real exchange rate and exchange rate policy in hungary

Economics of Transition, Volume 4 (I), 211-228, 1996

Real exchange rate and exchange rate policy in Hungary' L6sz16 Halpem

Institute of Economics Hungarian Academy of Sciences Pob 262 1502 Budapest Hungary TEL:361 1853770

Abstract Five real exchange rate indicators are computed to assess the international competitiveness of Hungarian industry. These indicators are explained in econometric equations by employment, unemployment, productivity, interest spread and real producer wage. Causality tests reveal that external performance has an impact on real exchange rates, and contributes to explaining real exchange rates. There is very limited scope for policy intervention to constrain the negative effects of capital inflows without incurring other costs.

JEL classification: F41 Keywords: real exchange rate, exchange rate policy, Hungary.

1. Introduction

The real exchange rate is the most widely accepted indicator of international competitiveness. In spite of important contributions to the topic, the purchasing power parity doctrine - either in its absolute or in relative form - has remained in the centre of the discussion and analysis of real exchange rates. This paper will concentrate on the link between the real exchange rate and fundamental variables.'

The exchange rate became one of the most important policy variables in Hungary. The stabilization package of March 1995 included the introduction of a pre-announced crawling peg regime with monthly devaluations of 1.9% in the first half of 1995, and I .3% devaluation in the second half. The package involved an immediate 9% devaluation accompanied by an 8% import surcharge on consumer and intermediate goods for domestic sale. The expected effect was to improve the external balance or, more precisely, reduce the extent of the imbalance.

Halpern and Wyplosz (1995) offer a general interpretation of the real exchange rate movement and exchange rate policy in Central and Eastern Europe. That paper did not deal with the relation between current and capital account and exchange rate, mainly due to the lack of appropriate data. As is widely known, Hungary is a special case, although

212 Real exchange rate and exchange rate policy

not unique, because of its rather significant and stubborn external imbalance, which creates the need for a special study of the relation between this imbalance and the exchange rate.3

This paper presents alternative real exchange rate measures and tries to estimate econometric equations. In the second step different measures of external disequilibrium are investigated to establish whether they can add anything to the explanation of real exchange rates. It is argued that too much weight is given to arguments concentrating on merchandise flows, and it will be shown that the real exchange rate is also influenced by capital flows, bearing in mind that the separation between current and capital account is rather difficult, sometimes arbitrary and that the classification of individual transactions depends on the loopholes of regulation. Finally, policy conclusions are formulated.

2. Real exchange rate measures

There are four commonly used real effective exchange rate indicators. The first is computed on the basis of industrial wholesale prices. The second is computed using consumer price indices. The third measure is the real effective exchange rate based on unit labour cost (ULC). The fourth is the ratio of price indices of traded to non-traded sector output proxied by the ratio of producer to consumer price indices.'

The above measures - the PPI to CPI ratio excepted - put emphasis on either price or cost competitiveness. It is obvious that in these concepts there is no technology difference between industries producing for domestic or for export sale.' The first two indicators assume that there are no differences in supply conditions between the home and foreign country, and price has the only effect on demand. Basically there should be no difference between PPI and CPI, but this is far from the reality in transition countries. Factors influencing the wedge between these price indices are treated below. The third indicator assumes that prices are equal across countries due to competition and that lahour is the only production factor. The first assumption is far from reality: the presence of differentiated goods and the change in the export and/or import basket challenge this traditional view. The first case applies to trade among developed countries, the second case is more typical for countries in transition. If it is assumed that prices are more or less similar across countries then the change in unit labour costs reflects the change in profitability. Unit labour costs are related to the position of foreign competitors and are denominated in common currency by the nominal effective exchange rate. The assumption that labour is the only production factor is very restrictive during transition, since the shift in technology modifies the ratio of capital to labour and the intermediate input requirements. In this paper it will be assumed that labour costs represent all the other costs.

There is no reason to separate price and cost competitiveness. The fifth indicator proposed by Lipschitz and McDonald (1992) relates the total nominal relative wage costs to the relative production at current prices and reflects the combined effect of prices and labour costs related to the competitors. It is obvious that both prices and costs change; consequently this indicator gets closer to the concept of profitability, hence to competitiveness. This profit-based indicator of competitiveness can be expressed as a function of producer price and unit labour cost-based indicators, namely, it is equal to the ratio of unit labour cost to producer price-based real exchange rates6 Put differently: this measure is a product of relative productivity and relative real producer wage. The productivity and the real wage are related to those of the competitors. We share the view of Lipschitz and McDonald (1992), who claim that even the composite measures have

Halpern 213

drawbacks, e.g., costs other than wage costs are neglected. It can be rather biased especially when fast technological change takes place, which is quite evident in transition countries. Massive layoffs, capacity under-utilization in industries created for former CMEA-exports on the one hand, and significant inflow of foreign direct investment. on the other hand, lead to modifications in aggregate technology.

TO reduce the data requirements of this exercise the nominal effective exchange rate of the Hungarian currency was computed differently compared to the official basket. It was assumed that the basket consisted of 50% US$ and 50% DEM, compared to the official composition which has been 70% ECU and 30% USD since May 1994. This may cause some departures from NBH results, though our qualitative results remain valid.

Figure 1. Real exchange rate indicators (January 1990 = 1)

1.4

.A ..

81 I 8 8 I a9 I 9 0 I 9 1 I 9 2 I 9 3 I 9 4 1 9 5

- RERCPI ' .. RERPPI - RERPROFIT - PPI/CPI - RERULC

RERCPI: CPI based real exchange rate; RERPPI: PPI based real exchange; RERULC: ULC based real exchange rate; RERPROFIT: profit based real exchange rate PPI/CPI: ratio of PPI to CPI

Figure 1 shows the movement of different real exchange rates hetwien January 1987 and April 1995. An increase means real depreciation, a decrease real appreciation. The major difference lies between the four traditional indicators and the profit-based real exchange rate. According to the four measures the Hungarian currency has appreciated since January 1990, while the profit-based indicator shows that the competitiveness has remained more or less on the same level with some fluctuations. The profit-based indicator increased substantially in the first half of 199 I and reveals more than 20% real depreciation compared to the end of 1990. Afterwards the same magnitude of appreciation continued until July 1992. The same fluctuation - depreciation followed by appreciation - was produced between mid-1992 and mid-1993, but the extent was only 10%. Since mid-I993 the profit-based real exchange rate has remained around its January 1990 level.

There are important differences among the traditional real exchange rate indicators. First, the PPI to CPI ratio and the CPI real exchange rate exhibited real appreciation during the whole period amounting to 23-2576 real appreciation compared to January 1990. It should be mentioned that since the end of 1992 the CPI real exchange rate


remained more or lcss constant, while the ratio of PPI to CPI continuously declined from January 1990 until the end of 1993. Second, the PPI-based real exchange rate moved very close to the CPI real exchange rate until mid-1991, and afterwards returned to the same level which shows a 10% real appreciation compared to January 1990. Third, the ULC real exchange rate moved together with the profit-based indicator until the end of 1990, then appreciated by 20% during the next two and half years. Since mid-1993 i t has been stabilized between 80 and 90%.

The Hungarian exchange rate policy has been concentrating mainly on two indicators: PPI and ULC'-based real exchange rates. It is evident that these indicators systematically deviate from the profit-based indicator.

The profit-based real exchange rate consists of two components: relative productivity and relative real wage. Both are related to the indicators of the competitors. Competitiveness improves if the relative productivity increases faster (or decreases slower) than the real wage. If the relative productivity falls faster (increases slower) than the real wage, competitiveness deteriorates.

Figure 2. Components of the profit-based real exchange rate (January 1990 = I ) Real exchange rate = relative productivitylrelative real wage

1.3

88 I 89 I 90 I 91 I 92 I 93 I 9 4 195

- RERPROFIT ' '' Productivity -. Real wage

The movement of the two components is shown in Figure 2. Until the end of 1990 productivity was stable. As a consequence, changes in the profit indicator were induced by changes in relative real wage. Productivity has been increasing since early 1992 after a major fall in the second half of 1991. Between January 1992 and July 1993 real wages increased by 25%. This was only partially offset by the productivity increase, leading to a loss of competitiveness. Since mid-1993 the real wage fluctuations have been moderated and the profit-based indicator has been dominated by the upward trend of productivity.

There is a practical problem with the real exchange rate indicators using CPI. It stems from the stubborn difference between PPI and CPI. This was explained by the increasing retail margin. by the often increased sales (VAT, excise) taxes, and by the different role

Halpern 215

of unrecorded activities on price indices. Experts added that the direct comparison of these indices was somehow misleading, since the manner of their construction was totally different (for examplc, sampling, weighting scheme). Now one can offer some additional precision. These two indices and their difference can be followed on Figure 3. The wedge opened up in mid-1991 and vanished in early 1995. During this period energy prices lagged behind the average and, due to the fact that PPI is weighted by gross output while CPI is weighted by consumption, the PPI was downward biased when energy price increase was behind the average PPI. and vice versa." This is the reason why the CPI- based real exchange rate is also computed, since in a textbook case the eventual difference between CPI and PPI has no effect whatsoever on the competitiveness position of domestic exporters compared to their foreign counterparts. When the real exchange rate is proxied by the ratio of PPI to CPI, claiming that it expresses the change of - equilibrium - profit difference between non-traded and traded goods sectors, it neglects the potential spillover effects of eliminating bottlenecks in service industries (telecommunications, roads, efc.) on traded goods sectors, which is rather specific to transition countries.

Figure 3. Producer and consumer price indices and the difference (Sunre mottrh in [he prrvioiis yror = 100 per cent)

-10 ' J A J O J A J O J A J O J A J O J A J O J A J O J A J O J A J

88 I 8 0 I 9 0 I 9 1 I 9 2 I 0 3 I 0 4 1 9 5

--PPI ' "CPI -CPI-PPI

PPI: wholesale industnal pnce

3. Real exchange rate and capital inflows

Hungary has attracted relatively large amounts of FDI in the region. At the same time, the growing gap between exports and imports has widened. It is beyond the scope of this paper to give an account of the relationship between the trade balance and foreign direct investment. but what is important to note is that the fundamental equilibrium exchange rate in a country in which there are substantial net capital inflows is lower than the exchange rate which tends to equilibrate the current account.


There are two major concerns that policy-makers underline about capital inflows: first, since capital inflows are typically associated with real exchange rate appreciation and with increased exchange rate volatility, they may adversely affect the export sector. In Hungary it is argued that the government or central bank should intervene to offset the real exchange rate appreciation driven by capital inflow. The real exchange rate target should be guided by the trade balance or at least by the current account. The argument used is that real appreciation driven by capital inflows may lead to bubbles, which should be prevented. Second, capital inflows may be reversed very quickly, possibly leading to a domestic financial crisis. This is the "hot money" argument. Calvo et al. (1993) add a third concern: capital inflows - particularly when massive - may not be properly intermediated and may, therefore, lead to a misallocation of resources.

Analysing the role of capital inflows in Latin America, Calvo er al. (1993) conclude that improper intermediation, that is, improperly priced government insurance, lack of policy credibility, market failure, or some combination of these, could be the results of speculative bubbles. Although the bubbles hypothesis is very appealing, it does not follow that a bubble equilibrium calls for government intervention. A clear case for intervention could be made i f the government had better information than private agents and could, thus, prevent the creation of a speculative bubble. This proposition is doubtful; hence intervention could be ineffective and even counterproductive. Another case for intervention is when the speculative bubble is driven by the expectation that government will bail out speculators when the bubble bursts. Optimal policy to prevent this type of bubble could simply mean the setting up of appropriate mechanisms to prevent government from bailing out speculators. It rnay be optimal to make a credible commitment that government will not intervene if the bubble bursts. In practice, however, governments may be unable to make such commitments credible, especially when they involve the possibility of bank failures.

A reversal of capital inflows may exacerbate the negative effects of improper intermediation, or actually give rise to improper intermediation. In an environment characterized by asymmetric information, a sudden capital outflow rnay lead lenders to conclude that the country has suffered a negative supply shock, even when no shock has occurred. The sudden capital ilight, in turn, may bring about the discontinuation of efficient investment projects. Thus, i f start-up costs for these projects are significant, their discontinuation provokes a deadweight loss, which may be observationally equivalent to an exogenous negative supply shock. Consequently. the expectations that gave rise to these detrimental capital outtlows may become rational.

It was observed by Calvo et uf. (1993) that in Latin America real exchange rate appreciation was preceded by capital inflows. Looking at the potential factors, like the difference in rates of return, macroeconomic developments in Latin America, and external factors, it seems that important changes in the US capital market might have played a dominant role.

In Hungary the sequence is not that clear between FDI and the real exchange rate. Granger-causality tests reveal that both directions should be assumed, namely the relation between FDI and profit-based real exchange rate is mutual (see Table I).

Halpern 217

Table 1. Granger-causality between real exchange rate change and external performance

Real exchange rate change cpi PPi ppi/cpi ulc profit

*** ***

res * * X

*

External indicators

utr ** fdi imb

** ** ** * * ** ** ** ** cil

External indicators res X utr fdi imb ca

cpi ** ** * ** **

Real exchange ppi rate change ppi/cpi

* * *** ulc * profit * * * **

cpi: consumer price-based real effective exchange rate; ppi: producer price-based real effective exchange rate; ppilcpi: ratio of producer price index to consumer price index; ulc: unit labour costs based real effective exchange rate; profit: profit-based real exchange rate; x: exportdimports; utr: unrequitcd transferhports; imb: (imports+current account+foreign direct investment)limpons; fdi: foreign direct investmenUimports; res: international reservedi mpo ns; ca: (imports+current nccount)/imports; * significant at 10% level, ** significant at 5% level, *** significant at 1% level.

4. Real exchange rate and fundamental variables

In Halpern and Wyplosz (1995) monthly CPI real exchange rate in CEECs was explained in an error correction mechanism by fundamental variables like employment, unemployment, labour productivity, real producer wage, interest rate spread, which determine the real exchange rate in the long run. Other variables, such as lending interest rate, money and nominal devaluation, were used to assess the short-run relationship. This approach was used in Edwards ( 1989) for developing countries. For different reasons in Halpern and Wyplosz ( 1 995) two major fields - budget and foreign trade - were more or less neglected. Due to lack of data the budgetary position was proxied by the interest rate. The foreign trade or capital inflow were not included, because the link between real exchange rate and external performance cannot be reduced to this one-way causal direction. In spite of these considerations in this paper a one-sided approach will be followed to analyse the effect of external variables on the real exchange rate.

The five real exchange rate indicators were estimated in the spirit of this approach. The following explanatory variables were used: productivity, unemployment, employment,


interest rate spread and real producer wage. It is assumed that productivity, employment and unemployment have negative effects on the equilibrium real exchange rate, while an increase in interest spread and real producer wage leads to an equilibrium real depreciation."

Table 2. Error correction estimation results for different real exchange rates

Real exchange rates CPI PPI PPYCPI ULC PROFIT

Long-term equation Sample period Constant Productivity Unemployment Employment Interest sprwd Real producer wage

Adjusted R-squared Short-term equation Sample period Constant Adjustment tzriii

AProductivity AUnemployment AEinployimxt Alnterest spread AReal producer wage

Adjusted R-squared S.E. of regression Surii of squared residuals Log likelihood Durbin-Watson stat Mean dependent var. S.D. of dependent v i r . Akiike info criterion Schwartz criterion F-statistic Ramsey RESET test: White heteroscedwticity test: Jarque-Ben test of normality

R-squmd

R - y u m d

88:09-95:04 88:09-95:03 88:09-95:06 88:01-95:03 88:0-95:03 5.2010*** 3.5556*** 2.4491*** -1.5204*** -7,2544."

-0.0705 -0.1016** -0.3982*** -0.0688*** -0.0386*** -0.0495*** -0.0501 *** -0.0304***

-0 .020 -0.0061*** 0.0069*** 0.0 1 07 *

( ) .9 5 5 6 0.8277 0.9487 0.7574 0.1300 0.9.532 0.8207 0.9460 0.7516 0. I07 I

-0.1532** 0.1.595*** -0.45 lo***

8H: IO-95:oJ 88:OY-95:03 118:09-95:06 88:02-95:03 -O.(X)65*'* 0.0033 -O.oMO*** -0.0465"' -0.3SIJ'** -0.3401*** -0.1567*** -0.3086***

0.2076* -0.2651 ***

0.0187** -0.oss4*** 0.5344 0.6.532 0.6180 0.8345 0.502s 0.623') 0.58 I9 0.8 173 0.0 I" 0.0 I02 0.0106 0.0530 0.0'62 0.026 I O.OOX3 0.2166 '(W.33 201 .J 1 260.77 135.29 1.7001 I .')ShS 2.1429 1.9110

-O.(X)39 -O.O() I4 -0.oU35 -0.0038 O.O?-h') 0.03 I3 0.0164 0.1241

-7.8590 -7.H228 -9.0()30 -5.7748 -7.6790 -7.6 I I3 -8.7682 -5.5179

16.7s51=** 22.2927- i 7 . 1 0 3 ~ * 4n.s17s*** 0.4358 2.9426' 0.7645 6.7866***

2.7X36** 1.6523 2.6108*** 2.3337" 36.0567*** 3.169 2.366s 0.7080

Variables iue in logarithms. interest spread excepted. Dependent variable is the red exchange rate. cpi: consumer price-bard real effective exchange rate; ppi: producer price-based real effective exchange rate; ppilcpi: ntio of producer pricc index to consumer price index; ulc: unit labour costs based real effective exchange rate; prunt: profit-based real exchange rate; x: exponslimports: utr: unrequited transferlimpons; fdi: foreign direct investinendimpom; ca: (impons+current account)/iinpons; imb: (iinpons+current account+foreign direct investiiient)liinpons; res: international reservedimpons;

significant at 10% level. ** signiticant at S% level, *** significant at I(% level.

Estimation results are presented in Table 2. In the upper part of the table the long- term relationships are shown for which seasonally adjusted series were used."' In the

Halpern 219

lower part the short-term results are given. There is no long-term relation for the profit- based real exchange rate. It should be mentioned that neither productivity nor the real wage can be used as an explanatory variable, since the indicator directly includes both of them. No equation can be regarded as satisfactory for the other four real exchange rates. In the equations of CPI-based real exchange rate and of PPUCPI the sign of the real producer wage is significantly negative, in the equation of PPI-based real exchange rate the interest spread has a negative significant coefficient. The long-term equation for the unit labour costs-based real exchange rate can be accepted, but its short-term equation is not free from specification error.

5. Real exchange rate and external disequilibrium

Policy-makers and economists in Hungary tend to concentrate on one direction of the two-way relationship between the real exchange rate and external equilibrium. It is widely believed that real devaluation improves the external balance, the only economic policy problem being how to ensure that the effect of real devaluation lasts for a long time. Practically, policy-makers concentrate on how to contain real wages. The basic assumption behind this reasoning will be challenged here.

In Table I the Granger-causality test was run to shed light on the causality link between real exchange rates arid different measures of external performance. Six measures were used: ( I ) ratio of exports to imports; (2) ratio of unrequited transfers to imports (x); (3) ratio of' current account to imports (ca); (4) ratio of foreign direct investments to imports (fdi); ( 5 ) ratio of the sum of current account and foreign direct investments to imports (imh); (6) ratio of international reserves to imports (res). All the items in these indicators are measured in current US$. The higher the value of any of these indicators the bcttcr the extcrnal performance.

The first part of Table I shows the causal direction from the foreign performance indicators to real exchange ratcs; in the second part the opposite causal direction is tested, i.e. whether the real exchange ratcs Granger-cause the external variables. According to common sense the latter l ink should dominate and that is the basic idea in different policy proposals whose objective is to achieve a certain real exchange rate lor the sake of improvements in foreign performance. According to more differentiated reasoning i t is argued that capital tlows have an effect on the exchange rate in the short run, and the exchange rate has an impact on merchandise tlows in the longer run. It is difficult to separate variables along these lines: part of export earnings is transferred in the form of unrequited transfers; part of the capital flight takes the form of transfer pricing, part of imports takes the form of foreign direct investment due to import duty advantages.

In general there is a two-way causal l ink between real exchange rates and external performance variables. CPI- and PPI-based real exchange rates are preceded by almost all the variables, while they both influence unrequited transfers and foreign direct investment. Exports have an effect on the CPI- and PPI-based real exchange rates and are preceded by PPI and profit-based indicators. The ratio of PPI to CPI is preceded by unrequited transfers and foreign direct investment, but no variable has an influence on it. Unit labour cost real exchange rate Granger-causes three indicators and is Granger- caused by one measure. The profit-based indicator is preceded by the foreign direct investment and Granger-causes the exports, the unrequited transfers, the foreign direct investment and the current account.


Table 3. Error correction estimation results for CPI-based real exchange rate with different external variables in the long-term equation

X OTR FDI CA IMB RES

Long-term equation

Sample period 88:09-95:04 89: 12-9504 89:12-95:04 Constant 5.2010*** 5.1552*** 5.3 123*** Productivity -0.0705 -0. I 142- 0.0750* Unemployinent -0.0688*** 4.0795*** Employment

Real producer wage -0.1532** -0. I379*** -0.2607***

variable Lag structure (in II I I months) R - s q u ~ ~ d 0.9556 0.9475 0.9693 Adjusted R-squared 0.9532 0.9440 0.9673

Interest spread -0.0020 -0.0058***

Lagged external -0.0360* -0.0489***

Short-term eyuation Sample period Constant Adjustment term AProductivity AUnrinployinmt AEiiiployinent Alnterest spread AReal producer wage R-squared Adjusted R-squared S.E. of regression Sum of squared rcsiduals Log likelihood Durbin-Watson stat Mean drpndent var. S.D. of dependent var. Akaike info criterion Schwarfz criterion F-statistic Ransey RESET test: White heteroscedasticity test: Jarque-Ben test of normality

88:10-95:04 90:01-95:04 90:01-95:04 -0.(MS*** -O.O(Wl*** -0.007 I*** -0.3514*** -0.3756*** -0.4991 ***

I

0.0487** 0.0664 0.0838'** 0.5344 0.5064 0.4945 0.5025 0.4638 0.4602 0.0 190 0.0 I79 0.0 180 0.0262 0.0 I86 0.0 I9 1

204.33 169.76 168.99 1.7601 I.78O4 I ,765 1

0.0269 0.0245 0.0245 -0.0039 -0.0056 -0.00.56

-7.8590 -7.9553 -7.9627 -7.6790 -7.7.529 -7.7940

h.7551*** I I.9(W)4*** 14.4264*** 0.4358 2.7737' 1.6976

2.7836** 2.0569' 2.4586**

36.9567.'. 29.4679*** 55.3867***

89: 12-9594 4.8712***

-0.0846***

-0.0.0408**'

I I

0.9577 0.9563

90:01-95:04 -0.0072*** -0.3682**

0.0668** 0.4706 0.4347 0.0184 0.0200

167.52 1.8948

0.0245 -0.0056

-7.9166 -7.7480

13.1132*** 3.79770. 2.0419.

36.9567***

Variables are in logarithms. interest spread excepted. Dependent variable is the real exchange rate. Seasonal duininies in the short run equations are not reported. x: exponsliinpons; utr: unrequited transferlimpom: fdi: foreign direct investinrnthinpom; ca: (imports+cument account)/imports; imb: (importsccurrmt account+foreign direct investmentYimports; res: international reservcdimports; * significant at 10% level, ** significant at 5% level. *** significant at 196 level.

This test is only the first step in understanding the link between the two sets of variables. Note that according to this procedure the causality between exports and the PPI-based real exchange rate runs in both directions. It should be stressed that the ideal method to analyse this relationship would be in the framework of a full macro-model. That is far beyond the scope of this paper. Here we will only deal with the explanation of real exchange rates by adding foreign trade variables to the previously presented

Halpern 22 I

equations. The question was: is it possible to identify the appropriate lag structure of foreign trade and capital flow variables to improve the corresponding equation? The results can be found in Tables 3-7 for CPI-, PPI-based real exchange rates, for the ratio of PPI to CPI, for unit labour cost and profit-based indicators, respectively. The construction of these tables is the following: first the long and short-term estimation rcsults of the base version are presented without any foreign variable. Then six other versions follow in which the lag structure is identified” for the appropriate foreign variables.

The expected coefficient sign for foreign variables is negative, since i t is assumed that improving foreign performance ( in the form of ratio of exports, unrequited transfers, current account, foreign direct investment, international reserves to imports) causes equilibrium real appreciation.

The CPI-based real exchange rate equations (Table 3) are not improved by introducing foreign performance variables; only the exports, unrequited transfers and reserves lagged by I I months enter the long-term equation; the coefficients of the real producer wage and the interest spread remain negative; no short-term equation is found without heteroscedastic and non-normal residuals; only the unrequited transfers equation is free from misspecitication.

The introduction of external variables improves the PPI-based real exchange rate equations (Table 4). The short-term equation extended by two - 7 and 1 1 months - lagged values of exports is free froin illisspecification and has normal, homoscedastic residuals.

The lagged values of external performance cnter thc long-tern equation for the of PPI to CPI with positive coefficients in case of exports, foreign direct investment, current account, and the current account cum foreign dircct investment (Table 5). In the remaining two cases - unrequited transfer and reserves - the coefficient is negative. In every long and short-term equation the real producer wage has a significant negative coefficient. This is an expression of the positive effect of real wages on CPI, but i t is difficult 10 reconcile with the competitiveness interpretation of the PPI to CPI ratio.

The lagged values of unrequited transfers make the equation for unit labour costs- based real exchange rate acceptable; the overall effect of lagged values on the real exchange rate in the long-term equation is negative: two lagged values have negative, one has a positive coefficient (Table 6). In the short-tenn equation the adjustment parametcr has decreased compared to the base version, meaning that the estimated parameter reveals faster adjustment if the relevant lagged toreign variable is used.

There are only two long-term profit-based exchange rate equations which can be considered: equations extended by the ratio of unrequited transfers and reserves to imports (Table 7). In both equations. besides the external performance variables. unemployment and the interest spread determine the long-term path. The main problem is that the variables at our disposal do not quite explain the exchange rate: the R2 is rather low. which casts doubt on these long-term equations. The short-term equations are acceptable, with the exception that the residuals are heteroscedastic. The adjustment term, the change of employment and seasonal dummies explain monthly changes in relative profitability.

Summing up these results from the point of view of external variables it is clear that lagged values of exports make the PPI-based real exchange rate equation plausible both on economic and econometric grounds. The long-term equation is determined by productivity, unemployment, interest spread, real producer wage and two lagged values of exports to imports ratio. The short-term equation contains the adjustment term and seasonal dummies. The ratio of unrequited transfers to imports make it possible to have an acceptable explanation of the uni t labour costs-based real exchange rate. Productivity,


unemployment and thrce lagged values of the foreign performance ratio explain the real exchange rate in the long-run. The short-term equation contains the adjustment term and seasonal dummies. Finally, the unrequited transfers and international reserves ratio plays a part in estimating long-run equations for the profit indicator. Both short-term equations contain the change of employment besides the adjustment term and seasonal dummies.

Table 4. Error correction estimation results for PPI-based real exchange rates with different external variables in the long-term equation

X UTR FDI CA IMB RES

Lung-term equation

Constant 3.5356*** 3.6091'*' 2.9978". 3.51 IS*** 3.8982*** 1.8010*** 4.3214*** Sample p e r i d RX:W-'JS:03 89: I1-95:03 89:12-93:03 X9: 12-93:03 89:12-95:03 89: 12-95:03 89:03-95:03

Productivity -0 Il91*'* Unemploymiit - o . m h * * * -o.07~6*** -o.oJR~*** -o.osw** -0.0520*** - n . w * * *

Interest spread -0 006 I*** n.0052** - o . w 8 * * * -0.00~~- -0.0064'*' Employment

Real producer wage 0 lS'JS*** 0.1610*** 0.1783*** 0.1628*** 0.1 183.. 0.1346.. Ligged external -0.0692*** -0.0344". -0.01 10.' -0.0482*** -0.05 I 8**' 0.0471 *** variable I Lagged external -0.0601'. -0.0289* -0.02X.5' variable 2

nioiiths) R - y u ~ r d 0.H277 (1.KSX 1 0 X476 0.8343 0.8597 0.8617

Lag structure (in 7. I I I I I 7. I I 7. I I 2

Adjusted R-squared 0.~207 0.x432 n.xm 0.8446 0.R502 o.xs37

Ciinstoni 0 o m 3 O.OU24 -0 .0033 0.0019 O.(Mll I 00023 n.ooo9 Adjustment teriii -0.3401'*' -0 4 lO7'** -0.4402*** -0 3874*** -0.3561*** -0.3282** -0.36001*** AProducti vity AUnemployment AEmploynient 0.2076' Aliilerest spread AReA producer wage 0 120J'** R-squared 0.6532 0.3454 0.5766 n 6270 0.5138 n.mn o h m

S.E. of regression 0.0 I92 0.0 I CJ.7 O.0IXX 0.0194 0019X 0.0201 0.0192 SUlll of squwed 0 026 I 0.0212 O.OIOX n.om 0.0227 00230 00243 residuals Log likelihood 20 I 4 I Ib2.45 I6469 187.17 160.33 159% 1x566 Durbin-Watson stat. I .9563 I ."07 1.0487 I X953 2.0283 2.1033 1.9240

S.D. of depndrnt 0.03 I 3 0.0275 00273 on107 0.027s 0.0275 0.0300 var. Akaike info. criienon -7.1228 -7 8053 -7.X4.79 -7.8014 -7.7690 -7.7256 -7.R283 Schwanz criterion -7.6113 -7.6(XJ3 -7.6058 -7.6131 -7.5989 -7.3215 -76386 F-statistic 22.2927.'. l3.6749*'* 12.71 13**' 22.S274.O. 15.3208*** I1.7726'** 21.5393*** R;imsey RESET test 2.9426' I6066 4.4007.. 4.3136** 2.5675. 4.0174.. 2.2219 White 1.6523 0.6168 1.1211 0.5995 0.31 16 0.3295 0.2652 heteroscedasticity test Jarque-Ben test of 3 169 3 4622 4.5oRS 1.112.. 4.2912 5.4754' 12.23948'* normality

Adjuslcd R-squared 0.623') 0.5035 0.3313 0.5992 O.4X02 0.4649 0.5912

Mean dependent var. -0.0014 -0.003 I -0.OU3I -0 0002 -0.003 I -0.003 I -0.001 I

Variables are in logarithtns, interest spread excepted. Dependent variable is the real exchange rate. Seasonal dutntnies in the shon run equations are not reported. x: exportslirnports; utr: unrequited tnnsfediinports; fdi: foreign direct investtmt/iinports; ca: (itnponsHurrent account)fiinpons; imh: (itnports+current account+fonign direct investtnent)/itnports; res: international reserves/itnports. * significant at 10% level. ** significant at S% level, *** significant at I % level.

Halpern 223

Table 5. Error correction estimation results for the ratio of PPI to CPI with different external variables in the long-term equation

X UTR FDI CA IMB RES Long-term cyuatinn Sample ,xcnnd

Constant Prductiviiy Unemployment Employment Interest spread R K ~ producer w;ige Lagged exiernal variable I Lagged extcrn;il variable 2 hgged external v;irinble 3

hgged external v;irinhle 4

Lag StNCIurr f in nionths) R - y u u r d A~JUSICJ K-squared Shurt-term ecluilticm S;imple period

Constant Adjustiirni iertii APrwlucii viiy AU wtiqiloynieni AEn:ploynrnt

A R K ~ Iircwliiccr w;gc R-squared Adju~ted R-SC~II;UK~ S.E. of regrcssiori Sun1 of squared residuals Lig l ikr l ihw~d Durbin-W:iison stat

Me:iii ckpetideiit wir. S.D of d q x i i k n t v;ir. Akaike inlu criterion Schwiutz criierion F-statistic Rimsey R E S n 1-1

White Iwierosccd;lsiisity test

Jarqur-Bmi lest lit nornullity

AlIllKrKSl Spre:id

W09- 95:M

2.4491 9.8

-0.1016** .0.0495*"

0 006Y** * .O 45lO"*

0 0487 0 0460

80:l 1-95:07

2 2363"'

-0.0337***

-0 38.70*** 0.081 5-0 n.w.7-

7. II 0.9457 0.9424

89.12-95.06 89 07- 9S:M

1.3072. 3.2419***

-0.OS45*** 0.1793" 0.0047** 0.0069*'*

-0.5.768'*' -0.53.54*** -0.017 I ** 0.01 86".

I I 6 0937s 0.9453 0.9234 09420

90:Ol- 90:OI- 95:OS 95:07

2.3509'** 2.5654***

-0.0387*'* -0.0458***

.O?916*** -04199*** Oo43J*'* 00399*** 0 0.522". 0 0344'- 0 0?74*** 0 0235'

0 0269.' 0. 8. 12 6. 7. 10. 12 09639 09641 09608 09605

-0 265 I * * *

-0 05.54"' 061x0 0 5x10 00106 O O O X l 260 77 2 I429

-0 w75 00164

-0 0070

17 1072'*' 0 7645

26108".

-H 7682

-O.O3W* .0,2370**'

n ( ~ 2 4 . .o nsno***

06169 0.5564 0 01 10 0 0069 212.25 2 1524

- 0 . m I 00166

-8.X7.53 -8 5463

10 19XI"' I S428 I4548

-0 2169**' -0 221 I * * * -0 2463'*' -0.2488*** 00024' OOU25'

-0.0412*** -0.0472*** -0 0467" -0.0479.. 0601R O628Y 05750 0.5653 0 .~429 o snio 0 . 5 2 ~ 0.51217 00111 0.0106 0.01 I4 0.01 I4 00071 00070 O.OO74 0.0076 20806 226% 202.88 205.64 20123 20844 1.9806 1.9841

-000.77 -0ooJf -00040 -00029 00165 0.0164 0.0165 0.0164

-8 8701 -8.9776 -R 8340 -8.8269 -85715 -8.6'408 -85664 -8.5615

10.7665*** 13.1325*** I I 0183*'* 10.7744". 2 3576 19x70 I7087 1.1734

0.7400 I 3071 1.8440.

2.366s 025x9 0.4211 17220 2.1552

90:01-95:06

2 4256". 0.0891 *.

-0.0620***

0.01 29". -0.3026"' -0.0256*** -0.0270*'*

-0.0 147'' -0 0203''

6. 8. 10, I 2 0.97 I6 0.9676

90:02-95 :07

-0.o060"' -0.2404'"

-0 2645***

-0.OSIS" 0.597 I 0.5485 0.01 10 0 0070 208 IS ?W

-0.0039 0.0164

-8.9029 .8.6375

I2.2792*" 11156

1.9669.

2.2424

Viiriahles iue ill lognrithin. interest spread excepted. Dependrnl variable IS the red exchaitgc rate. .'kuonal dWumer in Ihc shon run cquatioiis :ue it111 rrponed x ' exponshmpans: utr: unrequited trmsieriimpns, fdi: foreign direct invrstment/imports: CP: (iniprts+current accountMmpons; imb. (in:ponr+cuneni nccouni+foreipn direct investnmtUimports; res: intrrii;ition;ll resrrvedimpons, * signilicaiit nt 10% level, ** significant at 5% level. .'* significani at I % level.


Table 6. Error correction estimation results for unit labour costs-based real exchange rate with different external variables in the long-run equation

X UTR FDI CA IMB RES Long-term equation

Snmple period Constmt

Productivity Unemployment Employment Interest spread Lugged cxtcmd variable I Lagged extrriwl variable 2 Lagged extem~l variable 3 Lag SINCtUfe (in months) R-squurd Adjusted R-squared Short-term equation

Sumpk period Constant

AdjustnEnt term

AProductivity AUwmploynwu AEmploynwnt Alnleresl spread R-squ;urd Adjusted R-squared S.E. of regression Sum 01 squared residuals L)g likeliliood Durbin-Watsiln SIBI

Mean dependent var. S.D. of dependent var. Akdke info criterion Schwmz cnterion F-statistic Ramsey RESET t a t .

88:01-95:03 89:11-95:05 90:01-95:03 -1.5204*** -1.0586*** -0.7521** -0.3982'" -0.2599'' -0.2067.. -0.O.MI *** -0.0579." -0.0623***

0.0824** -0.0892*** -0.0680** 0.0580***

10 I. 2. I2 0.7574 0.7239 0.8363 0.7516 0.7103 0.8219

88:02-95:03 89: 12-95:03 90:02-95:03 -0.0465*** -0.0472*** -0.0413*** -0.3086*** -0.3642*** -0.4534***

0 8345 0.8173 0.0530 0 2166 13529 1.91 10

-0 0038 0 1241 -5.7748 -5.5179

4x5175*** 6.7866**'

0.1576**

o xn43 0 X650 0 0433 0 1012 I1556 I8918 0 0008

0 1179 -6 1366 -5 7992

45 R702*** 4 9780'.

0.8687 0.8188

0 0401

0 OX54 116.25 I 843s

-0.0042 0.1032 -6.2974 -5.9886

43 8 I80*** 0.5656

White hetuoscedasticiiy tebt: 2 3337.. 0.9832 1 6057 Jarque-Bera test of normality 07080 0.7714 I 9018

89:11-95:03 89:04-95:03 89:03-95:03 -0.8.341*** -0.9061*** -1.1507**' -0.1978.. -0.2257.' -0.2810'** -0.0622*** -0.0634*** -0.04%***

0.1338*** O.062OL -0.0510***

-0.0923.. 0.061 3- 3, 7, 10 3 2 0.7867 0.7643 0.7652 0.7686 0.7539 0.7549

89:12-95:03 89:05-95:03 89:04-95:03 -0.0472". -0.0494*** -0.0483*** -0.3144'* -03723°** -0.4286*'*

0.15.SO' 0.1614** 0.1577**

0.8742 0.8532 0.0452 0 I101 112.86 1.9663 0.OoOx 0.1179 -6.0524 -5.7 1 50

41.6807*** 5.809s **

0.8059 0.1466

0.8725 0.8536 0.0442 0.1193 126.05 I .7455

-0.0033 0.1156 -6.1069 -5.7882

46.36378*L 3.6864.' 0.9693 1.0369

0.8586

0.8381 0.0472 0.1381 123.07 I ,5494

-0.o005

0.1173 -5.9788 -5.6626

41.8465*** 3.9766-

1.3806 1.8490

Vnriables NT in logarithiiu. interest spread excepted. Dependent variable is the r d exchange rate. Seasonal dummies in the short run equations nre nor reported. x: exponslinipns: utr: unrequited tnnsfer/lnIports: Id: foreign direct invesrnunlhpons: CP: (impna+cumnt account)/inipons: imb (inipons+cument accouni+foreign direct invutment)/imports: rcs. inlcmational rrservrs/itiipons:

significant at 10% level. ** significant nt 5% level. *** significant at 1 % level.

6. Policy conclusions

Five main interventionist policies can be considered to counterbalance the negative effects of capital inflows: 1. tax on capital imports; 2. trade policy; 3. fiscal tightening; 4. sterilized and non-sterilized intervention by the central bank; 5 . a rise in marginal reserve requirements.

Recent experience of Latin American countries shows that a mix of policy intervention based on the imposition of a tax on short-term capital imports, on flexibility

Halpern 225

of exchange rate, and on raising marginal reserve requirements on short-term bank deposits might have the best outcome. The sterilized intervention may only be used if the capital inflows are tor short periods and no fiscal tension is present. Non-sterilized intervention is to be avoided due to its inflationary effect. Trade policy is quite heavily constrained by international agreements, and may have a very negative impact in a recently liberalized economy.

Table 7. Error correction estimation results for profit-based real exchange rate with different external variables in the long-run equation

X UTR FDI CA IMB RES Lung-term equation Sample period Cuiuiant Productivity Unempluynwni Employmeni lnteresi spreud R r i l producer wilgr Lagged external variable I Lsgged external variable 2

nioiiths)

AJjusied K-yuamd

SINCIUrK ( 1 1 1

R - Y U U ~

Short-term rquaticm S:iniple period Collstallt Adjustiiriit teriii APrduciivi iy AUoernployniciii AEniploynwnt Alnteresi spread AReal producer wage

Adjusted R-squared S.E. of regression Sum of squared

Log likelihood Durbin-Watson stat

Mean depcndcnt viu. S.D. of dependent v:ir Akmke info criarioii Schwcutt criterioii F-statistic Rnmsey RESET test: White kteroswdui ic i ty test: Jarque-Bera test of normality

R - ~ q u ~ e d

rrsiduclls

KX:W-Y5:03 89:07-95:04 W:01-95.03 89:02-95:03 89:02-95:03 89:03-9.5:03 90.01-95:03 -7 25qJ*** -7 43l6*** -5.9047"' -7..587.5*** -7.2366**' -7.2100*** -7.2622'**

-00108 -0 0304*** -0 I368**'

O.I026'**

6 2. 12

0 1 3 0 0 0 169.5 04341 0 1071 0. I 3 I 2 0 3950

'x) 02-95 03 -0 0977"' -0 4lK2 *

-069XI**

IIJ.28 2.0936 -0.oO03 0 I I82

-6 0726 -.5.5923

30.9009*** I0990

2.8099'"

0 83A6

OoOlS -O0308'*' -OO343'*' -00210'

0.CMX8 00108'* 0.0117" 00111**

-0 0354 0 07M*** 0,0684'. -0.0786."

I I I 2

0 I470 01x48 0.IX21 0 3175 0 110.5 0 1499 0 I471 0 2879

M'J 0)-95:03 -0 O'JH7*** -0 347.5**'

-0 6175**

0 9024 0 Y763 0 0480 0 1292

125.46 1.7810 0.0010 0. I366

-.5.8784 - S 3725

34.531 I**' 0.7167

2.2404'*

0.5794

Variables are in logarithm. interest spread excepted. Dependent variable i s the real exchange rate Srasonal dummies in the short run equations are not reported. x: expoftdinipons: utr : unrequited mnsfedimpons: fdi: foreign dimct investmenihmpwts: ca: (impms+cumnt accountfimpons: imb (impons+current nccwnt+foreign direct investment)hmports; res: international reserveshmpons: * significant at 10% level. * * significant pi 5 % level. *** significant iii 18 level.

Contrary to the experience of Latin American countries foreign direct investment in Hungary has not pushed the currency towards appreciation. instead, unrequited transfers


and international reserves have exerted this type of effect. Unrequited transfers are linked partly to currency substitution and partly to tax evasion, while the accumulation of international reserves retlects all the effects of current and capital account developments. A high level of international reserves is often regarded as positive; however, these computations have revealed that besides the direct costs associated with accumulating international reserves for a debtor country there are indirect costs in the form of upward pressure on exchange rate.

What is also important for Hungary is to increase the flexibility of the exchange rate in order to avoid large fluctuations in differences in yields on foreign and domestic assets. The pre-announced - and credible - crawl may cope with this problem, if the exchange rate has enough flexibility to react to the ever changing external and internal position.

Endnotes

I .

2.

3. 4. 5.

6 .

7.

a.

9.

10.

1 1 .

An earlier version of this paper was presented at the Conference on Convertibility and Exchange Rate Policy, Sofia, 22-23 September 1995. The conference was supported by a grant from the European Commission under its PHARE-ACE prograinme. Comments and criticisms by the participants are acknowledged. The relationship between the real exchange rate and inflation is treated in Calvo et al. ( 1 995). The effect of monetary shocks on the real exchange rate is discussed in Clarida and Cali ( 1994) and in Click ct 01. (1995). An important contribution is Oblath (1994). See Rogers and Jenkins (1995) for a different interpretation of CPI differences. Four indicators are almost the same as what is suggested by Marsh and Tokarick (1995). In this paper a PPI-based real exchange rate is also computed, and the export unit value indicator is not computed due to lack of data. Even a quarterly GDP-deflator is not yet available in Hungary. Csennely (1993) separated export and import price and cost competitiveness and computed corresponding indicators for Hungary. This is true if the unit labour cost is computed from the unit of production a1 constant prices. The indicator is constructed in such a way that the effect of the nominal exchange rate vanishes. In this respect it is similar to the ratio of PPI to CPI, but, the indicator preserves its relative character, since every term is compared to that of the competitor. The indicator computed at the National Bank of Hungary incorporates the labour productivity effect. Darvas (1995) computes the effect of different weighting schemes on different real exchange rates. The correlation between employment and unemployment is low due to an important decline in the participation rate. Employment reflects the output, unemployment stands for the wage pressure on the labour market. All the time series are I( 1) - unemployment excepted, which is I(2). There were at least two cointegrating equations between the real exchange rate and the explanatory variables. The econometric criteria were the coefficient significance and the Akaike criterion.

Halpern 227

References

Calvo, G.A., L. Leiderman and C.M. Reinhart (1993), "Capital Inflows and Real Exchange Rate Appreciation i n Latin America", IMF Stafl Papers, V01.40, pp. 108- 151.

Calvo, G.A., C.M. Reinhart and C.A. Vkgh (1995), "Targeting the real exchange rate: Theory and evidence", Journal of Development Economics, Vo1.47( I), June pp.97- 134.

Clarida, R. and J. Cali (1994), "Sources of real exchange-rate fluctuations: How important are nominal shocks?", Carriegie Rochester Conference Series on Public Policy, Vo1.4 I , pp. 1-56.

Csermely, A. (1993), "The Impact of Exchange Rate Policy on the Development of Industrial Competitiveness", KOPINT-DATORG Discussion Papers No.20, p.40.

Darvas, Z. (1995), "Volumen-, dr- 6s drfolyamindexek" ("Indices of volumes, prices and exchange rate"), mimeo, Hungarian National Bank, p.28, (in Hungarian).

Edwards, S. ( I989), Real Exchange Rates, Devaluation, and Adjustment. Exchange Rate Policy in Developing Countries, Cambridge, Mass: MIT Press, p.371.

Click, R., P. Kretzmer and C. Wihlborg (1993, "Real exchange rate effects of monetary disturbances under different degrees of exchange rate flexibility: An empirical analysis". Journal (fl International Economics, Vo1.38(3/4), May. pp.249-274.

Halpern, L. and C. Wyplosz (1995). "Equilibrium Real Exchange Rates in Transition", CEPR Discussion Paper No. I 145, p.42.

Lipschitz, L. and D. McDonald (1992), "Real Exchange Rate and Competitiveness: A Clarification of Concepts, and Some Measurements for Europe", Empirica, Vol. 19,

Marsh, I.W. and S.F. Tokarick ( 1993, "Competitiveness Indicators: A Theoretical and Empirical Assessment", IMF Working paper 94/29, p.47.

Oblath, G. (1994). "Exchange Rate Policy and Real Exchange Rate Changes in Economic Transition", In: Gics. J. and G. Winckler. eds, International Trade und Restructuring in Eastern Eiuope, Heidelherg: IIASA-Physica Verlag, pp. 15-46.

Rogers, J.H. and M. Jenkins (1995). "Haircuts or hysteresis? Sources of movements in real exchange rates", Journal of International Economics, Vo1.38, pp.339-360.

pp.37-69.

real exchange rate and exchange rate policy in hungary

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