: Do we understand what we see?”, BOFIT Working Paper no 6/2002 Egert, B. (2003): „Nominal and Real Convergence in Estonia: The Balassa-Samuelson (Dis)connection. Tradable Goods, Regulated Prices and Other Culprits”, William Davidson Institute, Working Paper No. 556

26. 26 Egert, B. (2005) "Balassa-Samuelson Meets South Eastern Europe, the CIS and Turkey: A Close Encounter of the Third Kind?" William Davidson Institute Working Paper 796 Egert, B. and K. Lommatzsch (2003): “Equilibrium Real Exchange Rates in Acceding Countries: How Large Is Our Confidence (Interval)?”, National Bank of Austria, Focus on Transition 2/2003 Egert, B. and L. Halpern (2006) “Equilibrium exchange rates in Central and Eastern Europe: A meta- regression analysis”, Journal of Banking and Finance, 30/2006 Egert, B., A. Lahreche-Revil and K. Lommatzsch (2007) “Real Exchange Rates in Small Open OECD and Transition Economies: Comparing Apples with Oranges?”, CESifo Working Paper no 1928 February 2007 Egert, B., L. Halpern and R. Macdonald (2005): “Equilibrium Exchange Rates in Transition Economies: Taking Stock of the Issues”, National Bank of Austria Working Paper no 106 Egert, B., T. Grueber and T. Reiniger (2003): “Challenges for EU Acceding Countries: Exchange Rate Strategies after EU Accession and Asymmetric Application of the Exchange Rate ”, National Bank of Austria Focus on Transition 2/2003 Egert., B., I. Drine, K. Lommatzsch and C. Rault (2003): “The Balassa -Samuelson Effect in Central and Eastern Europe: Myth or Reality?”, Journal of Comparative Economics, Elsevier, vol. 31(3), pages 552-572 Enders, W.(2004): „Applied Time Series Econometrics”, John Wiley & Sons Jazbec, B. (2002): “Balassa-Samuelson Effect in Transition Economies.The Case of Slovenia”, William Davidson Working Paper Number 507 MacDonald, R. (2000): “Concepts to Calculate Equilibrium Exchange Rates: An Overview”, Economic Research Group of the Deutsche Bank Discussion Paper 3/00 Mihaljek, D. and M. Klau (2004): “The Balassa-Samuelson Effect in Central Europe: A Disaggregated Analysis”, Comparative Economic Studies, 46(1): 63-94 Sarno, L., Taylor, M. (2002): “The Economics of Exchange Rates”, Cambridge University Press References