The equilibrium real exchange The equilibrium real exchange rate and the Balassa-Samuleson rate and the Balassa-Samuleson

effect in Romaniaeffect in Romania

The Academy of Economic Studies,Doctoral School of Finance and Banking

COORDINATOR,Professor Moisǎ Altǎr

MSc student, Dumitrescu Bogdan Andrei

The importance of the equilibrium real The importance of the equilibrium real exchange rate and the Balassa-Samuleson Effectexchange rate and the Balassa-Samuleson Effect The aims of the paperThe aims of the paper Literature reviewLiterature review The modelThe model The dataThe data Empirical analysisEmpirical analysis Concluding remarksConcluding remarks ReferencesReferences

Dissertation paper outlineDissertation paper outline

The importance of the equilibrium The importance of the equilibrium real exchange rate and the Balassa-real exchange rate and the Balassa-

Samuleson EffectSamuleson Effect

The equilibrium real exchange rate is very important The equilibrium real exchange rate is very important when judging the external competitiveness of a country. when judging the external competitiveness of a country. The equilibrium real exchange rate is also a very The equilibrium real exchange rate is also a very important variable for a country who wishes to joinimportant variable for a country who wishes to join ERM ERM II and has to be taken into consideration when setting II and has to be taken into consideration when setting the central parity.the central parity.The Balassa-Samuleson effect has major implications for The Balassa-Samuleson effect has major implications for interpretation of the inflation and the exchange rate interpretation of the inflation and the exchange rate criterion for membership in the European Monetary criterion for membership in the European Monetary UnionUnion

The aims of the paperThe aims of the paper

To determine the variables that influence the To determine the variables that influence the behavior of the equilibrium real exchange ratebehavior of the equilibrium real exchange rateTo determine the equilibrium value of the real To determine the equilibrium value of the real exchange rate using a BEER approachexchange rate using a BEER approachTo determine the misalignment of the real To determine the misalignment of the real exchange rate from its equilibrium valueexchange rate from its equilibrium valueTo determine the Balassa – Samuleson effect - To determine the Balassa – Samuleson effect - the extent to which differences in productivity the extent to which differences in productivity growth between tradable and non-tradable growth between tradable and non-tradable industries explain the observed differences in industries explain the observed differences in inflation between Romania and the euro area.inflation between Romania and the euro area.

Literature reviewLiterature review

The first attempt to determine a countries equilibrium exchange rate was The first attempt to determine a countries equilibrium exchange rate was made by made by Gustav Cassel (1922Gustav Cassel (1922) who introduced the purchasing power parity. ) who introduced the purchasing power parity. This theory can be seen as a long –term tendency for the exchange rateThis theory can be seen as a long –term tendency for the exchange rate

BalassaBalassa and and Samuleson (1964)Samuleson (1964) were the first who showed that the PPP were the first who showed that the PPP theory is not valid. The existence of non-tradable sector creates important theory is not valid. The existence of non-tradable sector creates important deviations from the level determined by PPP. deviations from the level determined by PPP.

Emprical studies that calculated the Balassa- Samuleson effect in Central Emprical studies that calculated the Balassa- Samuleson effect in Central and eastern Europe: and eastern Europe: Egert (2003,2004,2005Egert (2003,2004,2005), ), CandelonCandelon and and Kool (2006)Kool (2006), , Oomes (2005),Oomes (2005), MihaljekMihaljek and and Klau (2003)Klau (2003)

Wiliamson (1994Wiliamson (1994) introduced the concept of ) introduced the concept of fundamental equilibrium fundamental equilibrium exchange rate (FEER)exchange rate (FEER) which is the exchange rate consistent with the which is the exchange rate consistent with the macroeconomic balance, both internally and externallymacroeconomic balance, both internally and externally

ClarkClark and and MacDonald (1998) MacDonald (1998) introduced the introduced the BEERBEER approach approach (Behavioral (Behavioral Equilibrium Exchange Rate)Equilibrium Exchange Rate) which consists in estimating a reduced-form which consists in estimating a reduced-form model, that explains the behavior of the real exchange rate on medium and model, that explains the behavior of the real exchange rate on medium and long term.long term.

Emprical studies using BEER in estimating equlibrium exchange rate for Emprical studies using BEER in estimating equlibrium exchange rate for CEEC’ CEEC’ Halpern Halpern and and Wyplosz (2001)Wyplosz (2001), , De BroeckDe Broeck and and Slok (2001)Slok (2001), , Egert Egert (2002)(2002)..

The modelThe model This paper uses a BEER model in order to estimate equilibrium real This paper uses a BEER model in order to estimate equilibrium real

exchange rate.exchange rate. The starting point in this model consists in expressing the real The starting point in this model consists in expressing the real

exchange rate as a function of the expected value of the real exchange rate as a function of the expected value of the real exchange rate at maturity t+k, the real interest rate differential and a exchange rate at maturity t+k, the real interest rate differential and a time-varying premium-risk: time-varying premium-risk:

tttkttt rrqEq )()( *

I assume that the unobservable expectation of the exchange rate is determined solely by the long run economic fundamentals

tttt ZZEq 1111 ][ˆ

The total misalignment from the equilibrium real exchange rate can be expressed:

ttt Zqtm 11

The long-run economic fundamentals used in this paper are: ),,,( opennfaconsprodfqt

The Balassa-Samuleson model assumes that real exchange rate is determine by the nominal exchange rate and the relative price differential :

)])(1())(1[()(*** * T

tNTt

Tt

NTt

Tt

Tttt ppppppeq

We assume Cobb-Douglas production function both in tradable and non-tradable sector:

1)()( TTTT KLAY 1)()( NTNTNTNT KLAY

The profit functions can be written :

WLRKYP TTTTT WLRKYP NTNTNTNTNT

Profit maximisation implies :0

T

T

K

T

T

L

0

NT

NT

K NT

NT

L=0

By log-differentiating the equations above I obtain :NTTTNT

T

NT

aappp

p )(

The foreign economy (the euro area) is introduced by substituting the above relation into the first equation of the Balassa-Samuleson model:

)))[(1()]))[(1(***

*

*** NT

tTtt

NTt

Ttttt aaaaepp

The dataThe data

Quarterly observations of value added from the production side Quarterly observations of value added from the production side GDP estimates (decomposed into tradables and non-tradables)GDP estimates (decomposed into tradables and non-tradables)

CPI rates of inflation with subcomponents enabling a breakdown CPI rates of inflation with subcomponents enabling a breakdown into traded and non-traded goods and servicesinto traded and non-traded goods and services

Nominal exchange rates of domestic currency against the euro Nominal exchange rates of domestic currency against the euro (quarterly averages)(quarterly averages)

Employment (quarterly averages) in traded and non-traded Employment (quarterly averages) in traded and non-traded industriesindustries

Consumption, net foreign assets, openness as a share of GDP.

The source of data is The source of data is EurostatEurostat and and The National Bank of RomaniaThe National Bank of Romania database. The economies and periods covered are database. The economies and periods covered are Romania Romania (1998:1-2006:3)(1998:1-2006:3) and and Euro area (1998:1 - 2006:3)Euro area (1998:1 - 2006:3). The frequency of . The frequency of observations is quarterly and, in the econometric work, all series are observations is quarterly and, in the econometric work, all series are seasonally adjusted using seasonally adjusted using TramoSeats.TramoSeats.

Description of variables:

All variables are in constant prices (1998=100) and in the econometric work are expressed in logarithms.

Empirical resultsEmpirical resultsIn order to estimate the equilibrium real exchange rate using a BEER approach I have followed more steps.First I checked if the series used are stationary :

Series ADF Test Phillips-Perron Test Conclusion

  Level First difference

Level First differnce

 

LRER -1.8843 -4.2162 -2.0237 -4.1935 I(1)

  (0.3354) (0.0023) (0.2758) (0.0025)  

LPROD_DIF -2.8915 -5.193 -1.7621 -5.2575 I(1)

  (0.0578) (0.0002) (0.3922) (0.0001)  

LCONS -2.1098 -4.4646 -1.9199 -6.3654 I(1)

  (0.2454) (0.0014) (0.3196) (0.000)  

LOPENESS -2.3525 -4.0148 -2.6571 -5.8834 I(1)

  (0.1629) (0.0041) (0.092) (0.000)  

LNFA -2.5709 -5.1184 -2.4083 -9.892 I(1)

  (0.1087) (0.0002) (0.147) (0.000)  

Second I tried to determine a long run relation between variables using cointegration test. First I estimated a VAR. I have chosen the lag length by using Likelihood ratio (LR), Akaike informational criterion (AIC), Schwartz (SIC) şi Hanan-Quinn (HQ)

Table 1: Unit root tests for variables included in BEER approach

Table 2 : Choosing the lag length

Lag LR AIC SC HQ

0 NA -10.82199 -10.59297 -10.74607

1 154.0059 -15.18279 -13.80866* -14.72731

2 33.10951 -15.19693 -12.6777 -14.36188

3 58.40837* -17.28496* -13.62062 -16.07033*

The residual tests performed on the residuals are shown below :

Table 3 : Residual tests on VAR

  Test statistic P- value

LM autocorrelation test    

LM(1) 21.83 (0.6455)

LM(2) 12.97 (0.1635)

LM(3) 16.81 (0.8804)

LM(4) 9.32 (0.4078)

JB normality test 92.27 (0.8078)

White’s heteroskedasticity test 463.17 (0.3237)

Var also satisfies the stability condition:Table 4 : Checking VAR stability

Roots of Characteristic Polynomial

Endogenous variables: LCURS_REAL L_DIF_PROD LCONSUM LNFA LOPENESS

Exogenous variables: C

Lag specification: 1 3

Date: 07/04/07 Time: 15:43

Root Modulus

0.905770 - 0.181308i 0.923738

0.905770 + 0.181308i 0.923738

-0.852741 0.852741

0.799589 + 0.244422i 0.836113

0.799589 - 0.244422i 0.836113

0.038655 + 0.822617i 0.823525

0.038655 - 0.822617i 0.823525

0.641456 + 0.478957i 0.800541

0.641456 - 0.478957i 0.800541

0.450079 + 0.650484i 0.791013

0.450079 - 0.650484i 0.791013

-0.544867 + 0.567723i 0.786886

-0.544867 - 0.567723i 0.786886

-0.364578 - 0.157192i 0.397022

-0.364578 + 0.157192i 0.397022

No root lies outside the unit circle.

VAR satisfies the stability condition.

Next I performed a Johansen cointegration test. First I estimated a vector error correction model :

tktkttktt uyyyyy )1(1221 ......

The Johansen rests on examining the rank of the matrix

via its eigenvalues.

The test showed the presence of two cointegration vectors at both 1% and 5% level.

Sample(adjusted): 1998:4 2006:3        

Included observations: 32 after adjusting endpoints      

Trend assumption: Linear deterministic trend      

Series: LCURS_REAL L_DIF_PROD LCONSUM LNFA LOPENESS  

Lags interval (in first differences): 1 to 2        

             

Unrestricted Cointegration Rank Test        

             

Hypothesized   Trace 5 Percent 1 Percent    

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

             

None ** 0,91654135 139,6948506 68,52 76,07    

At most 1 ** 0,64863781 60,2259233 47,21 54,46    

At most 2 0,34761399 26,75591662 29,68 35,65    

At most 3 0,223734333 13,08811335 15,41 20,04    

At most 4 * 0,144220971 4,983778548 3,76 6,65    

             

Hypothesized   Max-Eigen 5 Percent 1 Percent    

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

             

None ** 0,91654135 79,46892732 33,46 38,77    

At most 1 ** 0,64863781 33,47000667 27,07 32,24    

At most 2 0,34761399 13,66780328 20,97 25,52    

At most 3 0,223734333 8,104334799 14,07 18,63    

At most 4 * 0,144220971 4,983778548 3,76 6,65    

*(**) denotes rejection of the hypothesis at the 5%(1%) level

Trace test and Max-eigenvalue test indicates 2 cointegrating equation(s) at both 5% and 1% levels

Table 5 : Cointegration test for BEER Model

If we normalize the cointegrating vector with respect to RER, we can obtain the following expression (standard errors in (), t-statistics in [] ) :

RER= -1.4336*PROD_DIF - 4.8498*CONS - 0.3151*NFA +1.8390*OPENESS - 0.6816 (0.1545) (0.8637) ( 0.029) (0.1273) [9.2795] [5.6158] [10.6710] [-14.4494]

An increase in the productivity differential ,in the net foreign assets and in total consumption, will lead to an appreciation of the real exchange rate.

An increase in the degree of openness will cause the current account deficit to widen, which will require real exchange rate depreciation.

All coefficients are statistically significant and correctly signed.

The next step in the BEER approach requires the estimation of the long run sustainable values for the variables used. In order to do that, I have used a Hodrick-Prescott filter on the extend ARIMA series.

Figure 1 : Equilibrium values for total consumption - Hodrick- Prescott filter

Figure 2 : Equilibrium value for productivity differential - Hodrick- Prescott filter

0.72

0.76

0.80

0.84

0.88

0.92

0.96

1.00

98 99 00 01 02 03 04 05 06

CONS CONS_ECH_

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

98 99 00 01 02 03 04 05 06

DIF_PROD_ECH L_DIF_PROD

Figure 3: Equlilibrium value for net foreign asstes - Hodrick-Prescott filter

Figure 4: Equlibrium value for openness- Hodrick-Prescott filter

-.2

-.1

.0

.1

.2

.3

.4

.5

.6

98 99 00 01 02 03 04 05 06

NFA_ECH NFA

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

98 99 00 01 02 03 04 05 06

OPENESS OPENESS_ECH

100_ xERER

ERERRERntmisalignmeTotal

In order to determine the equilibrium real exchange rate, I have replaced the values obtained by filtering the series in the cointegrating relationship estimated in step 1. :

The results are shown below :

Figure 6 : Total misalignment real exchange rate from its equilibrium value

Figure 5 :The real exchange rate and the real equilibrium exchange rate

The total misalignment of the real exchange rate from its equilibrium value was obtained by using the next formula :

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

98 99 00 01 02 03 04 05 06

RER_ECH RER

-30

-20

-10

0

10

20

98 99 00 01 02 03 04 05 06

Total_misalgnment

Misalignment of the real exchange Misalignment of the real exchange rates – remarksrates – remarks

During 1998:Q1-2001:Q1 the real exchange rate was undervalued During 1998:Q1-2001:Q1 the real exchange rate was undervalued from its equilibrium value, with a maximum misalignment of 28,96% from its equilibrium value, with a maximum misalignment of 28,96% in the first quarter of 1999. This misalignment was caused by the in the first quarter of 1999. This misalignment was caused by the rapid depreciation of the nominal exchange rate induced by the rapid depreciation of the nominal exchange rate induced by the liberalization of prices and of the foreign currency market. Also, the liberalization of prices and of the foreign currency market. Also, the inflations expectations were at a high level which determined the inflations expectations were at a high level which determined the population to keep savings in foreign currency, putting even more population to keep savings in foreign currency, putting even more pressure on the nominal exchange rate. pressure on the nominal exchange rate.

During 2001:Q2-2003Q4 the real exchange rate was fairly valued During 2001:Q2-2003Q4 the real exchange rate was fairly valued while in 2005Q3-2006Q4 it was slightly undervalued. while in 2005Q3-2006Q4 it was slightly undervalued.

In the last period, 2005Q3 -2006Q4, the real exchange rate was In the last period, 2005Q3 -2006Q4, the real exchange rate was overvalued. This situation was caused by the increase in the overvalued. This situation was caused by the increase in the productivity differential and the appreciation of the nominal productivity differential and the appreciation of the nominal exchange rate caused by the large speculative funds attracted by exchange rate caused by the large speculative funds attracted by the interest rate differential. The overvaluation can have the effect of the interest rate differential. The overvaluation can have the effect of losing external competitiveness inducing a larger current account losing external competitiveness inducing a larger current account deficit.deficit.

Estimation of the Balassa-Samuleson Estimation of the Balassa-Samuleson effecteffect

Table 6: Unit root tests for variables included in Balassa equation

)/ln()1()/ln()1( *** NTTtt

NTTt LPLPLPLP

All variables are stationary at the 10% level :

Series ADF Test Phillips-Perron Test Conclusion

  Level Level  

L_INFL_DIF -3.2559 -6.1916 I(0)

  (0.0267) (0.0000)  

L_PROD_DIF -2.8915 -1.7621 I(0)

  (0.0578) (0.3922)  

L_NOMINAL_ER -5.0843 -5.9843 I(0)

  (0.0002) (0.0002)  

The variables used are : the inflation differential between Romania and the euro area, the nominal exchange rate and the productivity differential. The latter is calculated using the next formula :

The estimated equation is :

INFL_DIF = 0.7022*L_INFL_DIF(-1) + 0.1822*L_PROD_DIF + 0.2110*L_NOMINAL_ER + 0.1096 (0.0519) (0.0458) (0.0483) (0.0089)

All the coefficients are statistically significant and correctly signed. An increase in the nominal exchange rate (which stands for depreciation) and in the productivity differential cause the inflation differential to increase. The linear regression has a high value of R Squared which proves that the inflation differential is well explained by this variables.

I have obtained the Balassa-Samuleson effect by multiplying the coefficient previously determined with the productivity differential. The results are shown below :

PeriodInflation in the

euro areaInflation in

Romania Infl_dif Prod_dif B-S

1998 2.17% 40,68% 38.51% -10.66% -1.94%

1999 4.64% 54,91% 50.27% 6.31% 1.15%

2000 7.55% 40,71% 33.16% 43.56% 7.93%

2001 6.40% 30,20% 23.80% -12.10% -2.20%

2002 7.02% 17,89% 10.87% -14.58% -2.66%

2003 6.22% 14,24% 8.02% -8.22% -1.50%

2004 7.09% 9,16% 2.07% -5.11% -0.93%

2005 7.20% 8,72% 1.52% 6.44% 1.17%

2006q3 4.62% 2,77% -1.85% 7.20% 1.31%

The Balassa-Samuleson effect explained on average only 0.5% of the inflation differential during the covered period. However in the last 2 years the effect was larger because of the increase in the productivity differential. It can be concluded that factors, other than the inflation differential, were responsible for the inflation differential between Romania and the euro area.

Table 7 : The Balassa-Samuleson effect in Romania

Concluding remarksConcluding remarks

In the covered period the real exchange rate had some important deviations In the covered period the real exchange rate had some important deviations from its equilibrium value which were determined by the liberalization of the from its equilibrium value which were determined by the liberalization of the prices and of the foreign exchange market and by the fluctuations of the prices and of the foreign exchange market and by the fluctuations of the nominal exchange ratenominal exchange rate

The nominal exchange rate had a high volatility because of its use by the The nominal exchange rate had a high volatility because of its use by the central bank in order to maintain a low inflation and because of the speculative central bank in order to maintain a low inflation and because of the speculative funds attracted by the interest rate differential. In the last period covered, the funds attracted by the interest rate differential. In the last period covered, the real exchange rate seems to be fairly valued which will lead to external real exchange rate seems to be fairly valued which will lead to external competitiveness.competitiveness.

This paper found a negative relation between productivity differential, total This paper found a negative relation between productivity differential, total consumption, net foreign assets and the real exchange rate which is consistent consumption, net foreign assets and the real exchange rate which is consistent with the literature. Also, an increase of the degree of openness is likely to with the literature. Also, an increase of the degree of openness is likely to cause a depreciation of the real exchange rate because of the increased cause a depreciation of the real exchange rate because of the increased demand for tradable goods from abroad.demand for tradable goods from abroad.

This paper has found evidence of the Balassa-Samuelson effect in RomaniaThis paper has found evidence of the Balassa-Samuelson effect in Romania The productivity differential explained on average only 0.5% of the inflation The productivity differential explained on average only 0.5% of the inflation

differential in the period covered with a higher impact in 2005 and 2006 (1.17% differential in the period covered with a higher impact in 2005 and 2006 (1.17% and 1.31%). The conclusion is that factors different from the productivity and 1.31%). The conclusion is that factors different from the productivity differential are responsible for the high inflation differential and that the differential are responsible for the high inflation differential and that the Balassa-Samuleson effect is not likely to put at risk the Maastricht inflation Balassa-Samuleson effect is not likely to put at risk the Maastricht inflation criterion. criterion.

Selected ReferencesSelected References

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