Abstract

Whether or not recent movements in real exchange rates are a cause for concern depends on whether they reflect underlying changes in equilibrium exchange rates. This chapter therefore considers a range of factors that typically affect equilibrium exchange rates in transition economies, and provides some quantitative assessments of the importance of these factors in the Baltics. The first section focuses on whether the productivity improvements discussed in Chapter 3 can explain the observed appreciation in real exchange rates in the Baltics. Some illustrative econometric estimates of equilibrium exchange rates in the Baltics are then presented. Alternative statistical methods to identify trend movements in real exchange rates are also considered and found to yield similar results, which are then compared against actual trade flows.

Whether or not recent movements in real exchange rates are a cause for concern depends on whether they reflect underlying changes in equilibrium exchange rates. This chapter therefore considers a range of factors that typically affect equilibrium exchange rates in transition economies, and provides some quantitative assessments of the importance of these factors in the Baltics. The first section focuses on whether the productivity improvements discussed in Chapter 3 can explain the observed appreciation in real exchange rates in the Baltics. Some illustrative econometric estimates of equilibrium exchange rates in the Baltics are then presented. Alternative statistical methods to identify trend movements in real exchange rates are also considered and found to yield similar results, which are then compared against actual trade flows.

A. Productivity and Equilibrium Real Exchange Rates

Perhaps the most simple methodology for defining equilibrium exchange rates is the purchasing power parity (PPP) approach, which states that the percentage change in the nominal exchange rate between two currencies will equal changes in the price levels of the corresponding countries—or, equivalently, that the real exchange rate between two countries remains a constant. The PPP approach is typically not a good explanation of exchange rate movements in the short to medium term, and is not therefore a good benchmark against which to assess competitiveness. But it can be of some use in analyzing longer-term trends. Currently, the exchange rates in all three Baltic countries are about 50 percent below the levels that would be necessary to ensure purchasing power parity with the euro area (i.e., price levels are about 50 percent below price levels in the euro area) (Table 3).

Table 3.

Exchange Rates Relative to Purchasing Power Parity (PPP) in 2001

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Source: IMF staff estimates.

The PPP approach can be further refined by taking account of differences in economic development. Empirically, it has been observed that there is a systematic tendency for prices to be lower in low-income countries than in high-income countries. The gap between a country’s market exchange rate and its PPP rate should therefore begin to close as real incomes converge on advanced country levels. De Broeck and Sløk (2001) find evidence from a large cross section of nontransition countries that catching up by 1 percent in real incomes will be associated with a 0.4 percent real appreciation.24 This relationship, and the position of the Baltic countries relative to it, is shown in Figure 13. It indicates that, at the start of the transition process, the Baltic currencies quickly converged toward exchange rate gaps that were similar to those in market economies at comparable stages of development. They remain below the central line, indicating a continued degree of undervaluation relative to productivity- or income-adjusted PPP rates (29 percent in the case of Estonia, 16 percent in Latvia, and 15 percent in Lithuania, relative to the euro). However, the confidence intervals are very large, indicating, for example, that the Estonian kroon might by undervalued by as much as 56 percent or overvalued by 14 percent.

Figure 13.
Figure 13.

Exchange Rates and Income Levels

Source: IMF staff estimates.

This empirical phenomenon is also known “the Balassa-Samuelson effect” (see Box 4). As part of the process of real income convergence, productivity in the tradable goods sector tends to rise relative to productivity in the nontradable sector. Given competitive pressures within the labor market, workers with similar skills will receive similar wages in the two sectors.25 Faster productivity growth in the tradable sector will therefore drive up the relative cost of production in the nontradable sector, and hence the relative price of nontradables will rise. Assuming the relative price of tradable goods across countries remains constant, the increase in the price of nontradables will lead to an appreciation of the real exchange rate. The theory suggests that this is a medium- to long-run phenomenon, which could be disturbed in the short run by cyclical or monetary developments.

The Balassa-Samuelson Effect

There is an expectation that, for most accession countries, there will be a trend appreciation of their exchange rates relative to the euro as part of the process of transition and the associated catch-up in productivity levels. Among the reasons for this is the Balassa-Samuelson effect, which in essence suggests that relatively faster productivity growth in the traded sectors of the accession countries will result in a higher inflation rate in these countries (if the exchange rate is held constant).

Under certain assumptions, it can be shown that for an accession country (A), inflation in the nontraded goods relative to the traded goods sector (πNT and πT, respectively) is determined by productivity growth in the traded relative to the nontraded goods sector (PT and PNT, respectively). The mechanism through which this occurs is straightforward. A rise in productivity in the traded goods sector will tend to drive up wages in this sector, but since the increase in wages is matched by higher productivity it will not give rise to higher traded goods prices. Labor is assumed to be mobile across sectors such that higher wages in the traded goods sector will drive up wages in the nontraded goods sector until wages are equalized. In the absence of a corresponding increase in productivity, however, the price of nontraded goods must also rise, such that

πNTAπTA=PTAPNTA.(1)

By construction, CPI inflation in country A(πA) is defined as a weighted average of inflation in the traded and nontraded goods sectors, where the weight of traded goods in the CPI basket is given by α:

πA=απTA+(1α)πNTA.(2)

From (1) it follows that CPI inflation will be determined by the increase in traded goods prices and the difference in productivity growth between the two sectors:

πA=πTA+(1α)(PTAPNTA).(3)

A similar relationship can be derived for inflation in the euro area (E). Under certain simplifying assumptions—namely that productivity growth in the nontraded goods sectors and the shares of traded goods in consumption are equal across countries, and that the law of one price holds such that the price of traded goods is equal across countries (when expressed in a common currency)— it can be shown that:

πAπE=(1α)(PTAPTE)+ε.(4)

Thus the difference between CPI inflation in an accession country and the euro area is determined by relative productivity performance in the traded sector, adjusted for changes in the exchange rate (ε). It follows that, other things being equal, the Balassa-Samuelson effect will tend to be smaller in small open economies such as the Baltics, where the share of tradable goods in consumption is typically high.

The Balassa-Samuelson effect is thought to be especially relevant for transition economies, where liberalization and movements in relative prices have led to restructuring and reallocation of resources to more productive, often exporting, sectors.26 Productivity growth has indeed been quite closely aligned with the appreciation of REERs in the Baltics in recent years (Figure 14). This contrasts with some other acceding countries: in the Czech Republic, exchange rate appreciation has for the most part exceeded the rate of productivity growth, while the opposite is true for the Slovak Republic. There have, however, been some sizable variations between the pace of productivity growth and real effective appreciation in individual years, especially in Latvia and Lithuania, when productivity growth failed to keep pace with the sharp appreciation of the exchange rate immediately following the Russia crisis. Since 2000, however, productivity growth has generally kept pace with the appreciation in Lithuania’s exchange rate and exceeded the appreciation of Latvia’s exchange rate.

Figure 14.
Figure 14.

Labor Productivity and Real Effective Exchange Rates, 1997–2002

Source: IMF staff estimates.1 Figures for Estonia are based on GNP rather than GDP.2 Productivity measured by GDP per worker, measured at purchasing power parity. Figures for 2002

Estimates of the Balassa-Samuelson effect in the Baltics are shown in Table 4. They are calculated on the basis of the relationships identified in Box 4 and on the basis of a range of alternative measures of productivity differentials relative to the euro area. The estimates assume that the share of nontradables in consumption is approximately one-third in the Baltics and two-thirds in the euro area.27 The resulting differences in pass-through from productivity growth to overall inflation have a significant effect in limiting the impact of relatively higher productivity growth in the Baltics on inflation differentials. Measures based on aggregate labor productivity convergence suggest that the Balassa-Samuelson effect could explain an annual inflation differential relative to the euro area of about 0.5–0.7 percentage point during 1997–2001.28 Abstracting from the effect of capital deepening and changes in labor inputs, the Balassa-Samuelson effect measured on the basis of the relative growth of TFP is somewhat lower, at about 0.3–0.5 percentage point. Measures of relative productivity in the tradable and nontradable sectors (measured by manufacturing and services, respectively) give even smaller results in Estonia and Latvia, where some of the catch-up process that has taken place reflects increased productivity in the nontradable as well as tradable sectors. Productivity in the financial services sector, for example, has risen rapidly in recent years.29

The ability of the Baltics to meet the Maastricht inflation criterion for participation in the EMU will partly depend on the scale of the Balassa-Samuelson effect. The estimates in Table 4, however, suggest that even a continuation of the recent impressive productivity performance in the Baltics need not necessarily push inflation above the Maastricht limit.30 In Estonia, inflation rates have recently fallen to levels that are close to this limit (Figure 15). In Latvia and Lithuania, by contrast, inflation has been close to or below the Maastricht reference value for inflation since mid-2002. This partly reflects the nominal appreciation of the lats and the litas against the euro over much of this period—a phenomenon that would of course not be repeated under ERM II, assuming Lithuania maintains and Latvia adopts a peg to the euro.

Table 4.

Alternative Estimates of the Balassa-Samuelson Effect on Inflation Differentials (1997–2001)

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Source: IMF staff estimates.

Measured at purchasing power parity (GNP for Estonia).

Total Factor Productivity estimates consistent with Figure 12.

Sectoral value added per worker in constant prices.

Figure 15.
Figure 15.

Inflation Convergence

Consumer Price Inflation (12-month average)

Sources: Country authorities and Eurostat.

Several other studies have attempted to quantify the extent to which inflation differentials between acceding countries and EU member states can be attributed to the Balassa-Samuelson effect.31 Estimates of the magnitude of the Balassa-Samuelson effect differ significantly depending on estimation methods, countries, time periods, and the definition of tradable and nontradable sectors. Studies that are based on relative price levels in accession countries compared to the EU tend to yield the highest estimates because they capture channels other than the Balassa-Samuelson effect that can give rise to real appreciation during times of economic catch-up. Pelkmans, Gros, and Núñez Ferrer (2000), for example, estimate that the equilibrium inflation differential between acceding countries and the euro area during 1997–99 was between 3½ and 4 percent. Most studies, however, are based on some measure of productivity growth differentials in order to capture the Balassa-Samuelson effect. Halpern and Wyplosz (2001), for example, estimate that the annual rate of real exchange rate appreciation due to the Balassa-Samuelson effect was about 3 percent on average for a sample of eight acceding countries (including the Baltics) during 1991–98. More recent studies attempt to further refine the analysis by quantifying other factors that can affect inflation differentials. Earlier studies that fail to control for these effects will therefore tend to overstate the “pure” Balassa-Samuelson effect. These factors are discussed below.

  • Initial undervaluation at the start of transition. It is possible that the appreciation of real exchange rates partly reflects a correction of an initial undervaluation of exchange rates. While it is not possible to test this directly given the data constraints, a number of studies have tested this indirectly by using out-of-sample estimates based on nontransition economies and using U.S. dollar wages as a proxy for the real exchange rate.32 They conclude that exchange rates were undervalued at the beginning of the transition process as a result of sudden excess demand for previously unavailable foreign goods and assets, capital flight associated with a burst of domestic inflation, and a tendency of authorities to set initial exchange rates at undervalued levels. More recent studies conclude that this catch-up phase from initial undervaluation tended to be mostly over about five years after the beginning of transition.33

  • Increases in price of tradables. Since the start of transition, there has been an increase in PPI-based real exchange rates in the Baltics, which, if the PPI indices are a reasonable proxy of tradable prices, suggests that an increase in the relative price of tradables has contributed to the overall appreciation in real exchange rates. This may reflect the fact that tradable goods also have a nontradable component, such that productivity-driven catch-up of nontradable prices also leads to higher traded-good prices.34 Or it may be related to the changes in the composition of tradables as domestic production and exports shift toward higher-valued-added products.35 Since 1999, however, PPI-based real exchange rates have been more stable or falling, suggesting that this process may have ended.

  • Changes in the structure of demand. As real incomes rise, the demand for services tends to increase. This in itself will push up the relative price of nontradables. Increases in government expenditure, which also tend to be concentrated on services and other nontradables, would have the same effect.36

  • The role of administered prices. The share of administered prices in Baltic consumer price indices remains significant, at about 20 percent (Table 5). Administered prices are typically concentrated on the services or nontradable sector. Consequently, the share of market-based services in the CPI, which provides the pass-through from productivity growth to overall inflation, is reduced. In addition, price liberalization has contributed directly to an increase in the price of nontradables.37

    Recent data suggest that increases in administered prices continue to exceed increases in other prices. Staff estimate that since 1997, administered price increases account for about 1.1 percentage points of the annual average CPI inflation of 5.6 percent in Estonia, and 2.8 percentage points of annual average CPI inflation of 1.7 percent in Lithuania (Figure 16). The extent to which such factors will affect future price formation is difficult to quantify. The liberalization of administered prices, or their adjustment to cost recovery levels, is in theory meant to be completed as a precondition for EU accession, but may be more gradual in practice. Residential energy prices, for example, which are the most important component of administered prices, remain about 20 percent below cost recovery levels.38 The need for adjustment may, however, be tempered by increased efficiency resulting from the restructuring of energy sectors, which remains largely incomplete in the Baltics. The adjustment of agricultural prices following integration into the EU Common Agricultural Policy may also place upward pressure on food prices. The extent to which such factors affect competitiveness, however, will depend on whether the resulting increase in consumer prices leads to higher wage claims, and indirectly to higher tradable prices.

  • Increased investment inflows. Increased capital inflows can lead to an appreciation of the real exchange rate.39 The establishment of macroeconomic stability in the Baltics and resulting reduction in risk premiums, together with the increased investment opportunities following capital account liberalization and privatization, have contributed to significant capital inflows.40 Whether this represents an equilibrium phenomenon is difficult to assess, and depends on whether the growth performance of the economy is enough to service the resulting external liabilities without the need for an adjustment in the real exchange rate.41

Table 5.

Share of Administered Prices in CPI

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Sources: Country authorities and European Bank for Reconstruction and Development.

Figure 16.
Figure 16.

Administered Prices and CPI

Sources: IMF staff estimates and country authorities.Note: CPI is Consumer Price Index.

B. Econometric Estimates of Equilibrium Real Exchange Rates

In this section, we report the results of an estimation of equilibrium real exchange rates in the Baltics. The estimation is based on a theoretical framework that incorporates the Balassa-Samuelson hypothesis and the balance of payments approach to the determination of the equilibrium exchange rate.42 It follows an illustrative model developed by Alberola and others (1999) based on the decomposition of the exchange rate into two different relative prices—the price of domestic tradable goods relative to foreign tradable goods and the relative prices of nontradable goods relative to tradable goods within each country.43 The first price captures the competitiveness of the economy and determines the evolution of a country’s net foreign asset position. It is associated with the external equilibrium of an economy, characterized by the achievement of a desired stock of net foreign assets. The second price incorporates the concept of productivity differentials and the allocation of resources within an economy. It can therefore be associated with internal equilibrium in an economy. Real exchange rates are then determined by the following relationship:

REER = β1 nfa + β2prod,

where nfa represents net foreign assets and prod represents relative productivity differentials as proxied by the ratio of consumer prices to producer prices.44 Estimation of the equilibrium exchange rate is then based on an unobserved component decomposition in a cointegration framework. The presence of a cointegration relationship is interpreted as evidence of a time-varying equilibrium exchange rate. The estimation results are summarized below but discussed in detail, along with the derivation of the model, in Appendix 1.45

For each of the Baltics, there is evidence of a relationship between REERs, the proxy for relative productivity performance, and net foreign assets (Table 6). The impact of changes in relative productivity on the exchange rate is, as expected, close to one for all three countries. The net foreign asset position, however, enters the long-run relationship with a negative sign for all three countries. The results must be interpreted with considerable caution, however, given the limitations in the underlying data; the short time period available for estimation; and the possibility that real exchange rates were significantly undervalued in the early 1990s (as discussed earlier) and that this is not captured by our estimates.46 The negative relationship between real exchange rates and net foreign asset positions requires careful interpretation, as it is at odds with the positive relationship normally associated with the balance of payments approach to determination of the equilibrium exchange rate. Countries with large external liabilities eventually need to run large trade surpluses to service them, and achieving these trade surpluses ultimately requires a more depreciated level of the real exchange rate. It may, however, take many years for exchange rates to converge on this long-run equilibrium level.47 In the interim, however, increased capital inflows, rising real exchange rates, and a deterioration in the trade balance may be a natural response to the increased growth potential of the Baltic countries, resulting for example from the establishment of macroeconomic stability, productivity-enhancing structural reforms, or the opportunities afforded by EU accession.48

Table 6.

Estimation Results

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The results suggest that equilibrium real exchange rates have appreciated significantly in all three Baltic countries since 1994, although the rate of appreciation has, to varying degrees, slowed since the beginning of 1999 (Figure 17). The difference between the estimated equilibrium and actual exchange rates is also illustrated in Figure 17, together with the 95 percent confidence intervals, to give an indication of the degree of accuracy of the results. At the beginning of 2002, the real exchange rates in Estonia and Lithuania appear to be only modestly undervalued, by anywhere from 4½ to 8½ percent and 2½ to 8¼ percent, respectively. The accuracy of the results in Latvia, however, is very low and it is not possible to say with any confidence whether the real exchange rate was under- or overvalued throughout the period under observation. Alternative statistical methods that identify underlying trend movements (using the Hodrick-Prescott filter) produce similar results (Figure 18). They also suggest a similar degree of undervaluation relative to trend of about 5 percent in all three Baltics in 2002. The recent strength of the euro, however, may have removed some of this undervaluation in Estonia and Lithuania.

Figure 17.
Figure 17.

Baltics: Real Effective Exchange Rate (REER) and Its Equilibrium (EREER), 1994Q1–2002Q1

Source: IMF staff estimates.
Figure 18.
Figure 18.

Baltics: Real Effective Exchange Rate and Its Permanent Component, 1994Q1–2002Q4

Source: IMF staff estimates.Note: The permanent component of the real effective exchange rate (REER) was estimated by applying the Hodrick-Prescott (HP) filter to quarterly REER series for the period 1994Q1–2002Q4 and projections for the period 2003Q1–2003Q4, using ARIMA(1,1,0) models. Projections are used to avoid end-period distortions induced by the HP filter when only historical data are considered (Kaiser and Maravall, 1999).

There appears to be no close relationship between external balances in the Baltics and movements in their underlying exchange rate positions, suggesting that trade flows have been determined primarily by income or supply factors rather than by movements in relative prices. The relationship between the deviations in exchange rates from their underlying or trend levels and external balances (both the current account deficit and the balance of trade in goods and services) is shown in Figure 19. The improvement in the external positions of Estonia between mid-1998 and 2000 took place during a period in which the kroon was rising relative to its underlying or trend value. The recent deterioration in the external positions in Estonia and Latvia took place while their exchange rates were falling relative to their trend values. Over the corresponding period, Lithuania’s external position improved gradually despite a sizable swing in the litas relative to its trend. This evidence has been confirmed more formally by a recent study by the Baltic central banks.49 They find that net trade flows are not closely correlated with CPI- and PPI-based measures of the real exchange rate or with measures of misalignment relative to an underlying trend or equilibrium. There are a number of possible reasons for this. Imports have been primarily determined by available income (which is, in turn, closely related to the volume of exports) while exports have to some extent been rationed by supply constraints or quality considerations rather than by relative prices. Recent increases in exports to the EU, for example, partly reflect investments that have been directed toward expanding export capacity and increasing product quality to meet required EU standards, rather than improvements in price competitiveness.

Figure 19.
Figure 19.

Real Effective Exchange Rate Deviations and External Balances

Source: IMF staff estimates.Note: REER is real effective exchange rate; HP is Hodrick-Prescott filter.
24

See also IMF (2000), Box 4.4, pp. 168–69, for a summary.

25

Halpern and Wyplosz (2001) find that relative wages across sectors have been quite stable in the Baltics and other accession countries.

26

The evidence for other countries is mixed. For a survey of Asian economies, see Ito, Isard, and Symansky (1997). ECB (1999) finds some evidence that the Balassa-Samuelson effect can explain inflation differentials across the euro area.

27

Recent estimates from the national central banks suggest that the share was 28 percent in Estonia and 30 percent in Lithuania in 2002. This is similar to the weights in other central and eastern European accession countries, quoted in Kovács (2002), but significantly lower than the average share in the euro area. The share of services in the CPI in Germany, for example, is 63 percent (Federal Statistical Office).

28

The average inflation differentials relative to the euro area over the corresponding period were 2.9 percent in Estonia, 1.6 percent in Latvia, and 0.3 percent in Lithuania.

29

Productivity has improved as a result of substantial foreign investment in the sector. In Estonia, other business services, including, for example, the operation of international call centers, have also increased in importance. These activities could more properly be classified within the tradable sector.

30

The Maastricht criterion states that average inflation should be no higher than 1.5 percentage points above the three EMU member states with the lowest inflation rates. The estimates in Table 4 suggest that higher productivity growth in the Baltics may lead to an inflation differential of up to 0.7 percentage points relative to the euro area. Inflation in the euro area has, in turn, generally been about 0.7–0.8 percentage points above the average of the three EMU member states with the lowest inflation rates.

31

For a survey of recent studies see Deutsche Bundesbank (2001) and European Commission (2002). There are few studies that consider the Baltics explicitly, although Ross (2001) estimates that a 1 percent rise in the income level in Estonia leads to a 0.7 percent increase in the price level. This implies that per capita income growth, which was about 3.2 percentage points higher than in the euro area during 1999–2002, more or less fully explains the average inflation differential of 2.1 percentage points over this period.

32

These studies typically estimate equilibrium U.S. dollar wage levels (as a proxy for the real exchange rate) based on a range of economic fundamentals such as indicators of productivity and human capital levels. See, for example, Halpern and Wyplosz (1996); Krajnyák and Zettelmeyer (1998); and, for a specific reference to the Baltics, Richards and Tersman (1996). The results are consistent with the evidence presented in Figure 13, which is also based on out-of-sample estimates of nontransition economies, and which also suggests a significant degree of undervaluation at the start of transition.

33

See Begg, Halpern, and Wyplosz (1999); Coricelli and Jazbec (2001); and Kim and Korhonen (2002). This also seems to be consistent with typical estimates of the speed of convergence on PPP, which suggest that half of a deviation from PPP disappears in about three to five years—see, for example, Rogoff (1996).

34

MacDonald and Ricci (2001) suggest that this may also explain their observation that increases in the productivity and competitiveness of the distribution sector—which is typically regarded as part of the nontradable sector but represents an important input into the production of tradable goods—lead to an appreciation of the real exchange rate. The distribution sector accounts for about 15 percent of both value added and employment in Estonia and Latvia, and about 15 percent of value added and 19 percent of employment in Lithuania. The sector has also attracted a significant share of inward investment, accounting, for example, for about 13 percent of the stock of FDI in Estonia. MacDonald and Wójcik (2002) find that productivity increases in the distribution sector led to an appreciation in the real exchange rate in Estonia over and above that generated by the Balassa-Samuelson effect.

35

Égert and others (2002) argue that a trend increase in the price of tradables explains at least part of the appreciation of real exchange rates in transition economies, including the Baltics, during 1995–2000. Ito, Isard, and Symansky (1997) find similar evidence of this phenomenon in Asia. This raises a methodological issue of whether consumer price indices adjust sufficiently for quality changes and the introduction of new goods.

36

Coricelli and Jazbec (2001) find that these demand effects have been particularly important in the Baltics.

37

MacDonald and Wójcik (2002) find that in a sample of acceding countries during 1995–2001, including Estonia, the adjustment of administered prices had an independent and possibly much stronger effect on real exchange rates than the Balassa-Samuelson effect.

38

See EBRD (2001).

39

Fischer (2002) argues that part of the observed productivity differential that is often fully attributed to the Balassa-Samuelson effect is in fact a reflection of increased investment demand.

40

Capital account liberalization was largely completed at an early stage in the Baltics. The only remaining restrictions relate mainly to real estate and certain sectoral restrictions on FDI.

41

For a more detailed discussion of the relationship between capital flows and exchange rates in the acceding countries, and the associated policy implications, see Lipschitz, Lane, and Mourmouras (2002).

42

For a discussion of the latter see, for example, Mussa (1984).

43

Hansen and Roeger (2000) follow a similar approach with respect to current EU member states, as do Broner, Loayza, and Lopez (1997) with respect to Latin America.

44

As discussed above, the CPI and PPI indices are, in some circumstances, likely to be weak proxies for relative productivity differentials in the tradable and nontradable sectors. The PPIs in some countries (including Lithuania and some of the Baltics’ trading partners such as Russia), for example, are very sensitive to swings in oil prices. Moreover, movements in the relative price of nontradables are likely to reflect a number of factors in addition to productivity differentials, including increases in administered prices and increased demand for nontradables as a result of rising real incomes or increased government expenditure. Net foreign assets are, in common with many other studies, estimated as the cumulative sum of current account positions, and may therefore be distorted by errors and omissions in the current account data, and by valuation changes.

45

For an earlier example of the application of this approach to Lithuania, see Alonso-Gamo and others (2002). This section and Appendix 1 essentially extend their analysis to all three Baltic countries.

46

It is well known that the power of cointegration tests is dependent on the length of time series available for estimation. Moreover, Shiller and Perron (1985) demonstrate that it is the time span, and not the frequency of available data, that determines the power of the tests. The time span available for estimation in the case of the Baltics is limited to just over eight years (1994–2002Q1).

47

Studies that do find a positive relationship between real exchange rates and net foreign asset positions tend to be based on much longer time series than our estimates (typically 20–30 years)—see, for example, Faruqee (1995); Gagnon (1996); Clark and MacDonald (1998); Alberola and others (1999); and Broner, Loayza, and Lopez (1997).

48

In these circumstances, as Baltic assets become more attractive, there will be a reduction in the desired long-run stock of net foreign assets. The real exchange rate will need to appreciate temporarily in order to reduce the trade balance and thereby the current stock of net foreign assets toward its lower desired long-run level. Changes in risk premiums may have also affected the relationship between the exchange rate and net foreign assets. A reduction in risk premiums in the Baltics, for example, would tend to reduce the size of the trade surplus that would ultimately be required to service external liabilities.

49

For Estonia, see Randveer and Rell (2002); Latvia, see Bitans (2002); Lithuania, see Vetlov (2002).

Competitiveness on the Eve of EU Accession
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