Exchange Rate Regimes and Sustainable Parities for CEECs

in the Run-up to EMU Membership

Virginie Coudert, Cécile Couharde

Aim of the paper:Provide equilibrium exchange rate ’s estimations for the currencies of Central and Eastern Europe Countries Why the issue of equilibrium of exchange rates?Participation in the European Exchange Rate Mechanism (ERM2) Context in which currencies of these countries have undergone a massive real appreciation

CURRENCY BOARDS Exchange rate versus Euro

(100 = 01/93)

Basis 100 = January 1993

An increase in the real and nominal exchange rates stands for an appreciation.

Source : ECB, IMF

Nominal exchange rateRER calculated with CPI pricesRER calculated with PPI prices

Bulgarie

Estonia Lithuania

50

100

150

200

250

300

350

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

0

100

200

300

400

500

600

700

800

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

April 1994Currency board

-200

0

200

400

600

800

1000

1200

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

July 1997Currency board

PEGS Exchange rate versus Euro

(100 = 01/93)

Nominal exchange rate

RER calculated with CPI prices

RER calculated with PPI prices

LATVIA CZECH REPUBLIC

80

100

120

140

160

180

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

April 1997Managed float

Peg

50

100

150

200

250

300

350

400

450

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

Nominal exchange rate

RER calculated with CPI prices

RER calculated with PPI pricesBasis 100 = January 1993

An increase in the real and nominal exchange rates stands for an appreciation.

Source : ECB, IMF

CRAWLING PEGS Exchange rate versus Euro

(100 = 01/93)

Nominal exchange rate

RER calculated with CPI prices

RER calculated with PPI pricesBasis 100 = January 1993

An increase in the real and nominal exchange rates stands for an appreciation.

Source : ECB, IMF

POLANDHUNGARY

20

40

60

80

100

120

140

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

April 2001Float

Crawling peg

20

40

60

80

100

120

140

160

180

200

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

April 2000Float

Crawling peg

MANAGED FLOATS Exchange rate versus Euro

(100 = 01/93)

Nominal exchange rate

RER calculated with CPI prices

RER calculated with PPI prices

Basis 100 = January 1993

An increase in the real and nominal exchange rates stands for an appreciation.

Source : ECB, IMF

Roumanie

Slovak Republic Slovenia

70

80

90

100

110

120

130

140

150

160

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

40

50

60

70

80

90

100

110

120

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

-50

0

50

100

150

200

250

01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02

What methodology to estimate CEEC equilibrium exchange rates?

PPP approach Relative version : PPP compares the real exchange rate with its level in a reference period in which the parity is thought to be in equilibriumReference period 1993-2001 a sustained trend of RER appreciation in most CEECs during this period, at least with CPI deflators- Does this overvaluation still exist when taking tradable prices as deflators?- Do the last nine years constitute an adequate reference period?

Absolute version:

PPP defines equilibrium exchange rates consistent with equalisation of price levels across countries

Price levels are much lower in CEECs than in the euro area. This reflects the Balassa effect.

Do these price discrepancies are in line with what is observed in other emerging countries? Regression of price levels on GDP per capita (sample including 168 countries in the world). The fitted values could be interpreted as a reference for a PPP parity taking into account the Balassa effect.

Table 1. PPP GDP per capita and price levels, relative to the euro area, for CEECs

Euro area=100 PPP GDP per capita Relative price levels Calculatedmisalignment in %

(***) 1999 2001 (*) 1999 2001 (**) 1999 2001

Czech Republic 49.0 49.7 47.4 53.2 -13.2 -3.0

Slovak Republic 40.5 40.7 38.7 45.2 -24.8 -12.3

Poland 38.5 38.5 46.6 59.4 -8.0 17.2

Hungary 37.7 39.1 57.3 64.5 13.8 26.7

Estonia 41.3 44.1 39.7 41.6 -23.3 -21.3

Lithuania 19.8 20.6 65.8 76.3 59.9 83.1

Latvia 24.0 26.1 50.5 56.6 15.5 26.1

Bulgaria 20.9 21.8 31.1 34.9 -25.7 -17.7

Romania 15.5 15.8 44.0 51.6 15.4 34.5

(*) updated with 2001 GDP estimates.(**) updated with consumer price index.(***) a plus sign indicates overvaluation, a minus sign indicates undervaluation; observed value of price level lessfitted value obtained by applying regression (1).Source: CEPII-CHELEM, IMF, IFS, Datastream, authors’ calculations.

FEER approach

Definition of the equilibrium exchange rate:

Real effective exchange rate consistent with internal equilibrium (in terms of the goods and labours markets) and external equilibrium (in terms of sustainable current accounts)

Main advantage :

Provide a multilateral framework for calculating equilibrium exchange rates consistent at a world level The exchange rate misalignment depends on both imbalances of the particular country involved and the imbalances of others countries

Main drawbacks :

Difficulty in applying this approach to CEECs. Approach mainly focusing on industrialised countries.

1. Problem of trade elasticities2. Calculate of internal and external equilibrium

We modify trade elasticities and the current account targets and in order to find out whether the results heavily depend on these assumptions.

Methodology:

Resolution of a long-term model based on Nigem for fourteen leading industrialised countries and five CEECs : the Czech Republic, Hungary, Poland, Slovenia and Estonia

Single relationship between a currency’s misalignment and the deviation of the structural current account from its medium-run equilibrium level as a % of GDP.

n

jjtjtijtitit bcbcREERREER

1

**

Table 2. Elasticities of deviations from FEER with respect to deviations from current accounttargets, ij in equation (2).

D eviation of the effective exchange rate 1 from its equilibriumvalue

w ith respect to the deviationof structural current account

to external balance (*jj bcbc ) of

Euro Czechkoruna

Hungarianforint

Polishzloty

Estoniankroon

Sloveniantolar

U nited States 4.0 0.2 0.1 0.1 0.2 0.1Japan 1.3 0.0 0.0 0.0 0.1 0.0Euro area -4.8 0.8 0.7 0.7 0.8 0.8U nited K ingdom 1.2 0.1 0.1 0.1 0.1 0.0Canada 0.3 0.0 0.0 0.0 0.0 0.0Czech Republic 0.0 -0.5 0.0 0.0 0.0 0.0H ungary 0.0 0.0 -0.6 0.0 0.0 0.0Poland 0.0 0.0 0.0 -1.2 0.0 0.0Estonia 0.0 0.0 0.0 0.0 -0.3 0.0Slovenia 0.0 0.0 0.0 0.0 0.0 -0.51 Real effective exchange rate in consumer price terms. A rise in the real effective exchange rate corresponds to a real appreciation.

Source: authors’ calculations from NIGEM.

Exogenous variables: output gap and deviation from the current account balance target

Internal imbalances computing domestic output gaps by using a Hodrick-Prescott filter. Sustainable levels of current accounts: fitted value of an econometric model of equilibrium saving-investment balancesHigh public savings and high growth of the capital share in added value (a proxy for the saving capacity of firms) contribute to domestic savings, whereas the share of the private sector in domestic output and income per capita are proxies for the level of investment. 0.40 0.09 0.13 0.09 0.077it it it it it itCA SPU PRIV Log INC Log VA OPEN

Table 5. Exchange rate misalignments for the euro, the U.S. dollar and CEEC currencies1

In %, for year 2000 euro U.S.dollar

Czechkoruna

Hungarianforint

Polishzloty

EstonianKroon

Slovenian tolar

Real effective exchange rate2 -10 36 -1 -1 6 -1 0Real bilateral rate versus euro - 31 0 0 7 -1 0

In %, for year 2001 euro U.S.dollar

Czechkoruna

Hungarianforint

Polishzloty

EstonianKroon

Slovenian tolar

Real effective exchange rate2 -6 26 -2 1 2 0 1Real bilateral rate versus euro - 21 -1 2 3 1 1

1: A positive sign indicates currency overvaluation and a minus sign currency under-valuation2: Real effective exchange rate in consumer-price terms.Source: Author’s calculations

Table 6. Exchange rate misalignments for the euro, the U.S. dollar and CEEC currencies, with alternativeassumptions on price elasticities1 , in %

EuroArea

U.S. CzechRepublic

Hungary Poland Estonia Slovenia

Export price elasticity2 0,72 0,38 1,05 1,97 0,81

For year 2000

Real effective exchange rate3 -10 36 -1 -2 12 -1 0

Real bilateral rate versus euro - 31 0 -1 12 -1 0

For year 2001

Real effective exchange rate3 -6 26 -4 3 3 0 1

Real bilateral rate versus euro - 21 -3 4 4 1 2

1A positive sign indicates currency overvaluation and a minus sign currency under-valuation2 Source: Aglietta, Baulant and Moatti (2002).3 Real effective exchange rate in consumer-price terms.

Source: Authors’ calculations

Table 7. Exchange rate misalignments for the euro, the U.S. dollar and CEEC currencies, with alternativeassumptions on current account target1,2

euro U.S.Dollar

CzechRepublic

Hungary Poland Estonia Slovenia

For year 2000

Real effective exchange rate3 -10 36 1 2 8 0 0

Real bilateral rate versus euro - 31 2 2 9 0 0

For year 2001

Real effective exchange rate2 -6 26 0 4 4 1 0

Real bilateral rate versus euro - 21 1 4 5 1 1

1 A positive sign indicates currency overvaluation and a minus sign currency under-valuation2 Current account targets set to zero.3 Real effective exchange rate in consumer-price terms.

Source: Authors’ calculations