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Estimating the Equilibrium Exchange Rate of the Central and Eastern European Acceding Countries: The Challenge of Euro

Adoption Author(s): Balzs gert and Amina Lahrche-Rvil Source: Review of World Economics / Weltwirtschaftliches Archiv, Vol. 139, No. 4 (2003), pp. 683-708 Published by: Springer Stable URL: http://www.jstor.org/stable/40440982 . Accessed: 10/06/2013 06:55
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the EquilibriumExchangeRate Estimating of the Centraland EasternEuropean AccedingCountries: The Challengeof Euro Adoption
Balzsgert andAmina Lahrche-Rvil
Oesterreichische et Vienna; Centred'tudesProspectives Nationalbanky Paris Internationales^ d'Informations

Thisstudy estimates theequilibrium realandnominal rates Abstract: exchange A and Eastern new forfiveCentral countries. is (CEE) European approach rate(FEER) which combines thefundamental equilibrium exchange adopted, In rate (BEER) methodology. with the behavioural equilibrium exchange we estimate structural a VAR-based equations 3-equation system, cointegration to therealexchange rate. The and external balances and linkthem for internal nominal rates. is usedto derive estimated equilibrium exchange misalignment rate is investigated on ex ofan ERM-II-type Thesustainability exchange regime thecurrencies ofCEE countries offixing problem postdata,and thecredibility no. E31,F31,Oll, P17 is analysed. thesingle vis--vis JEL European currency rate;transition; ERM-II; rate;realexchange Equilibrium exchange Keywords: euroadoption

1 Introduction rates hasbeena common ofrealexchange The systematic appreciation Nevertheand EastEuropean(CEE) countries. forall Central feature ratehas been of theappreciation oftherealexchange less,theextent theCzechReForinstance, across thecountries. rather heterogeneous realappreciation of an average haveexperienced publicand Slovakia 1991and 2001.This can be explained 4-5 per centperyearbetween accompanied byposilongunchanged pegofthecurrencies bythefor
referee forhis useful comwouldliketo thank theanonymous The authors Remark: theofficial in thearticle do not necessarily The opinions ments. represent expressed to Balzs Pleaseaddress Nationalbank. viewsof the Oesterreichische correspondence Research Oesterreichische Division, 3, Nationalbank, Otto-Wagner-Platz Foreign gert, e-mail: A-1090Vienna; balazs.egert@oenb.co.at

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ofWorld Review Economics 2003,Vol. 139 (4)

tiveinflation in differentials thereference countries.1 Likewise, against theconjunction ofexchange and capital moverateflexibility Poland, ment ina strong liberalization resulted realappreciation of5-6 percent realappreciation hasbeenrelatively lowin counperyear. Bycontrast, tries withactiveexchange real ratemanagement. The annualaverage from to 4 in and to 2.5 appreciation percent Hungary amounts ranges 1.5-2percentin Slovenia. Asrealexchange rates tothesetofmacroeconomic competibelong trend tiveness a invites thequestion as towhat indicators, appreciation ifat all,competitiveness While is eroded. extent, parpower purchasing usedas a first for it differences, ity(PPP) is widely approximation price cannot as far as transition of competitiveness ground analysis developing countries are concerned becauseproductivity gapscreate equilibrium In thelongrun, and developed countries. price gapsbetween emerging theBalassa-Samuelson is assumed to provide a refer(B-S) hypothesis encefor realequilibrium rates. as shown However, measuring exchange (see gert2002a,2002b;gertet al. 2003; Fleket al. 2002; recently Kovcs2002;Mihaljek and Klau 2003),theB-S effect turns out to be a relatively in CEE weakyardstick forequilibrium realexchange rates andthis callsfor a more connected tothe structural countries, approach fundamental rates i.e. real rates (FEER), equilibrium exchange exchange wheninternal and external attained are equilibria simultaneously. theequilibrium rate realexchange for CEE countries also Assessing bearsgreat in thelight oftheEU enlargement and importance process, theperspective ofeuroadoption for countries. candidate Theeuroentry shouldindeed be as closeas possible to theequilibrium nominal parity the levels and the macroeconomic balances of rate, exchange given price thecountries In this under consideration. estimates ofnominal respect, rates can be market used to direct equilibrium exchange expectations and ensure a smooth introduction oftheeuro. Thispaperprovides estimates for realexchange theequilibrium rate theconcepts of fundamental and behavioural combining equilibrium rate(FEER and BEER) so as to derivereal exchange rate exchange for the Czech Slovakia and Poland, misalignments Hungary, Republic,
1 It is remarkable rate depreciated that,while the nominalexchange by almost 300 per centin Hungary and Polandduring theperiodunderstudy, theSlovakand Czechcurrencies terms. onlydepreciated by20-30 percentin nominal

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theEquilibrium Rate gert/Lahrche-Rvil: Estimating Exchange

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Slovenia. on theseestimates, a range ofequilibrium nominal Drawing is determined. rates exchange The remainder ofthepaperis as follows: 2 overviews Section the of real rate. Section 3 the esticoncept equilibrium exchange presents mation andtheempirical results. 4 offers Section an assessment strategy ofrealexchange ratemisalignments and addresses thequestion ofthe central rate for ERM-II.Section 5 concludes. optimal entering 2 Measuring Real ExchangeRates Equilibrium Whenit comesto estimating the equilibrium real exchange ratefor one can distinguish between three of countries, acceding types estimationsas regards thetheoretical The and mostsimple first background. candidate modelis theBalassa-Samuelson model(B-S hereafter). This a two-sector smallopen economy framework describes composedof In thetradable tradable and non-tradable goodssectors. goods,internominal the rate is determined sector, competitive nationally exchange In the law of one the non-tradable price. wages by goods(closed)sector, aresetin linewith goods(open) secproductivity gainsin thetradable In the event ensures tor,becauselabourmobility wage equalization. in withthat in faster the sector that rises open compared productivity increase in whole the which theclosedsector, nominal economy, wages in theclosedsector's costs.As a consean increase produces thereby aretranslated into productivity gainsin theopensector quence, higher in therelative of non-tradable an increase prices price goods.Higher Iftheproductivity overall inflation. ofnon-tradable goodsmeanhigher theinflation in thehomecountry exceeds that then differential abroad, and leadsto a realappreciation is expected to be positive of differential all things The B-S model is theexchange rate, equal. theoretically being on thegrounds thatmostof the economies wellsuitedfortransition in the sector. This that occurred open implies proprivatizations early havebeenfaster there thanin theclosed ductivity gainscouldpossibly thetwo to a positive differential between sector,2 productivity leading sectors.
2 The financial and restrucis an exception becauseit has been consolidated sector It is, however, neither in the in all countries underinvestigation. not included tured offices northeharmonized statistical consumer priceindexpublished bythenational consumer priceindexof theEurostat.

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Itis common to test theextended version oftheB-S model practice demand side variables such asprivate andpublic including consumption. ifappropriate datais notavailable, is often Furthermore, productivity GDP that not but is proxied per capita by onlycaptures productivity also a proxy fordemand sideeffect and is connected to education and factors. demographic recent research shows in that theroletheB-S effect However, plays theappreciation oftherealexchange ratein transition countries is not that as thought before etal.2002;Kovcs and 2002;Mihaljek (Flek strong Klau 2003).As shown in gert in et and (2002a,2002b, 2003) gert al. aretwomainreasons for this. Themost obvious oneisthat (2003),there increases in productivity havenotbeenlarge if in not enough, negative, sometransition countries suchas theCzechRepublic. Asa consequence, theobserved realappreciation oftheexchange rate cannot be completely ascribed to relative differentials. The secondreason liesin productivity thestructure ofconsumption andsubsequently inthat oftheconsumer offact, theshare ofnon-tradable priceindex(CPI). As a matter goods in the consumer index is about 30 cent on average. Conprice per evenifproductivity in theopen sector at a much increases sequently, inthesheltered overall inflation will notincrease sector, pacethan higher as thenon-tradable from proportionately price pass-through productivtowards overall inflation remains weak. ity relatively Generally speaking, in CEE countries observed can be onlya partoftherealappreciation Thisisactually itseems tobe important explained bytheB-S effect. why to explore andemploy morecomplex inorder models toassess whether or nottheappreciation oftherealexchange ratecan be considered as sustainable. theestimation oflarge macroeconometric models should be Second, In these mentioned. models Williamson the funda(1994), inspired by mental rate as therealexchange (FEER)isdefined equilibrium exchange rate that allows for thesimultaneous attainment ofinternal andexternal i.e.when isset toitspotential level andwhen thecurrent balances, output account isfinanced flows. While theNATREX through long-term capital modelconstructed from a specific theoretical byStein(1994),derived stock-flow relies on a similar definition of theFEER, model, dynamic itsambition is less normative thanpositive, becauseit is intended to detect fundamental determinants thatinfluence thebehaviour of the real exchange reduced-form and time-series rate,through equations analysis.

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definition of the otherestimates Third, relyon a morestatistical rate.Thisis thecase ofthebehavioural equilibequilibrium exchange and Clark MacDonald rium rate ( 1998), (BEER) developed by exchange determinants oftherealexchange rate arequanwhere thefundamental estimation with an extended version ofthe tified econometric through as thetheoretical interest rate uncovered parity background. A fourth models. strand ofpapersis basedon general equilibrium models a three-sector Edwards others, (ex(1994) economy Among In the real this and model, equilibrium imports non-tradables).3 ports, as therelative ratedefined priceof non-tradable goods deexchange of the non-tradable on thebehaviour market, pendssimultaneously and ofthe inaccordance and on that with cleared demand, productivity inis setthrough thenation's where theequilibrium markets tradable the real rate The of behaviour constraint. exchange tertemporal budget where the econometric reduced-form assessed is then models, through that affect theinternal to thefundamentals is related rate realexchange refundamentals The macroeconomic balances.4 and external usually and levels and oftrade, aretheterms tained consumption private public arealso orad hocvariables other labour However, specific productivity. noted that similar be in It should the introduced analysis. frequently modelrecently stock-flow in the intertemporal, are derived variables countries. (1999) for developing developed byMontiel it usedas a background, models theoretical from thedifferent Apart theeconometric studies between todistinguish isalsopossible regarding data. The use of time and series i.e. time panel techniques employed, factors. to allows series However, identify country-specific techniques basisrequired or monthly thelackofdataon a quarterly bytheshort toswitch toannual force oftransition) 10years time may span(roughly efficient. be more to datawhere prove paneltechniques ofa strucon theestimation either one can rely Usingtimeseries, or the model macroeconometric tural approach. upon single-equation the is to estimate thefirst theFEERapproach, stepoftheanalysis Using and to domestic with account current of the (Y) (CA) respect elasticity rate(REER),i.e. and to therealeffective ( Y*) income exchange foreign
3 See also Elbadawi and Montiel et al. (1999) and Hinkle (1999). (1994),Baffes 4 This oftrade volume series thelimited allowsto overcome availability methodology the use of theWilliamson whichconstrains and transition in developing economies, methodology.

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CA = CA(Y, r' REER).Subsequently, a valuefor theREERshould be determined so thatCA, Y and 7* converge towards their equilibrium values.However, thiswouldimply thattheREER shouldaffect three variables at thesametime.Forthisreason, it is supposedin practice that internal balance is achieved oftheREER.So thecurindependently rent withinternal accountcompatible balanceis determined. Finally, theREERis derived which wouldmovethecurrent account modified for internal balance to itstarget value. The alternative and moreoften theequiemployed wayto estimate librium realexchange is the rate(ERER) to approach single-equation thebehavioural rate(BEER) (see Clark andMacequilibrium exchange Donald 1998). The BEER approachconsists the relationestimating between the real rate and a number of fundamentals ship exchange and transitory The actualdeviation factors. from is the equilibrium residual of thisestimate. The long-run rateis equilibrium exchange values of the which are obfundamentals, computed usinglong-term tained in either the series into and bydecomposing question permanent filter, components transitory Beveridge-Nelson (e.g.Hodrick-Prescott or by evaluating thelong-run value (see decomposition) subjectively Baffes et al. 1999),and is used to derive thedeparture of theactual rate from itslong-run value.Thus,thetotal deviexchange equilibrium ationdepends on theshort-term factors and the of transitory departure thefundamentals from their value.Alternatively, Clarkand long-term MacDonald(2000) showthat itis alsopossible to obtain thetotal deviationdecomposing thecointegration vector itself intoa permanent and a transitory rate component equilibrium (permanent exchange (PEER)) via theGonzalo-Granger method. thelong-run Thus,after estimating there is no needto evaluate valuesfor thefunrelationship, long-term damentals. The philosophy behindtheuse of panel data is somewhat differentcompared with thetimeseries the analysis. Estimating relationship between therealeffective rateand thefundamentals enables exchange us to obtainsomekindof"average" coefficients fora setofcountries. The idea is thatthese"average" coefficients obtained from thepanel the describe behaviour of the individual countries' correctly long-term realexchange in thelongrun, rate. Putsimply, therealexchange rate is to react to changes in fundamentals in eachcounsupposed similarly The substitution oftheobserved fundamental timeseries intothe try. estimated would the real ratefor equation yield equilibrium exchange

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series from eachcountry. As inthetime case,thedeviation equilibrium oftheobserved REERand the as thedifferential can then be computed realexchange rate. estimated equilibrium and Data 3 Methodology whenestimating modelsare usually equiemployed Single-equation ratesfordeveloping and transition economies. librium realexchange on smallopen economy theoretical often models, However, rely they relative rateis defined internal where therealexchange prices through thenominal do notinclude 1999).Thesemodels (seeMontiel explicitly in theforeign countries. And and pricedevelopments rate5 exchange forCEE countries characthisis whythesemodelsare inappropriate Forthis movements.6 rates and free terized capital byfloating exchange definition oftherealexchange we shalluse themacroeconomic reason, in thesame to domestic i.e. theratioof foreign rate, prices expressed about from allows to abstract which questionable hypothesis currency,7 rate. the nominal of thebehaviour exchange for models tosingle-equation Thealternative equilibrium estimating which relies the is rates Williamson, developed by approach exchange such balanceequations. and external internal on structural However, and models macroeconometric on based are require large equations for CEE countries. to obtain dataon NAIRU, uneasy in is developed a newalternative Therefore, methodology empirical rate fundamental combines the which this exchange equilibrium paper, rate withthebehavioural (FEER) methodology equilibrium exchange internal and external to estimate we seek (BEER) approach. Actually, ofnon-tradable interms oftherelative defined balances price goodsand account of current the thelong-run respectively, position, sustainability cointeofa VAR-based outin theframework and is carried 3-equation and the for relative values Estimated prices long-term system. gration
5 It is thatPPP holdsfortradable assumed goods. implicitly 6 See evidence on the et al. (2003) forempirical (2002a,2002b)and gert e.g. gert failure of PPP fortheopen sector. 7 The real ratedecomposition by MacDonald(1997) showsthattheinterexchange butthey should oftherelative are indeeda component nal relative priceindex; prices withthe relative be considered goods (whichdependon pricesof tradable together in oil suchas variability of tradable the substitutability goods,and on otherfactors in theeconomy. sector theshareofthenon-tradable and with prices),

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in thesimultaneously current accountare thensubstituted estimated the realeffective ratewithrelative relationships connecting exchange andthecurrent account. prices Theestimations arecarried outusing the VAR-based methJohansen 5 for the CEE countries the Czech Poland, odology Republic, Hungary, Slovakia and Slovenia. The periodunderstudy runsfrom 1992:Q1to theCzechRepublic, andPoland andfrom 2001:Q2for 1993:Q1 Hungary to 2001:Q2for Slovakia and Slovenia. The realexchange rateis defined ineffective terms a basket thedollar andtheeurowith against including theGerman mark a the euro in the for until 1999. being proxy Weights basket are derived from tradewiththeUnitedStates and theEU (see Table4 for moreprecision). The following vectors are estimated and normalized cointegration to relative the current account and the effective real (REL), (CA) prices rate(REER),respectively: exchange Internal balance REL + uPROD + nCONS (1) External balance CA + lxTOT + n OPEN (2) Realeffective rate REER+ 5YREL + ^CA. (3) exchange REL is the relative PROD standsforrelative priceof non-tradables, labourproductivity of the basket CONS represents countries, against realprivate CA is thecurrent TOT is theterms account, consumption; oftrade, and OPEN is theopenness ratio ofthecountry defined as total tradeoverGDP. All variables are transformed in natural logarithms. REERis theCPI-based realeffective rate. Moredetails on data exchange definition and sources areavailable intheAppendix. the Ina small internal balance. ( 1) describes Equation openeconomy, internal balance isreached when relative the of non-tradables (REL) price clears themarket. relative reflect the internal balance. Hence, prices They aredetermined (PROD) anddemand (COATS).8 byrelative productivity An increase in productivity9 shouldlead to an increase in therelative in consumption shouldalso priceofnon-tradable goods.An increase in an increase result in relative if it falls on non-tradable prices, mostly demandwas seriously constrained goods. In CEE countries, private
8 Thesevariables are also usedin Halpern and Wyplosz et (1997,2001),De Gregorio al. (1994),De Gregorio and Wolf(1994) and Coricelli and Jazbec (2001). Or in percapitaGDP measured in purchasing standards (PPS) whenproducparity couldnotbe used. tivity

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before the transition and the liberalization of the economy process, in private increase whichwas an led to an important consumption, and of inflation current account deficits.10 source important imports, In other thesevariables shouldbear negative words, signsin the vector. The relative expected price-normalized cointegration signsfor relative vector aretherefore the[relative demand] prices, productivity, 1--1 u theexternal balance.It is reached whenthe Equation(2) describes Current account decurrent account(CA) is sustainable. equilibrium withtheterms oftrade{TOT) beingthe factors, pendson structural The current accountalso demain one in a small open economy. on economic on variables, particularly thetradeprotecpends policy on tradeprotection are usually so the tionlevel.Timeseries missing, used as a for trade liberalratio is (OPEN) traditionally proxy openness in openness, inasmuch as it stemsfrom trade An increase ization.12 cuts in tariff and non-tariff and therefore liberalization, protection, becauseit generates an increase the current shouldworsen account, in terms of tradecan havean ambiguin imports. An improvement relative thevalueof exports ous effect. On theone hand,it increases the current acand fora giventradevolume, to imports, improves intoa worsencountin value.On the otherhand,ifit is translated The it can also havea volumeeffect. competitiveness, ing of export in value can deaccount and thecurrent shrinks volumeof exports vector[curteriorate. Hence,theexpected signsof thecointegrating i.e.: of are terms rentaccount, trade] partially ambiguous, openness, [1,?,+]. balancescontribute to the deand external bothinternal Finally, thethird rate.Thisis thereason oftherealexchange termination why
10 In alternative on failed to haveanysignificant impact publicdemand specifications, of economic retheconsequence This is probably therelative priceof non-tradables. in publicexpenditure. Publicexin a significant reduction which resulted structuring, in salaries and therefore are reflected of civilservants now mainly consist penditures of households. consumption private 11 The theother wayround.Thatis, a +(- ) signmeans signsshouldbe interpreted beara positive relationshould a negative Hence,relative prices relationship. (positive) and private consumption. shipto productivity 12 If the lead to spuriweremadeon cross-country data,thiscouldpossibly analysis Howon thesize of thecountry. ratioalso depends becausetheopenness ous results ratiocan be viewed as an appropriate time-series data,theopenness ever, proxy using fortradeliberalization.

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rate(REER) links therealeffective relationship cointegration exchange and the current to therelative accountreprepriceof non-tradables A risein the the internal and external balance, respectively. senting a real aprelative of non-tradables be associated with should price whilst a current account of the should,to the preciation; worsening The expected contrary, producea realdepreciation. signsof the [real relative vector are current rate, account] exchange prices, cointegration in in the mid-1990s of capitalflows occurred The liberalization it has all countries Slovenia treatment because except special requires in monetary and exchange ratepolicies, considerable breaks produced in dummies are and the Czech Therefore, Republic. especially Hungary is introduced to account for The for policy changes. dummy Hungary and2001:2. setto0 between 1992:1 and 1995:1, andto 1 between 1995:2 FortheCzechRepublic, itis0 between 1992:1 and 1997:1 and 1between 1997:2 and 2001:2.14 It should be notedthat theestimated coefficient oftheproductivity in in (1) is found andthe differential Slovenia Slovakia, non-significant balance is altered the CzechRepublic.15 theinternal Therefore, equation following way: Internalbalance REL + nCAPITA, (1')

[1,+,+l13

where CAPITAis the(log of) percapitaGDP expressed in PPS terms. terms of force us to trade data estimate thefollowing Finally, missing for external balance Slovakia:

CA +2lOPEN.

{!')

13 Put of the differently, e.g. an increasein relative pricesand an improvement current account positionshould lead to the appreciation of the real exchange rate. 14 In the exchange rate policychangeoccurred in March 1995 as part Hungary, of a stabilization In the Czech Republic, the korunacrisisburstin programme. the widening of the fluctuaspring1997.Despitethe capitalaccountliberalization, tionmargins and the float, dummies did not turnout to be significant forPoland and Slovakia.In Slovenia, no major exchange rate policychangetook place duralso confirmed time ing the periodunderstudy, by the absenceof any significant dummy. 15 between therelative (2002a,2002b) showsthattherelationship gert productivity therelative and therealexchange in these rateis weaker differential, pricedifferential countries thanin other CEE countries.

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4 EmpiricalResults 4.1 The Determination Real Exchange Rate of theEquilibrium The estimated and thediagnostic tests are relationships cointegrating setoutin Tables1-3. It is possible to find VARs in terms well-specified ofserial and normality forall countries. correlation The Johansen test thepresence indicates ofthree Itshould vectors. be noted, cointegrating thatin Polandand in theCzechRepublic, thetracetestalso however, thealternative ofat leastfour vectors. accepts hypothesis cointegration
Table 1: Johansen Tests Cointegration XI = [REL, PROD,CONS],a' = [1,, expected signs[1,-,-] X2 = [CA,TOT,OPEN],' = [1,lx,22], expected signs[1,?,+] X3 = [REER, REL,CA],' = [1,3l,02], expected signs[1,+,+] k Ho 1 Coefficient 2 tra Vector 1 Coefficient 1* 1* 1* -0.603 (-13.109) 0.278 (1.183) 0.699 (13.706) -0.286 (-5.837) 0.648 (6.113) 2.198 (25.558) -0.512 (-7.420) 0.345 (15.899) 0.572 (12.443) -0.539 (-11.978) 0.653 (10.046) 1.253 (12.165)

1992:1-2001:2 Hungary, R = 0 219.15*** XI m3,k=l,r = 3 R=l 128.39*** R = 2 71.25** R = 3 39.67 X2 R= 4 17.84 R= 5 3.84 R= 6 0.03 X3 1992:1-2001:2 Poland, R = 0 309.04*** XI ml,k=l,r = 3 R=l 166.33*** R = 2 87.11*** R = 3 42.04** X2 R= 4 17.81 7.05 R= 5 R= 6 1.16 X3

1* 1* 1*

thatthe null hypothesis is the Johansen statistic. Note:Atrace *, ** and *** indicate 5 percentand 1 per centlevels, The at the 10 percent, (Ho) is rejected respectively. of lags (k) and the cointegration modeltested (ml, m2, m3, m4, m5), the number are presented underthe nameof thecountry. Sturank(r) used in the estimations * abovethe in parentheses theestimated coefficients. under t-statistics areshown dent's is significant at the thatthenormalized variable i.e. 1 indicates normalized variable, normalization. 5 percent levelin another

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Tests Table 2: Johansen Cointegration


X2 = [CA, TOT, OPEN], ' = [1, , nl expectedsigns [1,?,+] X3 = [REER,REL, CA], ' = [1, 3' , &2]> expectedsigns [1,+,+] k Ho 2 1 Coefficient Xtrace Vector 1 Coefficient 178.87*** 107.89*** 65.98*** 31.97** 9.25 2.87 XI X2 X3 1* 1* 1* -0.907 (-18.435) 0.659 (6.013) 1.675 (45.270) -0.746 (57.385) -20.924 (-76.365) 1.843 (20.252) 1.035 (-2.221) -0.077 (-12.833) 0.752 (30.080) 0.481 (13.743)

XI = [REL,CAPITA], a! = [1,, expected signs[1,-,-]

Czech Republic, 1992:1-2001:2 R= 0 m3, k = 2, r = 3 R=l R= 2 R= 3 R= 4 R= 5

Slovenia, 1993:1-2001:2 R= mO,k = 2, r = 3 R= R= R= R= R=

0 1 2 3 4 5

131.63*** 79.02*** 47.34*** 23.99 8.05 2.47

XI X2 X3

1* 1* 1*

Slovakia, 1993:1-2001:2 R= m3, k = 1, r = 3 R=l R= R= R=

0 2 3 4

123.98*** 75.13*** 38.69*** 11.69 0.119

XI X2 X3

1* 1* 1*

-0.949 (-27.912) 1.471 (16.528) 0.246 (5.125) -0.102 (-3.000)

Note: See Table 1.

out on the cointegration At the same time,the stability testcarried rankrejects the stability vector. of theforth Therefore, cointegrating The estifor countries.16 thethree-equation is estimated both system and mated turn out to be relationships significant, areall cointegration also showthatnoneof The long-run exclusion tests correctly signed.
16 The 24-28). testsare not shown here. However,theyare reportedin gert (2002c: stability

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theEquilibrium Rate Estimating Exchange gert/Lahrche-Rvil: Table 3: DiagnosticTests Skewness p-value Hungary Poland CzechRepublic Slovenia Slovakia 3.90 6.88 9.67 8.75 7.12 0.79 0.44 0.14 0.19 0.21

695

Jarque-Bera normality Kurtosis p-value p-value Skew&kurt 9.69 5.56 8.42 7.49 8.49 0.21 0.59 0.21 0.29 0.13 13.60 12.44 18.08 48.94 15.62 0.48 0.57 0.11 0.18 0.11

p-valueWeakexogeneity p-value Exclusion p-value Stationarity Hungary REER REL CA PROD CONPRIV TOT OPEN Poland REER REL CA PROD CONPRIV TOT OPEN CzechRepublic REER REL CA CAPITA TOT OPEN Slovenia REER REL CA CAPITA TOT OPEN Slovakia REER REL CA CAPITA OPEN 24.87 21.77 22.08 20.88 21.17 29.25 25.22 35.23 32.12 31.37 33.01 31.51 32.70 33.77 24.20 21.48 22.61 28.32 21.70 15.68 19.91 11.37 16.58 11.25 14.86 18.67 7.77 20.26 22.49 13.06 23.41 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.00 0.01 0.00 0.00 0.02 0.00 0.00 0.00 0.00 9.79 0.62 13.79 4.84 48.25 13.48 2.19 5.14 9.09 44.99 9.68 90.60 42.83 8.04 14.53 12.28 11.71 6.42 5.05 17.44 11.51 11.62 4.36 13.08 11.61 3.73 18.15 25.21 11.76 15.38 9.82 0.02 0.89 0.00 0.18 0.00 0.00 0.53 0.16 0.03 0.00 0.02 0.00 0.00 0.045 0.00 0.01 0.01 0.09 0.17 0.00 0.01 0.01 0.23 0.00 0.01 0.29 0.00 0.00 0.01 0.00 0.02 22.32 23.36 26.46 25.19 10.04 22.32 16.34 25.39 60.59 53.46 14.54 35.24 36.07 34.62 22.06 30.43 16.79 10.09 23.68 11.63 11.74 24.10 12.13 15.43 11.20 13.17 27.05 25.58 3.64 28.14 16.81 0.00 0.00 0.00 0.00 0.02 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.02 0.00 0.01 0.01 0.00 0.01 0.00 0.01 0.00 0.00 0.00 0.30 0.00 0.00

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ofWorld Review Economics 2003,Vol. 139 (4)

thevariables are excluded from thecointegration space.An exception is thecurrent account variable for Slovakia with thep-value indicating Themultivariate exclusion. tests exwithout long-run stationary reject, conditioned on the of the rest of the ception, stationarity, stationarity variables. Astothe weak variables arefound someofthe tests, exogeneity to be weakly i.e. they do notcontribute to theshort-term exogenous, adjustment. The initial modelperforms wellforHungary and Poland.An imin the differential tends to increase therelative provement productivity of non-tradables. The of relative to relative price elasticity prices producare0.6 for and roughly 0.3 for Poland.A risein private tivity Hungary leadsto a significant increase in therelative consumption priceofthe non-tradable and the size of coefficient is 0.5 in goods, approximately bothcountries. Notealso thatthecointegration also turnout vectors at the5 percent level. statistically significant As regards the modified internal balanceequation, the estimated coefficients and are of 0.9 for the Czech and appearsignificant Republic Slovakia and somewhat 0.75 for Slovenia. lower, to theexternal an improvement in theterms of balance, Turning tradehas a systematic accountwith impacton the current negative theexception of Slovenia. Thismaybe explained thatthis bythefact a reveals in an environment improvement competitiveness deteriorating of strong of demand.17 In Slovenia, an appreciation in priceelasticity theterms of tradeis associated withan improvement of thecurrent account. theestimated coefficient seemsto be too high.We However, notethat for all coefficients arestatistically except Hungary, significant at the5 percent level. As to openness, it has a systematic effect on thecurrent worsening account. Thisresult is consistent with theapproach oftrade as openness a proxy for trade reforms. With thefast liberalization and reorientation of CEE markets to EU ones,imports of high-quality have products ina worsening ofexternal inthe accounts increased, ending past10years, which callsfora depreciation oftherealexchange rateto raiseexport revenues that couldbring thecurrent account backto equilibrium. As fortherelationship therealeffective rate connecting exchange = tointernal andexternal balances REL,CA], given byX3 [REER(CPI), thesignsofthecointegration vector are in linewithexpectations. An
17 et al. (1998) confirm thatCEE countries are pricetakers. Aglietta

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theEquilibrium Rate gert/Lahrche-Rvil: Exchange Estimating

697

inrelative increase ofnon-tradable (decrease) prices goodsis associated of the realexchange withan appreciation whilst rate, (depreciation) ina depreciaa worsening ofthecurrent account results (improvement) tion(appreciation) ofthereal rate. Twoexceptions areSlovenia exchange andSlovakia because therealexchange rate when thecurrent depreciates account theelasticities, eventhough Nonetheless, improves. significant arevery atthe5 percent level, low,i.e.closeto zero. 4.2 Exchange Rate Misalignments in CEE Countries Wewouldliketo figure outhere whether therealexchange rateexperiencedan excessive and whether it was overvalued over the appreciation under For this we the observed investigation. purpose, compare period ratewiththeestimated oftherealexchange appreciation equilibrium the estimated realexchange rate.In orderto derive real equilibrium the series are first substituted into the internal rate, original exchange Thishelps us obtain values for andexternal balances equation. long-run and the current account. these relative Subsequently, long-term prices intothethird estimated vector that valuesaresubstituted cointegrating rate to relative and the current aclinks therealeffective prices exchange with the estimated real andthis us count, equilibrium exchange provides rate. in 1992 areusedas indexes normalized that realexchange rates Given and in for and the Czech 1993 Slovenia for Poland Republic, Hungary, in levto assessoveror undervaluation itis notpossible and Slovakia, of the observed and estimated the relative evolution els.Instead, only we are ratescan be assessed. realexchange Nevertheless, equilibrium inlevels a reference ourresults abletointerpret byselecting year during ratecan be regarded as beingin which theequilibrium realexchange Edwards Elbadawi This is what (1994), (1994),Mongardini equilibrium. (2000) do, and we also makeuse ofthismethod. (1998) and Filipozzi The realexchange rate is viewed tobe at itsequilibrium valuewhenthe and current account are close to their relative prices longunderlying on theexternal values.We put a specialemphasis term sustainability whenchoosing thebase year. The reference chosenare 1997for years and 1994forPoland,Slovakia 1993fortheCzechRepublic, Hungary, becausein these the account was sustainand Slovenia, years current financed thecurrent accountdeficit able in thesensethatFDI largely 1). (Figure

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698

Review ofWorld Economics 2003,Vol. 139 (4)

1: Current Account Balance PlusFDI, 1993-2000 Figure


6000 - y' . ' 1 CzechRepublic ^-t^

4000

'

./ Poland

7^

2000 -

SIovenif /

1993 /

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^

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The difference between theobserved andtheestimated equilibrium realexchange i.e.theextent ofa possible overor undervaluation rates, aresetoutin Figure 2. Wecandistinguish inHungary between twocases.While andSloveratedoes not seemto be overvalued overthe nia, therealexchange under there are of substantial real in overvaluation period study, signs thecasesoftheCzechRepublic, In Hungary, Polandand Slovakia. alwe can observe an of 10 in undervaluation to cent the first though up per half ofthe1990s, therealexchange rate turns outto converge to andto stabilize arounditsestimated value. This is because ofthe equilibrium which considered the evopre-announced crawling pegsystem, explicitly lution ofthefundamentals when itcametodetermining therate ofcrawl. The caseofSlovenia is very similar to what we can observe in HunIt is to that over the whole the Slovenian real gary. possible say period, ratewasvery closeto itsequilibrium value.Once again,it is exchange due to theexchange ratepolicyconsisting in managing the probably nominal rate so that the real rate never exchange exchange appreciated too much.

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Rate theEquilibrium gert/Lahrche-Rvil: Estimating Exchange

699

theObserved and theEstimeted Real Figure2: The Gap between Equilibrium Rate Exchange
0.20

(1997) Hungary

Slovenia(1994)
0.20-j

0.15

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1

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as

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1

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toPoland, theCzechRepublic 2 shows andSlovakia, Turning Figure a substantial in all three overvaluation casesat theend of theperiod under some differences haveto be noted. As to However, study. major is not too important Poland,it is trueto saythatthe misalignment in theearly1990sand evenabsentin 1994but becomeslarger from 1995onward. themisalignment vis--vis theequilibrium Nevertheless, rate is pretty volatile. Theresponsibility for theincreasing and exchange more volatile in the second half of the studied can misalignment period to the increased and of the nominal go volatility appreciation exchange

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700

Economics Review ofWorld 2003,Vol. 139 (4)

the ofthefluctuation bandandthen rate from theenlargement resulting moveto free floating. reveals a widening thecase oftheCzechRepublic gap Examining rate. andtheestimated real between theobserved equilibrium exchange inreal oftheCzechcurrency overvaluation Wecanobserve an increasing should note that ofthetransition We thebeginning terms from process. in 1997, dateofthecurrency seems tobe broken overvaluation thetrend the estimated sustainable moves close to real rate crisis: the very exchange and the overvaluation Butsoonafter rate. realexchange that, reappears in the of free in 2001. As case 15percent isaround Poland, floating going ineffective terms ofthecurrency intandem with a nominal appreciation for this. couldbe responsible different from thatof the Czech The case of Slovakiais slightly rate turns outtobe close in the real that Poland and exchange Republic it theearly 1990s. valueduring sustainable to itsestimated Afterwards, of themaximum terms andreaches inreal overvalued tobe getting seems stabilization Since the atabout10percent. the overvaluation programme tends to of the the extent in early wasimplemented 1998, misalignment in 7-8 percent 2001. and attains be smaller Rates and EMU Entry 4.3 NominalEquilibrium Exchange the rateallowsus to compute realexchange The estimated equilibrium the countries rate oftheacceding nominal against exchange equilibrium here theeuro.The underlying and against basket effective hypothesis is rate. thenominal with canbe corrected that themisalignment exchange a with correscan be eliminated a realovervaluation In other words, rate. ofthenominal exchange depreciation ponding rateoftheacceding nominal Table4 showstheobserved exchange basket of theeffective the euro of the the countries euro, weight against for of the size and the previously 2001:Q2. computed misalignment and then of the euro to the real misalignment, theweight Applying to the actualnominalexchange nominalmisalignment the obtained vis--vis the rate thenominal we can derive rate, exchange equilibrium share of of the 4. Because row of Table in last the euro,displayed high nominal the intheeffective EU countries basket, appears misalignment 15 cent from 10 to i.e. real to the close per ranging misalignment, very and beingcloseto zeroin Polandand Slovakia in theCzechRepublic, and Slovenia. Hungary

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the EquilibriumExchange Rate gert/Lahrche-Rvil: Estimating

701

Table 4: NominalEquilibrium Rates in 2001:Q2 Exchange


Poland Czech Rep. Slovakia Hungary Slovenia Observed nominal exchangerate (X/euro) Weightof the euro in the basket (in percent)18 Nominal overvaluation againstthe euro (in per cent) Equilibriumnominal exchangerate (X/euro) 3.49 62 15 4.12 34.30 80 11 38.39 43.00 74 10 47.54 257.46 83 2 263.90 214.44 89 2 217.94

Note: The equilibriumeuro-dollarexchangerate is assumed to be equal to the observed exchangeratein the second quarterof 2001.

criterion on nominal exto assesstheMaastricht We nowattempt ofa hypothetical ratein theframework ERM-II-type exchange change theeuro.Forthispurpose, theestimated rateregime equilibagainst ratein 2001:Q2 are used as the central riumnominalexchange parenter the15 percentfluctuacountries withwhich theacceding ity nominal rate howtheobserved 3 displays tionband.Figure exchange counwithin thelargeband in thefive has been developing acceding tries.19 and Polandappearto have i.e. theCzechRepublic Twocountries, the fluctuation out of their currencies margins. hypothetical moving ERM-IIin early ourbenchmark exited The Czechkoruna 2002,butit sideof in a rangeof20-25 percenton thestrong has thenstabilized out of the side the broke As to thecentral Poland, stronger zloty parity. the nominal a while. for ofthebandin mid-2001 Afterwards, exchange inside the15 percentmargins hasbeenmoving rate accompanied by substantial swings. hasbeenevolvtheexchange rate andSlovenia, In Hungary, Slovakia The ERM-II. our the framework of within Hungarian imaginary ing on thestrong side bandof10percent ina relatively narrow forint stayed in The exitfrom thecrawling rateregime. oftheexchange peg system
compute the weights,trade with the rest of the world is allocated between the euro and dollar areas in proportionto the share of trade with the EU and the United States. 19 We also plot the 2.25 per cent margins,withinwhich most actual EMU member currencieshad de factocome back afterthe early 1990s crises. 18 To

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702

Review of World Economics 2003, Vol. 139 (4)

EMR-II Ratesin theHypothetical Figure3: NominalExchange


Czech koruna
0.20 M5 010 0.05 1 0.15 A 0.20

Polish zloty

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2001produced an episodeofhigh butsince then thenominal volatility, rate has been a koruna The Slovak exchange exhibitingstriking stability. shows a similar ofnominal this staHowever, pattern stability. apparent occursin closeproximity of theupper, side of the limits bility strong oftheexchange rateregime. The case of Slovenia differis somewhat entcompared withthatofHungary in thateventhough and Slovakia thenominal rateremains within thesystem, it turns out to exchange movefrom thestronger sidetowards theweaker limits oftheexchange rate Thisis becausetheactive ofthetolar regime. brought management abouta steady nominal of the tolar aimed atcompensating appreciation

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theEquilibrium Rate gert/Lahrche-Rvil: Estimating Exchange

703

forthepositive inflation differential between Slovenia and itstrading partners. Severalinteresting seem to emerge. conclusions it appears First, thata credible central a and credible commitment of thenaparity tionalauthorities in maintaining and theECB maybe very crucial the between the fluctuation band. Announcing a credible cencurrency tralratemight offer an anchorto expectations, hereby contributing to curbexchange ratevolatility and to driveexchange rateexpectationstowards an equilibrium level. rate This is the reason exchange thenominal rateis a crucial issue. equilibrium why defining exchange commitment of thenational central bankand the Second,a credible and to maintain thecurrency within ECB to defend theERM-IIwould market to in mid-2001). the rate exit the band Poland prevent (e.g. to because the currencies tend exit on the limitof However, stronger could be easier.Third, and overthe fluctuation bands,the defence the nominalexchange thedifficulties, ratestability could all, despite the the currencies be fulfilled Nonetheless, relatively easily. longer stay rateinstability in the ERM-II, the higher the risksof exchange appear. 5 Conclusion:How Should the ExchangeRate Be Managed into the Euro? beforeEntry Czechand Slovenian curthatin 2001 thePolish, indicate Our results whereas the rencies did not appearto be at their value, equilibrium currencies turned out valued. and Slovenian fairly Hungarian setthe"good" toenter theeurorapidly should CEE countries willing enter theERM-II,as thischoiceconditions central rateas soonas they theadoption thetwoyears rate theexchange stability preceding during be credible for markets to ratemusttherefore oftheeuro.Thiscentral it.20 accept areboundbytheexchange rate these countries Furthermore, stability of in theMaastricht The included criterion treaty. flexibility exchange in CEE countries seemsto be accompanied rateregimes by growing ratestabirate andnotbysteady nominal exchange exchange volatility,
20 This before EMU entry thatstructural reforms be achieved (privatization, implies forthey issue. forinstance), are an integral banksector reform partofthecredibility

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704

ofWorld Review Economics 2003,Vol. 139 (4)

rate themarket a notfully credible central couldprevent lization. Setting rate rate totheequilibrium toprogressively exchange exchange converge to EMU acceding. prior showsthatthe our hypothetical ERM-II simulation Nonetheless, rate could be metin Maastricht on nominal criterion exchange stability Thisresult is ofutmost themedium there is credibility. runprovided in thelightof recent of the Balassa-Samuelson importance findings the in the literature to which most of countries, according acceding has area and the euro structural inflation differential vis--vis Germany beenand is expected to continue to be below1.5 percentrequired by theMaastricht criterion on pricestability. Hence,themuch-heralded seemsto be of between nominal and realconvergence incompatibility earlier. lessconcern than believed In this isthespeedofentry intoEMU.The another context, problem and the is beingmostdebated between institutions European question CEE countries. totheEuropean most Commission, impatient According theECB andmembers oftheESCB (Deutsche Bundesbank, OeNB),fast Exas not view unsustainable. is desirable because early entry they entry the affect to the nature of could related unsustainable pectations entry market in all EU countries, andthus be attherootofa conconfidence On theother overto other countries. tagionphenomenon spreading inconverging fiscal is structurally over 3 percent countries deficit hand, inparticular and duetofinancing infrastructure investment (seeKopits Szkely2002). CEE countries wouldcancelthe entry conversely arguethata fast of rate which is renominal negative consequence exchange volatility, in for of the real and these counmost sponsible appreciation volatility tries thefree to itsdefenders, such ofcapital. through entry According a strategy wouldalso constrain realappreciation to thenon-tradable sector inflation differential translated intooverall inflation differentials, which is already with and coincides an narrow, mostly equilibrium apwhile a monetary unioncancels realappreciation However, preciation. linked tothenominal rate as wellas volatility, itdoesnotdelete exchange and rooted in evenin short-run inflows: appreciation volatility capital in such inflows can indeed end the Dutch disease union, monetary with a in the phenomenon, liquidity economy, coming along overhang resolved In this sector investment and overvaluation. bynon-tradable adhesion should not substitute for structural reforms premature setting, and financial sector and stability). (banking strength

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theEquilibrium Rate Exchange gert/Lahrche-Rvil: Estimating

705

A Appendix
5.1 Data Sourceand Definition in natural All times series areseton a quarterly basisand are expressed logais 1992:1 to 2001:2 for rithms. The periodunder Polandand study Hungary, 1993:1 to 2001:2for Slovakia and Slovenia. theCzechRepublic and spansfrom is computed the German Theeffective realexchange rate mark (usedas against flows trade with 15and a proxy for theeuro)andtheUSD, andweighted EU by tradewiththerestof theworldbeing theUS (exports and imports average, in trade). to theweight oftheUS and Europe These reallocated proportionally trade. for themajorpartofCEE countries' countries account from in Tranrate is taken theWIIW database Countries Thenominal exchange of monthly 2001 and is computed as the arithmetic sition average exchange rates. Indicator the OECD Main Economic are takenfrom Consumer priceindexes in order to cancel thedisand arecomputed as three-month database averages fluctuations. effect ofshort-run ruptive Therelative usingOECD data,and is goodsis calculated priceofnon-tradable as services in theCPI overtheproducer defined priceindex. from in percent theWIIW CounofGDP is drawn account balance Thecurrent in Transition database. tries as and is obtained is basedon labourproductivity Theproductivity differential in the industrial the number of divided industrial employees by production theweighted averwith is compared ofCEE countries Theproductivity sector. and US labourproductivity. age ofGerman Terms are theratioof theexport price priceindexovertheimport oftrade in theterms oftrade. an improvement An increase in theratiodenotes index. + imports to GDP in valueterms. is defined as theratioof exports Openness wereseasonally Tradeseries (4). averages through moving adjusted Method 5.2 Estimation suchas ADF,PP or KPSSare unit-root tests Whenusing analysis, cointegration It is,however, to study thestationthefirst possible stepoftheanalysis. usually multivariate tests. in VAR of series stationarity The tests through systems arity ofstationarity. thehypothesis in Table3, and they arepresented reject It mustbe well-specified is estimated. In a secondstep,theVARsystem relations.21 robustness of thecointegration to ensure thesubsequent in order criAkaike and Schwarz information defined the is theoptimal First, using lag
21 Notice VARs. arethoseofthewell-specified tests that thestationarity presented

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706

Economics Review ofWorld 2003,Vol. 139 (4)

and theabsence ofserial correlaand theportemanteau test. teria, Normality of the tionis checked theJarque-Bera testto theresiduals ex post,applying of and via correlogrammes forthevector individual of thesystems equations to be residuals. therootsof theVARallowstationarity of thesystem Finally, controlled. in the trend of a constant, trend thepolynomial (inclusion Subsequently, test individual series is determined. Thetrace thecointegration and/or vectors) rankto be defined, of whichis thenallowsthecointegration therobustness checked testprovided (1998). Fiusingthestability byHansenand Johansen the are identified restrictions on the nally, long-run relationships byimposing vectors. cointegration References de and V. Coudert(1998). Comptitivit et rgime M., C. Baulant, Aglietta, CEPII Working changeen EuropeCentrale. Paper 10. Centred'tudes et d'Informations Paris. Internationales, Prospectives I. Elbadawi, of theEquiand S. O'Connell(1999). Single Baffes, J., Equation librium Real Exchange Rate.In L. Hinkleand P. Montiel (eds.),Exchange and Measurement RateMisalignments: Countries. Concepts forDeveloping A World NewYork: Press. BankResearch Publication. Oxford University P. and Rates and Economic FundaR. MacDonald Clark, B., (1998).Exchange A Methodological IMF mentals: of BEERs and FEERs. WorkComparison D.C. ingPaper67. IMF,Washington, P. B., and R. MacDonald(2000). Filtering the BEER - A Permanent Clark, and Transitory IMF Working Decomposition. Paper144.IMF,Washington, D.C. in Transition RateDynamics Coricelli, F.,and B. Jazbec (2001). RealExchange Economies. Centre forEconomic Research Discussion Series Policy Papers 2869.CEPR,London. De Gregorio, of Trade,Productivity, and the J.,and H. Wolf(1994). Terms RealExchange Rate.NBERWorking Bureauof EcoPaper4807.National nomicResearch, Mass. Cambridge, De Gregorio, A. and Evidence on J., Giovannini, H. Wolf (1994).International Tradable and Nontradable Inflation. Economic Review 38: 1225European 1244. S. (1994). Real and Monetary Determinants of Real Exchange Edwards, Rate Behavior:Theoryand EvidencefromDevelopingCountries. In Rates.Washington, J.Williamson (ed.), Estimating Equilibrium Exchange D.C: Institute forInternational Economics. B. (2002a). Estimating theImpactof theBalassa-Samuelson Effect on gert, Inflation and theRealExchange Rateduring theTransition. Economic Systems 26 (1): 1-16.

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oftheLong-Run RealExchange P. (1999). Determinants Montiel, Equilibrium Rate: An Analytical Model. In P. J. Montieland L. E. Hinckle(eds.), and Measurement Rate Misalignments: Concepts forDeveloping Exchange UniverA World NewYork: Oxford Countries. BankResearch Publication. Press. sity RealExchange RateoftheUS Dollarand DeStein, J.L. (1994). The Natural In J. ofCapital Flows. Williamson terminants (ed.), Estimating Equilibrium Rates. D.C.: Institute forInternational Economics. Exchange Washington, of FEERs.In J.Williamson Williamson, J.(1994). Estimates (ed.), Estimating forInternational Rates. D.C.: Institute Equilibrium Exchange Washington, Economics.

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