11

Determinant factors for the Determinant factors for the appreciation of the domestic appreciation of the domestic

real exchange ratereal exchange rate

MSc Student: Daniel MSc Student: Daniel NaftaliNaftali

The Academy of Economic Studies

Doctoral School of Finance and Banking

Coordinator Professor: Moisă Altăr

Bucharest, 2007

22

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

33

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

• 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 the domestic currency will be prone to speculative attacks and the Central Bank won’t be able to defend the central attacks and the Central Bank won’t be able to defend the central parityparity

•Therefore it is necessary to assess which exchange rate might be best suited for entry to ERM II and for the irrevocable conversion rate.

44

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

55

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

66

RER Behavior in Transition Economies

3.3

3.4

3.5

3.6

3.7

97 98 99 00 01 02 03 04 05 06

Real Exchange Rate based on CPIReal Exchange Rate based on PPI

Czech Republic

1.24

1.28

1.32

1.36

1.40

1.44

1.48

1.52

1.56

1.60

97 98 99 00 01 02 03 04 05 06

Real Exchange Rate based on CPIReal Exchange Rate based on PPI

Poland

5.4

5.5

5.6

5.7

5.8

5.9

97 98 99 00 01 02 03 04 05 06

Real Exchange Rate based on CPIReal Exchange Rate based on PPI

Hungary

3.5

3.6

3.7

3.8

3.9

4.0

4.1

4.2

97 98 99 00 01 02 03 04 05 06

Real Exchange Rate based on CPIReal Exchange Rate based on CPI

Slovakia

77

The Real Exchange Rate Measurement • Combines nominal exchange rate (S) with measures of domestic (P) and overseas prices (P*)

ppsRERP

PSRER

*)ln(

*

•In a multilateral framework (REER):

n

i

n

ii

wii wRERREERP

PSREER

i

1 1

*

)ln()ln()(

•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

88

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:

NTT

T

NTTNT

aapp

))***

*())((1(** NTT

T

NTNTT

T

NTTT aaaappeq

99

The Data (1)

Quarterly data series for the period 2000Q1:2007Q1

• IndustryIndustry (excl. constructions) (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.

1010

48%44% 45% 44%

42% 42% 41%39%

28%

8.4% 8.8% 8.2% 7.5% 7.4% 7.8% 8.3% 8.5%

13.0%16.5%

19.0%21.2% 22.5% 22.1% 21.6% 22.8%

28%30%29%31% 31%

28% 27%

0%

11%

22%

33%

44%

55%

2000 2001 2002 2003 2004 2005 2006 2007

Food Non-food (excl. Adm.) Services (excl. Adm.) Adm. prices

Relative prices between tradables and non-tradablesCPI basket structure

1111

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.

1212

The Data (3)

.24

.28

.32

.36

.40

.44

.48

.52

.56

.60

2000 2001 2002 2003 2004 2005 2006

Q_CPI

-.52

-.48

-.44

-.40

-.36

-.32

-.28

2000 2001 2002 2003 2004 2005 2006

DIF_PROD_REL_SA

-.05

.00

.05

.10

.15

.20

.25

.30

.35

2000 2001 2002 2003 2004 2005 2006

DIF_PRICES_REL_SA (incl. adm prices)

-.08

-.06

-.04

-.02

.00

.02

.04

2000 2001 2002 2003 2004 2005 2006

DIF_PRET_REL_SA (excl. adm)

1313

Testing the pre-requisites of the Testing the pre-requisites of the HBS modelHBS model

1. Testing PPP in the open sector 1. Testing PPP in the open sector -ADF test applied to the Tradable Prices Index based real exchange rateADF test applied to the Tradable Prices Index based real exchange rate-The test shows that we can’t reject the null of a unit rootThe test shows that we can’t reject the null of a unit root

2. Wage equalisation across the tradables and non-tradables 2. Wage equalisation across the tradables and non-tradables sectors sectors

3.Capital mobility 3.Capital mobility

50%

70%

90%

110%

130%

150%

1998 1999 2000 2001 2002 2003 2004 2005 2006Industry Constructions Hotels and restaurantsTrade Transport Health and social assistance

Education P ublic administration and defence

1414

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.

)()( NTTTNT aafpp

1515

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.

Sample (adjusted): 2000Q3 2007Q1 Included observations: 27 after adjustments Standard errors in ( ) & t-statistics in [ ]

Cointegrating Eq: CointEq1 REL_PRICES_RO_SA(-

1) 1.000000

REL_PROD_RO_SA(-1) -1.488994 (0.12785) [-11.6465]

C -0.671532

Sample (adjusted): 2000Q3 2007Q1 Included observations: 27 after adjustments Trend assumption: Linear deterministic trend Series: REL_PRICES_RO_SA REL_PROD_RO_SA Lags interval (in first differences): 1 to 1

Unrestricted Cointegration Rank Test (Trace) Hypothesized Trace 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.463587 17.99940 15.49471 0.0205 At most 1 0.042849 1.182447 3.841466 0.2769

Trace test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None * 0.463587 16.81696 14.26460 0.0193

At most 1 0.042849 1.182447 3.841466 0.2769 Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

1616

The external transmission mechanism (1) – Trivariate model

Cointegrating Eq: CointEq1 CointEq2

Q_CPI(-1) 1.000000 0.000000

DIF_PRICES_REL_SA(-1) 1.755332 1.000000 (0.30263) [ 5.80019]

DIF_PROD_REL_SA(-1) 0.000000 -1.961728 (0.24163) [-8.11858]

C -0.793370 -0.962957

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.744564 49.85342 29.79707 0.0001 At most 1 * 0.457386 15.73385 15.49471 0.0460 At most 2 0.017837 0.449945 3.841466 0.5024

Trace test indicates 2 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None * 0.744564 34.11957 21.13162 0.0005

At most 1 * 0.457386 15.28391 14.26460 0.0344 At most 2 0.017837 0.449945 3.841466 0.5024

• 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;

1717

The external transmission mechanism (2) –

Bivariate models

Cointegrating Eq: CointEq1 DIF_PRICES_REL_SA(-

1) 1.000000

DIF_PROD_REL_SA(-1) -2.615841 (0.44345) [-5.89884]

C -1.309365 (0.17943) [-7.29716]

Cointegrating Eq: CointEq1

Q_CPI(-1) 1.000000

DIF_PROD_REL_SA(-1) 2.682586 (0.49357) [ 5.43511]

C 0.597486

• 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.

1818

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.

)()1(NTTSB

aaq

YearYear Including Adm. PricesIncluding Adm. Prices Excluding Adm. PricesExcluding Adm. Prices

20012001 5.0%5.0% 1.21%1.21%

20022002 -1.8%-1.8% -0.4%-0.4%

20032003 0.4%0.4% 0.7%0.7%

20042004 2.4%2.4% 0.4%0.4%

20052005 0.8%0.8% 0.14%0.14%

20062006 6.7%6.7% 1.3%1.3%

Annul averageAnnul average 2.24%2.24% 0.45%0.45%

1919

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.

.2

.3

.4

.5

.6

.7

2000 2001 2002 2003 2004 2005 2006

Q_CPI FITTED_Q_CPI

Including adm. prices Excluding adm. prices

.2

.3

.4

.5

.6

.7

2000 2001 2002 2003 2004 2005 2006

Q_CPI FITTED_Q_CPI

-.3

-.2

-.1

.0

.1

.2

.3

2000 2001 2002 2003 2004 2005 2006

APPRECIATION

-.3

-.2

-.1

.0

.1

.2

.3

2000 2001 2002 2003 2004 2005 2006

APPRECIATION

.2

.3

.4

.5

.6

.7

2000 2001 2002 2003 2004 2005 2006

Q_CPI FITTED_Q_CPI

2020

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.

)1(),( nfaprodfq PPI

)2(),( nfarelfqCPI

)3(),,( nfarelprodfqCPI

)4(),( nfaprodfqCPI

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.

2121

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)

2222

Estimation Results

E q u a tio n 1 E q u a tio n 2 C o in te g ra tin g E q : C o in tE q 1

Q _ P P I(-1 ) 1 .0 0 0 0 0 0

P R O D _ S A (-1 ) 0 .2 0 2 2 5 0 (0 .2 9 7 1 4 ) [ 0 .6 8 0 6 5 ]

N F A _ S A (-1 ) 2 .4 9 3 2 8 0 (0 .6 7 5 2 5 ) [ 3 .6 9 2 3 6 ]

C -0 .8 2 0 1 1 6

` `` `` `` ` `` `` ` `` C o in te g ra t in g E q : C o in tE q 1

Q _ C P I( -1 ) 1 .0 0 0 0 0 0

D IF _ P R IC E S _ R E L _ S A (-1 ) -1 .2 7 4 4 9 6

(0 .1 3 3 9 6 )

[ -9 .5 1 4 2 3 ]

N F A _ S A (-1 ) 4 .4 2 4 7 6 1

(0 .2 9 5 1 5 )

[ 1 4 .9 9 1 7 ]

C -1 .7 1 8 9 6 6

E q u a tio n 3 E q u a tio n 4 C o in te g ra tin g E q : C o in tE q 1

Q _ C P I(-1 ) 1 .0 0 0 0 0 0

P R O D _ S A (-1 ) -4 .1 9 7 6 1 0 (1 .6 0 7 1 6 ) [-2 .6 1 1 8 2 ]

D IF _ P R IC E S _ R E L _ S A (-1 ) 0 .8 3 4 4 5 0

(1 .5 0 1 7 5 ) [ 0 .5 5 5 6 5 ]

N F A _ S A (-1 ) 9 .6 1 6 0 1 5 (1 .7 1 0 9 8 ) [ 5 .6 2 0 1 9 ]

C -1 3 .2 3 9 8 2 (4 .2 5 8 8 0 ) [-3 .1 0 8 8 1 ]

C o in te g ra tin g E q : C o in tE q 1

Q _ C P I(-1 ) 1 .0 0 0 0 0 0

P R O D _ S A (-1 ) -1 .0 1 7 1 6 2 (0 .1 3 9 9 9 ) [-7 .2 6 5 9 6 ]

N F A _ S A (-1 ) 3 .8 9 0 6 8 3 (0 .3 3 0 2 7 ) [ 1 1 .7 8 0 2 ]

C -4 .1 2 4 6 3 4

2323

Estimation Results

• 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.

2424

- The Balassa-Samuelson effect is present in the The Balassa-Samuelson effect is present in the Romanian economy, but only partly explains the real Romanian economy, but only partly explains the real appreciation of the Romanian RON;appreciation of the Romanian RON;

- As expected, the HBS effect is less powerful when we As expected, the HBS effect is less powerful when we eliminate administered prices;eliminate administered prices;

- The Equilibrium exchange rate computed using the The Equilibrium exchange rate computed using the HBS estimations shows that the domestic exchange HBS estimations shows that the domestic exchange rate is currently overvalued by approximately 18%;rate is currently overvalued by approximately 18%;

- The Johansen cointegration tests show that there is a The Johansen cointegration tests show that there is a long term relationship between the real exchange rate long term relationship between the real exchange rate and the Net Foreign Assets, so an increase in this and the Net Foreign Assets, so an increase in this variable leads to real appreciation;variable leads to real appreciation;

- The relationship between the real exchange rate and The relationship between the real exchange rate and productivity is ambiguous because it appears with productivity is ambiguous because it appears with different signs in different cointegration relations. different signs in different cointegration relations.

Conclusions

2525

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