Equilibrium Exchange Rates in Transition Economies
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

A stylized fact of the transition process is an early profound exchange rate depreciation followed by continuing real appreciation. Absent historical reference points, it is difficult to judge whether the real appreciation is threatening competitiveness. This paper interprets the stylized facts and offers estimates of the equilibrium real exchange rate based on an international comparison of dollar wages and on a study of the dynamics of real exchange rates in several transition economies. The results suggest that the process of real appreciation is a combination of a return to equilibrium following the early overshooting and equilibrium appreciation.

Abstract

A stylized fact of the transition process is an early profound exchange rate depreciation followed by continuing real appreciation. Absent historical reference points, it is difficult to judge whether the real appreciation is threatening competitiveness. This paper interprets the stylized facts and offers estimates of the equilibrium real exchange rate based on an international comparison of dollar wages and on a study of the dynamics of real exchange rates in several transition economies. The results suggest that the process of real appreciation is a combination of a return to equilibrium following the early overshooting and equilibrium appreciation.

I. INTRODUCTION

In transition economies as elsewhere, exchange rates often reveal the deep inner working of macroeconomic policies. Table 1 shows that all possible arrangements have been tried in the few years since transition began. Some countries have adopted a fixed exchange rate regime early on, and have since kept it; this is the case of the Czech Republic and Estonia. Estonia even established a currency board, and was followed in 1994 by Lithuania. Two countries (Poland and Croatia) started out with a fixed rate and then adopted a crawling peg. Russia first floated and adopted a (mostly crawling) peg once disinflation was under way. Other countries have adopted a fixed but frequently adjustable rate regime (Hungary until March 1995). Yet, the most popular arrangement is a managed float, as in Albania, Bulgaria, Macedonia, Romania, Slovenia and numerous former Soviet Republics. The Latvia currency has eventually been appreciating vis-à-vis the hard DM. The tendency of the floaters, however, has been towards increased exchange rate stability, especially as inflation declined.

Table 1.

Exchange Rate Regimes Since the Beginning of Transition

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Notes:

The Czech Republic is considered as a continuation of Czechoslovakia.

Depreciations occurred in 1989:3 (5%), 1989:5 (6%), 1989:12 (10%), 1990:2 (5%), 1991:1 (15%), 1991:11 (5.8%) and then in more frequent smaller instalments (3 times and a total of 5.5% in 1992; 15% in 5 times over 1993; and 16.8% in 7 times in 1994).

One devaluation (16.8%) in 1992:5.

One devaluation (10%) in 1993:7.

It may be surprising that countries which share a common challenge with broadly similar initial conditions adopt so diverse exchange arrangements, in fact covering the whole spectrum of possibilities. The choice of an exchange rate regime has been controversial for times immemorial and the debates in transition economies revisit familiar themes: rules versus discretion, credibility versus realism, inflation versus competitiveness, etc.1 In the end, different choices reflect different perceptions of the underlying trade-offs and of the importance of starting positions (the availability of foreign exchange reserves, the structure of the economy, previous attempts at liberalization). These different perceptions have led to disagreements on the speed of transition.

This paper represents an early attempt at drawing systematic, yet preliminary, lessons from the short experience accumulated so far. It distinguishes two periods. First, with few exceptions (Czechoslovakia, Hungary), transition economies have undergone a sudden and massive burst of inflation. The choice of the exchange rate regime during this period is largely dominated by the search for an effective disinflation policy and the associated nominal anchors. This important issue is not examined in this paper which, instead, focuses on the second period, the one that starts once inflation has been brought back to relatively comfortable levels—in the range of 20 to 40 percent per annum. While (dis)inflation remains a central concern, competitiveness and uncertainty about the proper level of the exchange rate become important policy issues. Price stability argues for relatively fixed nominal exchange rates and little validation of inflationary pressure. At the same time, with output dramatically reduced and unemployment emerging as a central social cost, policy must necessarily prepare a prompt return to growth. Export-led growth, in turn, argues in favor of an exchange rate policy which emphasizes competitiveness. Ideally, the solution is to steer the nominal exchange rate so that the real exchange rate remains close to its equilibrium level, avoiding overvaluation and tolerating only a limited degree of undervaluation.

The question naturally becomes: what is the real equilibrium exchange rate level? It is perhaps unavoidable that the principle of purchasing power parity (PPP) be invoked at this stage. The usual signals for determining a benchmark value for the real exchange rate are missing: no track record of competition within an open trading system; a brief history of current accounts responding to exceptionally sharp short term movements in production, consumption and investment, quickly changing labor and other costs, and the redeployment of the entire structure of the economy. In such troubled times, simple rules become naturally appealing. With a logic easily understood by policy-makers, and even by the population given the widespread use of foreign currencies2, PPP appears to fit the needs.

Unfortunately, in this case more than ever, PPP is the wrong rule to follow. It is well known that PPP only holds under very restrictive conditions. These conditions are approximately verified among countries which undergo broadly similar shocks.3 The presumption must be that these conditions are not even remotely met in transforming countries which undergo massive productivity changes. As a consequence it is only to be expected that the real exchange rate will vary quickly and by large amounts. This paper provides evidence that the observed dramatic real exchange rate appreciations—up to 10 percent to 20 percent a year—do not threaten competitiveness.

This result has not been widely shared by observers and policy-makers. One often hears surprise, if not dismay, at the sight of nominal exchange rates which remain strong despite still high inflation. For example, a Deputy Prime Minister of Slovenia claimed that the currency that he helped to create was nothing short of miraculous:

The strength of the tolar, coupled with the graduate abolition of foreign exchange rate restrictions and the growth of foreign exchange reserves in the first six months, more and more appeared to be a “miracle” which repudiated forecasts of experts and contradicted theoretical findings. (Mencinger, 1993, page 427)4

The theory can be made deceptively simple. In economies which undergo profound real shocks, all relative prices, including the real exchange rate, are likely to change. The main objective of the present paper is to draw the practical implications of this statement. It attempts to deal with crucial questions like: what is the “proper” level of the exchange rate? And what is its “normal” evolution over time? These are issues of major import for policymakers and their advisers. Yet, so far, the answers are kept implicit. They are not based on the kind of formal and data-based analysis which is common practice for more economically-stable countries. There are good reasons for that: reliable quantitative information is not available or of poor quality and covers a very short time period. Importantly there currently does not exist any worked-out theory of the exchange rate in transition. These difficulties are obvious in the present paper and imply that the results presented here are not meant to be definitive. Our goal, rather, is to contribute to a debate which has been lively but, so far, mostly based on a ‘soft’ treatment of the data. Specifically, the paper presents estimates of the equilibrium paths of the real exchange rate for countries for which sufficient data has been made available: Croatia, the Czech Republic, Hungary, Poland, Russia, the Slovak Republic and Slovenia, with partial results available for other countries as well.

The next section proposes a framework to approach the issue. Section III estimates the equilibrium dollar wage based on international comparisons. It suggests that most countries started with a significantly undervalued exchange rate but then went on to catch up. In some instances, there are indications of overvaluation. Section IV studies in greater detail which factors have driven the exchange rate over the first few years of transformation. The last section summarizes our results and draws the policy implications.

II. A Framework and A Stylized Fact

Empirical studies of the exchange rate face two familiar hurdles. First, nominal shocks temporarily affect the real exchange rate and can move it away from its equilibrium level. Second the equilibrium real exchange rate itself may change in response to real shocks. Most transition economies have undergone massive nominal shocks and the transformation process itself is constituted of a quick succession of large real shocks. Our approach is to first identify the path of the real equilibrium exchange rate and then to explain the evolution of the actual real exchange rate about its equilibrium path. We also attempt to detect the sources of temporary deviations of the real exchange from its (moving) equilibrium level.

In this section, we start by clearing up some basic issues regarding definitions of the real exchange rate and of its equilibrium level. We then suggest that real exchange rates exhibit a typical pattern in the early phase of transition by proposing a stylized fact that the paper intends to establish. This section concludes with a simple framework designed to organize the data and interpret the empirical results presented in the rest of the paper.

A. The Real Exchange Rate

At a very general level, the exchange rate is at its equilibrium level when the economy is simultaneously in internal (output, employment, inflation) and external (current and capital account) equilibrium. Often, internal equilibrium is taken to mean that the nontradable good market clears in the current period and is expected to do so in the future (see e.g., Edwards, 1989), while external equilibrium occurs when current account balances are compatible with sustainable capital flows (see e.g., Williamson, 1985).

For the practical purpose of determining the real equilibrium exchange rate, two main difficulties follow from this very general definition. First, there is not a unique definition of the real exchange rate. It is defined as the relative price of a pair of goods but there are several logical ways in which goods can be partitioned into two classes: domestically versus foreign produced, traded versus nontraded, exported versus imported, and the relative cost of inputs, mainly labor costs. Interest in the equilibrium real exchange rate is based on the view that it is a key variable which determines a country’s competitiveness, the allocation of resources across industries, the pattern of spending and intertemporal transfers of incomes through current account imbalances. Yet, changes in the real exchange are difficult to interpret. For example, a real appreciation may be explained by a loss of competitiveness if domestic costs and prices exogenously rise faster than the exchange rate. But it may as well be the endogenous response to an improvement in competitiveness, such as an exogenous increase in world demand for domestic output. This has led Lipschitz and McDonald (1992) to correctly suggest that international competitiveness is better captured by measures of producer profitability like the ratio of relative producer prices or value-added deflators to relative labor costs than by “the” real exchange rate. Unfortunately, such data is not available for the transition countries. To cope with this difficulty, we need to use different—and imperfect—real exchange rate indicators. We will use three real exchange rates: the CPI-deflated real exchange rate, the ratio of traded to nontraded prices, and the dollar wage.

The second difficulty that we face is that virtually any variable which has real effects is bound to affect the real exchange rate. Thus the list of variables of potential interest, and the precise effect of each of them on the real equilibrium exchange rate, depend on the particular model in use. Inevitably therefore, we must be selective. In the next section we survey those factors most likely to play a first order role during the early phase of transition.

B. A Stylized Fact

Figure 1 presents the evolution of three measures of the real exchange rates for a number of transition economies. The first measure is the CPI-deflated real exchange rate (Λ = P/EP*, where E is the exchange rate defined as the domestic price of foreign currency, P and P* respectively the domestic and foreign CPIs). The nominal exchange rate is the geometric average of the US and DM exchange rates. Similarly, the foreign CPI is the geometric average of the US and German CPIs, in both case using equal weights. The second measure is the ratio of nontraded to traded good prices (M = PN /PT). It is approximated as the ratio of the CPI to the industrial price index. Our third measure is the dollar wage (Ω = W/E). The dollar wage is a frequently used measure of the real exchange rate5 because it avoids the “index problem”, the fact that price indices are not comparable across countries.6 In this figure and in the rest of the paper, given our definition of the exchange rate, an increase represents an appreciation.

Figure 1(1).
Figure 1(1).

Real Exchange Rates

(average vis a vis the US Dollar and the DM)

Citation: IMF Working Papers 1996, 125; 10.5089/9781451854794.001.A001

Source: IMF, RECEP
Figure 1(2).
Figure 1(2).

Real Exchange Rates

(average vis a vis the US Dollar and the DM)

Citation: IMF Working Papers 1996, 125; 10.5089/9781451854794.001.A001

Source: IMF, RECEP

The CPI-based real exchange rate (thereafter referred to as the real exchange rate) exhibits a strikingly similar feature across all countries, irrespective of the exchange regime. It appears to undergo an initial massive depreciation (where available data exist). Eventually, once the macroeconomic situation is brought under control, it follows a trend of appreciation. The total rate of real appreciation from the trough ranges from about 30 percent in Hungary to 1,000 percent or more in Russia. Albania, Romania and Ukraine illustrate cases of setbacks along the way, with relapses into inflation and in the setting up of market mechanisms. Slovenia emerges as an outlier with a stable real exchange rate.

The relative price of nontraded and traded goods generally follows the same pattern although the trend rate of appreciation is lower than for the real exchange rate. The exceptions are Russia where the ratio actually depreciates, and Hungary and Slovenia where the trend rate of appreciation is larger than for the real exchange rate. Finally the dollar wage generally exhibits the same behavior as the real exchange rate, including in the special case of Slovenia once the dollar wage has rebounded from its January 1992 collapse.7

The observed similarity across real exchange rate measures and across countries is striking and cannot be just a fluke. It suggests the stylized fact proposed in Figure 2. The figure shows our hypothesis regarding the evolution of the actual and equilibrium real exchange rates in a transforming economy.8 The actual real exchange rate initially depreciates and overshoots its equilibrium path so that there is at first a sizable undervaluation. Over time the real exchange rate appreciates for two reasons. First, the initial undervaluation is gradually corrected. Second, the real equilibrium exchange rate itself appreciates as a result of the transformation process. The rate of equilibrium appreciation is higher the more complete is the market system and the faster capital is accumulated.

Figure 2.
Figure 2.

The Stylized Fact

Citation: IMF Working Papers 1996, 125; 10.5089/9781451854794.001.A001

In order to make sense of the stylized fact, we now need to explain the undervaluation and the subsequent appreciation trend. The next section sketches what could be the elements of a yet-to-be-written theory of exchange rates during the transition.

C. Initial Undervaluation

Undervaluation typically occurs at the time when markets are liberalized. Frequently, it takes the form of a big bang corresponding to the end of the command economy and when the system of previously prevailing multiple exchange rates is replaced by a single rate set in a reasonably free market. Three explanations are possible.

First, the long-repressed pent-up demand for foreign assets (previously reflected in the black market premium) faces a negligible supply. Since the available net stock of foreign assets cannot increase instantaneously in volume, market equilibrium requires a price increase. The undervalued exchange rate, in turn, allows for the net acquisition of foreign assets through current account surpluses. Over time, correction from undervaluation leads to the closing of the current surplus as the domestic stock of foreign assets rises to meet demand at the equilibrium exchange rate.

Second, the freeing of prices in the presence of a monetary overhang is met by a sudden burst of inflation. The ensuing flight from domestic currency further exacerbates the demand for foreign assets, in this case foreign cash. This disequilibrium situation also results in undervaluation.

Third, the return to some degree of convertibility raises a difficult policy issue for untested authorities lacking credibility. This is further aggravated by the ignorance of what is the appropriate—equilibrium—level of the exchange rate (Berg and Sachs, 1992). In such a situation, the authorities must decide whether to err on the side of over or undervaluation. Prudence suggests taking the risk of an undervaluation rather than taking the risk of being unable to sustain convertibility.

D. The Process of Real Appreciation

The correction of the initial undervaluation implies a subsequent path of real appreciation as the exchange rate returns to equilibrium. There are reasons to suspect that the real equilibrium exchange rate itself will also appreciate for some years.

First, fast productivity gains are expected when formerly inefficient economies respond to market forces. As firms move away from output and employment maximization and towards profit maximization, a deep overhaul of the economic structure takes place. It takes the form of the end of overmanning and the closure of activities which are not profitable at world prices. The visible outcome is a dramatic reduction in the size of industry and agriculture and the development of the service industry. The mere emergence of services (banking and finance, management consulting, marketing, etc.) is likely to considerably raise aggregate effectiveness. If productivity gains are higher in the traded than in the nontraded goods sector, the real equilibrium exchange rate appreciates as predicted by Balassa (1964) and Samuelson (1964). The effects on the real exchange rate of both aggregate and sectoral productivity gains are studied in the next section.

Second, transition economies inherit a set of natural resource prices considerably below world prices. Similarly, public utility prices used to be set low and governments worry of upsetting a much unsettled public opinion. This leads to low nontraded goods prices. The situation is not sustainable, though. As these prices are raised, the real exchange rate appreciates.9

Third, demand for public spending changes, without necessarily declining. An appropriate welfare system has to be built. As the private sector becomes more productive, social returns from public investment (infrastructure and environment, for example) rise and warrant higher public spending. With the emphasis on inflation containment and, frequently some reasonable degree of central bank independence, budgetary needs have to be financed through explicit taxation and borrowing. In the command economy, firms used to provide most of government revenue. As the market economy sets in, very high rates of corporate taxation become highly inefficient and in fact receipts quickly shrink.10 The whole tax system needs to be deeply overhauled. Wherever tax reform has moved ahead, personal income taxation and VAT have become the dominant source of fiscal income. These are real changes bound to disturb a number of tax wedges. The result should be a change of a wide array of relative prices, including the real exchange rate, even if the sign of the effect is unclear. Non-monetary financing of public deficits is likely to lead to real appreciation via high real interest rates. Higher taxes have specific effects which require detailed analysis beyond the scope of this paper.

Fourth, transforming economies need to accumulate capital for which return is potentially very high. Foreign direct investment tends to produce a real exchange rate appreciation. At the outset of a long period of buildup of the stock of capital, possibly partly financed from abroad, such an appreciation is properly seen as a permanent or equilibrium change. Given the timing of effects, capital inflows and the attendant real appreciation occur before capital is put in place and productivity rises.

Finally, locally produced traded goods were initially of poor quality and poorly marketed. As firms learn to operate on world markets, the terms of trade are likely to improve.

E. Framework

This section clarifies the link between our three measures of exchange rates and summarizes the discussion of the previous section. Using lower case letters to represent logs (e.g., λ = 1nΛ) we have:

(1)λ=pep*
(2)μ=pNpT
(3)ω=WeW*

In the presence of price and wage stickiness, all these measures are likely to be affected by both nominal and real disturbances. Overlooking for now nominal disturbances, we concentrate on the sources of fluctuations of the real equilibrium exchange rate.

Let the CPI be written as p = γpN + (1 - γ) PT. Initially at least, domestically produced traded goods are of poor quality and poorly marketed. As they sell at a discount on world markets, the law of one price does not apply. We assume:

(4)pT=k+e+p*

where κ can be thought of as a measure of “quality”, presumably rising over time. “Quality” must be understood in a wide sense: it includes market power and the ability to differentiate domestic products on both domestic and foreign markets. Initially, we assume κ<0. Then we obtain:

(5)λ=κ+γμ

Optimizing firms set the real wage equal to the marginal productivity of labor. As this may not be a realistic description of the early phase of transition, we allow for a more general formulation:

(6)WT=ρT+pT+aTWN=ρN+pN+aN

where ρi is a measure of excess wages and ai is (the log of) marginal productivity of labor in sector i (i= T, N).

Finally, we allow for wages to differ, possibly temporarily, across sectors:

(7)θ=WNWT

With these notations, we get:

(8a)μ=θ+ρTρN+aTaN
(8b)λ=κ+γθ+γ(ρTρN)+γ(aTaN)

The four terms in (8b) illustrate four reasons why we might observe a real exchange rate appreciation:

1) Domestic producers of traded goods improve the quality κ of their products. This effect results in an improvement in the terms of trade.

2) Wages in the nontraded goods sectors rise relative to wages in the traded good sector. Initially, wages in the informal, fast growing and often informal nontraded goods sector (new services, imports of foreign goods) are lower than those in the traditional (industry-based) traded good sector. Over time, we would expect the gap to be closed for two reasons. First, trade unions are likely to ask for wage equalization at the lower end of the spectrum. Second, at the higher end, enterprising people are likely to build expertise and raise the average remuneration level in the previously neglected service industry.

3) In line with the previous case, we expect that initially wages far exceed productivity in the traded good sector, while the margin is nil, or even negative, in the nontraded goods sector. Consequently the excess of wages over productivity declines faster in the traded than in the nontraded goods sector.

4) Finally, the Balassa-Samuelson effect predicts a real exchange appreciation when productivity in the traded good sector increases faster than in the nontraded goods sector.

Equation (5) suggests that improved “quality” of traded goods is one reason why the real exchange rate has typically increased faster than the ratio of nontraded to traded goods prices. It leaves unexplained the cases of Slovenia—where the latter has increased while the real exchange rate has remained about constant—and Russia.

The dollar wage is a measure of real exchange rate: it is equal to ω if we assume that the foreign wage is taken to be constant and normalized to unity (so that w* = 0). Then:

(9)ω=ρ+(aa*)+λ

where a and a* are, respectively, the aggregate marginal productivity of labor at home and abroad, and ρ is the aggregate excess of wages over labor productivity at home (it is assumed that p*=0).11 An important implication of (9) is that while appreciation of the CPI-based real exchange rate is predicated upon differences in sectoral productivities, the dollar wage rises when aggregate productivity rises faster at home than abroad.

III. Equilibrium Dollar Wages

A. Methodology and Data

This section provides estimates of the real equilibrium exchange rate. Usually, the real exchange rate is found by determining a benchmark period during which the actual rate is believed to be in equilibrium. One may then track down the evolution of the equilibrium rate over time. The main advantage of this method is that it does not require international comparisons of price levels: easily available national price or wage indices can be used. In the case of transforming countries, this method cannot be used because of the absence of relevant history. Pre-1989 exchange rates and prices were not governed by market forces, and it is hard to find a period since then where equilibrium has been reached.

Our approach, therefore, is different. We resort to international wage comparisons. We do not attempt price comparisons, even though some are available from the Heston-Summers (1991) “International Comparison Program” (ICP), for two main reasons. First, the dollar wage is a measure closely monitored in all transition countries. Therefore it is familiar to analysts and policy-makers. Second, it is available without delay at a monthly frequency while the ICP measures are available at a five-year frequency with a considerable lag, making them unsuitable for policy purposes.

On the other side, dollar wages suffer from a number of well-known defects. The definition of labor costs vary widely from one country to another. This is a particularly crippling issue in transforming countries where direct labor costs used to be only a portion of total costs given the “social function” of firms. A “normalization” is under way but this contributes to pollute the data. Furthermore, it proceeds at different speeds from one country to another. These caveats must be kept in mind when assessing our results.

In order to search for estimates of the equilibrium dollar wage we formalize the popular rule-of-thumb approach which consists in comparing a transforming country’s dollar wage to the dollar wage in relevant countries, where relevance is defined as broad similarity in terms of the stage of development. We make this process systematic by bringing to bear all the countries of the world for which we can assemble adequate data.

The choice of data follows from (8) and (9) which show that the dollar wage is driven by: 1) a number of indicators of economic effectiveness (“quality” κ, the gap between sectoral wages Θ, and aggregate excess wage ρ); 2) aggregate productivity a; 3) differences in productivity and effectiveness across sectors (aT - aN and ρT - ρN). Sectoral productivity and effectiveness data are not available for most countries. Aggregate (average) productivity is trivially measured by GDP per worker. The choice of proxies for the other terms follows from the large recent literature on growth catch-up (see e.g., Barro and Sala-i-Martin, 1995): human capital (usually proxied by investment in human capital, education), the size of government and of the agriculture sector have been found to be convincing explanatory variables of economic effectiveness.

The dollar wage is estimated using a pooled cross section-time series sample: it includes 80 countries from all five continents; they are listed at the end of Table 2. For each country we include, whenever available, five observations taken five years apart (1970, 1975, 1980, 1985, 1990): this allows us to exploit the long run growth effects on the dollar wage while keeping data collection manageable. The measure of aggregate (average) productivity, GDP per worker, is provided by the ICP database update on Internet12: this source offers comparable PPP-adjusted measures of GDP.13 The dollar wage is computed using the wage series and average hours of work as published in the ILO Statistical Yearbook (various issues) and converted into monthly average wages.14 The conversion to US dollars is done using average exchange rates from International Financial Statistics (on tape). Education is measured as the proportion of the population of school age in secondary schools. These series, along with the ratio of agriculture to industrial output and the share of government spending in GDP, are from the World Bank’s Social Indicators of Development (1995). It should be noted that not all five annual observations are available for every country in the sample. The number of observations (country and date coverage) is entirely determined by data availability and is presented with the results.

Table 2.

The Dollar Wage Equation

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Notes: All variables are in logs except school enrolment and inflation which are in percent, t statistics in parentheses. Heteroskedasticity-consistent standard errors and covariance.

indicates significant at the 1% confidence level,

at the 5% level. Not reported: constant, non-planned economy country dummies.

Year dummies: (1) 1975: 0.21 (1.88), 1980: 0.41 (3.92); (2) 1975:0.15 (2.04), 1980: 0.36 (6.29); (3) 1975:0.19 (2.11), 1980: 0.40 (4.93); (4) 1975: 0.14 (2.07), 1980: 0.37 (7.09).In regression (3) regional dummies have been interacted with right hand-side variables. The significant terms concerning GDP are reported in the table in the dummy lines. Other significant terms are: school enrolment interacted with Planned Economy: 1.35 (2.11); with Latin America: -1.73 (-2.96); Agriculture/Industry interacted with OECD: -0.17 (-2.27).In regression (4) regional dummies have been added as constant and interacted with right hand-side variables. The significant interacted terms concerning GDP are reported in the table in the dummy lines. Other significant terms are: school enrolment interacted with Planned Economy: 1.42 (2.17); with Latin America: -1.42 (-3.89); Agriculture/ Industry interacted with OECD: -0.15 (-2.22). Fixed country effects are not reported but few were actually significant; the only planned economy dummy with a significant coefficient is Czechoslovakia as reported in the table.

While converting wages into dollars is customary, it is a source of spurious fluctuations due to the wide fluctuations of the dollar. For example, at the height of the dollar value in 1985, all dollar wages were much lower than in 1980 or 1990. To correct for this effect, we use year-specific dummy variables. In addition, to allow for a secular trend in dollar wages worldwide we introduce a linear trend (all variables are estimated in log form).

B. Results

As we estimate the dollar wage for a large number of countries over a 20 year period, we implicitly assume that the same process drives the dollar wage world-wide. In order to test for this assumption we have searched for regional effects, using dummies (both fixed and variable effects, see below) for the following country groupings: OECD, Africa, South-East Asia, Latin-America and transition economies. In addition, we have also explored whether individual country dummies were warranted, with particular attention to formerly planned economies.

In interpreting the results, we assume that market forces eventually bring the actual exchange rate to the vicinity of its equilibrium level. Consequently departures of actual from equilibrium dollar wages are interpreted as temporary deviations captured by the error term. Equivalently, we assume that the fitted values of the regression provide an estimate of equilibrium dollar wages. We know that many countries present in the sample have experienced very high, and sometimes sustained, inflation during the period under review.

Because of possible short-term non-neutralities of the inflation process, we have added the inflation rate as a regressor. However, we do not consider inflation as a determinant of the equilibrium dollar wage.

Table 2 presents the regression results. We only report the significant coefficients, once the non-significant ones have been purged. All variables are in logs except the school enrollment ratio and the inflation rate, which are in percent. The first column presents the raw panel results. It assumes that the elasticities of the dollar wage to its determinants are the same in all countries. The second column allows for fixed effects, i.e. we experimented with country dummy variables. With (at most) five observations per country, country dummies are unlikely to be significant. We have therefore looked for significant “regional dummies”, lumping together the OECD countries, the centrally planned economies, South-East Asia, Africa and Latin-America, leaving out the Asian countries as the residual. Given the paper’s focus, we have scrutinized more carefully the role of country dummies for formerly planned economies. Other country dummies have also been tested and several turned out to be significant but are not displayed in the table. We report the result of the search which exhibited the best overall performance in terms of the standard tests reported at the bottom of the table (normality, heteroskedasticity, stability). Column (3) reports tests of the assumption that elasticities are identical. For that purpose we have interacted the regional and country dummies with each coefficient. Again, we only report the significant terms. Finally column (4) reports tests for both fixed and slope effects.

The results accord with common sense, the coefficients are generally estimated quite precisely and are robust from one specification to another. The main limitation comes from specification tests: for simulation purposes we will use regression (3) which passes at the 1 percent confidence level all tests, except for normality.15

The size of agriculture relative to industry is a standard measure of development: a 10 percent decrease in this ratio raises the dollar wage by 1 to 2 percent. The growth-enhancing role of government spending has been recently studied in the endogenous growth literature (Barro and Sala-I-Martin (1995)). Our results are in line with previous estimates: a 10 percent increase in the size of government raises wages by 3 to 6 percent. This effect is interpreted as measuring the effect of public services and infrastructure on aggregate productivity. Yet, public spending may also be a source of inefficiency and especially so in planned economies. In that case, the coefficient of the government variable should be different (and negative) for the planned economies. We have tested and rejected this assumption.

In column (1) the estimated effect of GDP per worker on the dollar wage is large, but it declines when we use regional and country dummies, suggesting that this variable partly works as a proxy for country specific effects. Conversely, the effect of investment in human capital—measured here as secondary school enrollment—rises as we introduce the regional and national dummies. Both effects are clearly established. Finally, it may be noted that 10 additional percentage points of inflation reduce the dollar wage by 1.5 to 2.5 percent, a powerful effect to which we return below.

The role of the regional dummies is interesting.16 Unsurprisingly, we find that being in the OECD group brings in a dollar wage premium of about 60 percent (regression (2)) or raises by 6 percent the effect of productivity (regression (3)). Similarly, being a planned economy is found to bring a discount of 130 percent, or to reduce the effect of productivity by 16 percent. Presumably, this captures unmeasured effects like infrastructure, the stock of human capital, possible network externalities, inefficient use of resources, intangible assets such as the legal and political systems. We return to this issue below. Regression (3) offers an interpretation of the channel through which these regional specificities operate. It is interesting to note that the positive effect of secondary education is stronger in the planned economies than in the rest of the world. The results are compatible with the generally-held view that planned economies operated with an inefficient capital stock (hence a comparatively low productivity of labor) combined with an efficient school system.17

C. Estimates of Equilibrium Dollar Wages

We use Regression (3) of Table 2 to generate estimates of the equilibrium dollar wage. The idea is that the regression captures long run effects: shorter run aspects are eliminated by the combination of the time (observations five years apart over 20 years) and cross-section dimensions. Thus it is appropriate to use the regression to predict what is the dollar wage compatible with a country’s indicators of economic and social development.

Table 2 shows that inflation exerts a significant negative influence on the dollar wage. If inflation is neutral in the long run, this must be considered as a short run effect, corresponding for example to capital flight and exchange rate depreciation. In that case inflation should not be allowed to affect the equilibrium dollar wage. But inflation may exert permanent effects, for example through market inefficiencies and dollarization. The literature generally supports the view that inflation is non-neutral.18 This suggests that we should keep the inflation term in our simulations, but we should not use the actual rate of inflation to measure a permanent equilibrium effect. The estimates presented here assume a permanent rate of inflation of 10 percent.19

Another question is how to treat the regional and country dummy variables. They are meant to capture special conditions which make a particular country different from the international norm. If we are interested in using the regression to predict the dollar wage at the outset of the transition period, we need to include the significant planned economy dummies. If on the contrary we are interested in predicting the dollar wage that would emerge under “normal” conditions, we should set the dummies equal to zero. Finally, if we believe that the OECD countries represent the correct reference for the planned economies, we need to include the OECD dummy variable.20

The results from these three approaches are shown in Table 3 for 1990, or the latest available data used for the estimation. It provides an assessment of the situation before transformation. Column (1) shows the dollar wage that we should observe if these were “normal” economies. The discount for being a planned economy (column (2)) is heavy, close to 30 percent. Column (3) shows the far out estimate if these countries could instantaneously acquire the intangible OECD factors of development. Taking as reference the estimates obtained using the planned economy dummy, the actual wage (column (0)) is below equilibrium for most countries (Bulgaria, China, Czechoslovakia, Poland, Romania, Russia and Croatia). This may reflect undervaluation, mismeasurement of labor costs, overestimation of the performance indicators (in particular the PPP-adjusted GDP), or a distribution of income skewed toward the shareholder i.e. the State. Hungary appears to be at equilibrium if we use the planned economy estimate; it is below equilibrium if we consider that it had already covered some of the distance between the command system and a market economy. Only Slovenia appears to be clearly overvalued but it must be remembered that the estimate is based on data for the whole of Yugoslavia.

Table 3.

Actual and Estimated Dollar Wages

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Source: Actual wage (average): IMF; Equilibrium: authors calculation from Regression (3) in Table 2.Note: for Croatia and Slovenia we use the equation estimated for Yugoslavia.

Using various estimates for the evolution of the right hand-side variables after 1990, the regressions in Table 2 can be used to produce estimates of the equilibrium dollar wage after the beginning of transition. Figure 3 shows the results obtained with the same five-yearly data (1970 to 1990) as those used in the regressions, as well as with annual estimates for the period 1991-96.21 Along with the actual dollar wage (W) displayed in Column (0) of Table 3, the figure presents two estimates of the equilibrium level: Wl which corresponds to the normal situation (no dummy variable as in Column (1) of Table 3) and W2 which uses the planned economy dummy (as in Column (2)). We regard Wl as an upper bound for the equilibrium wage, which will be reached once most of the market economy institutions are in place and functioning smoothly. We regard W2 as a lower bound which corresponds to the starting situation. We consider that the actual equilibrium dollar wage lies in-between, gradually rising from the lower to the upper bound as transformation takes place. We expect the equilibrium dollar wage to eventually incorporate the OECD features; since this is a very long run goal, we do not show the corresponding estimate.

Figure 3.1.
Figure 3.1.

Dollar Wages

Citation: IMF Working Papers 1996, 125; 10.5089/9781451854794.001.A001

Source: IMF and PlanEcon. W is actual dollar wage.Note: W1 is estimated equilibrium dollar wage, assuming no regional specificity (col. (1) of Table 3). W2 assumes planned economy specificity (col. (2) of Table 3.
Figure 3.2.
Figure 3.2.

Dollar Wages

Citation: IMF Working Papers 1996, 125; 10.5089/9781451854794.001.A001

Source: IMF and PlanEcon. W is actual dollar wage.Note: W1 is estimated equilibrium dollar wage, assuming no regional specificity (col. (1) of Table 3). W2 assumes planned economy specificity (col. (2) of Table 3.

With the exception of Slovenia and Hungary, all countries are found to have started the transition process with a significantly undervalued exchange rate, as our stylized fact hypothesizes. Overtime the gap narrows, but very slowly. The countries which have been more determined in adopting the market economy and stabilizing the macroeconomy (the Czech Republic and Poland) have by now dollar wages close to the lower bound, i.e. not very far from equilibrium. The same applies to Croatia. Hungary seems to have let the actual dollar wage trail behind its equilibrium level. In Russia, the massive fall of the actual dollar wage is entirely explained by inflation. More generally, if we re-estimate the equilibrium wage using historical inflation rates instead of the “steady-state” rate of 10 percent (see Appendix I), we find that most of the initial undervaluation is related to inflation in those countries which started of with a burst of price increases (Bulgaria, Poland, Russia and Croatia).

We conclude that by 1996 the real exchange rate is in the neighborhood of equilibrium in Croatia, the Czech Republic, Poland, Slovenia and possibly Hungary. Undervaluation most likely still characterizes the other countries in our sample. Needless to say, the results presented in the present section need to be considered with great prudence. This applies with special force in the successor countries of the former Yugoslavia and Czechoslovakia.

Iv. Dynamics of the Equilibrium Exchange Rate

A. Methodology

The previous section offers estimates of the path of the equilibrium real exchange rate. It does not provide any explanation of the path of the actual real exchange rate during the first years of transition. This section uses higher frequency (monthly) data to check whether the real exchange rate has been moving towards equilibrium as postulated by the stylized fact. The strategy for studying the evolution of a variable about its equilibrium level is the error-correction-model approach where a (cointegrating) equilibrium relationship is imbedded into a dynamic specification. We adopt this strategy but we emphatically do not pretend to capture cointegration over the brief sample period available (less than five years). In fact, it does not even make much sense to test stationarity.22 Accordingly we assume that the long-run relationship characterizing the real exchange rate λ (or μ) is:

(10)λ=βX

where x is a vector of real variables explaining the real equilibrium exchange rate as in (8). If in addition, in the short-run, off-equilibrium, the real exchange rate responds to the vector z of nominal and real temporary disturbances, including lagged changes in λ and x, the error-correction-model (ECM) equation to be estimated is:

(11)dλt=α[λt1βXt1]+ΦdZt1+ϵt

The coefficient α, which comes in front of the once-lagged “cointegrating factor” describes the speed of adjustment towards equilibrium.

The choice of the variables in λ, x and z is dictated partly by data availability, partly by the theoretical considerations presented in Section II. For the real exchange rate we have already defined three measures shown in Figure 1 (the doubly deflated nominal exchange rate λ, the ratio of nontraded to traded goods prices μ and the dollar wage ω). We present results for all three measures.

Vector x collects the variables which affect the equilibrium real exchange rate. Equations (8) list the variables of interest. Most of them are not directly observable or are unavailable. This is particularly the case of sectoral level data such as the Balassa-Samuelson term (aT - aN). Using (6) and the definition of aggregate productivity, (8b) can be rewritten (in logs) as:

(12)λ=κ+γθ+ρ(WP)+aT

Two of the right hand-side variables can be matched reasonably well by existing data. The real aggregate producer wage (w - p) is measured as (the log of) the ratio of the average wage and the wholesale or industrial price index. The drawback is that the nontraded goods sector is likely to be under-represented. Marginal labor productivity in the traded good sector aT is approximated by average labor productivity in industry.

Equation (12) directs attention to structural factors which capture distortions of the transition economy. In the present formulation we expect κ (“quality”) and θ (the wage gap wN- wT which we believe is negative) to increase as transition progresses. (12) says that this should lead to a real appreciation. We have less intuition for the sign and likely evolution of ρ, the gap between aggregate real wages and the marginal productivity of labor. Unfortunately data precisely corresponding to these factors do not exist. In any case, we regard our formulation as just one example of a more general framework. In the empirical implementation, we use all available data which can measure economic distortions, noting the risk of collinearity with productivity in industry.

Given the extreme brevity of the period under review, we use monthly data. We also increase the sample size by pooling available data across countries in transition. This severely limits the number of countries and variables which can be included. Our choice of indicators of distortions, therefore, is a compromise between data availability and theory. We first look at the financial and banking system and use the spread between the lending and deposit interest rates (iL - iD). In principle, a large spread corresponds to a poorly functioning financial system, although it may also signal a liberalization of the market. In fact, in many countries the spread has declined with liberalization and the elimination of inflation. Another potentially useful indicator is the velocity of money. This variable has been included but turned out never to be significant, maybe for reasons discussed below.

Second, we attempt to capture the evolution of labor market distortions with the level of employment and the rate of unemployment. Given the initially high levels of employment in centrally planned economies, it was expected that labor force participation would decline. One reason is personal preferences should lead a number of persons to choose to stay at home. Another is the end of the practice of overmanning which resulted from the employment guarantee offered by the State through firms which did not operate for profit. Consequently, declines in employment L and the rise of unemployment U may reflect a step towards a normalization of the labor market.23 These are bound to be noisy indicators, though, as they are also likely to be affected by traditional macroeconomic factors.

The variables collected in the vector z are meant to represent those which, in addition to those already in x, exert a temporary influence on the dynamics of the real exchange rate when it is not at its equilibrium level. This suggests looking mainly at nominal variables, representing monetary and fiscal policy. The log of money was found not to enter significantly. There is no monthly indicator of fiscal policy so we use instead the lending interest rate, implicitly assuming a reduced form in the IS-LM tradition. The nominal exchange rate is meant to capture the transitory effect of nominal exchange rate changes on the real exchange rate. Including changes in the exchange rate is interesting. As in Edwards (1989) the estimated coefficient is interpreted as the degree to which the nominal exchange rate temporarily affects the real exchange rate, while the speed of adjustment coefficient a indicates how quickly this effect is dissipated.

Finally, inflation has been found in Section III to be an important factor affecting the real exchange rate. Yet we cannot use it as a regressor here. Looking at (11) we note that the regressand dλ includes both inflation and the rate of exchange rate depreciation. When the rate of exchange rate appreciation—de—enters as a regressor, inflation cannot be used on the right hand-side.24

B. Data

The data used in this section are unpublished, provided by the IMF European Department which forewarn us that reliability is not guaranteed. To undertake cross section-time series estimation, we need to have identical data for all countries. This limits our investigation to six countries: Croatia, the Czech Republic, Hungary, Poland, the Slovak Republic and Slovenia. For each country, the starting date has been chosen to eliminate the initial high inflation episode. The end date is dictated by data availability.

A number of dummy variables are designed to account for sharp and clearly identified policy changes likely to affect the real exchange rate independently of the other variables: this concerns primarily major changes in either taxation or tariffs. The dates chosen are: October 1992 for Croatia (introduction of sales tax); January 1993 for the Czech Republic, Slovakia (introduction of VAT); July 1993 for Poland (introduction of VAT) and Slovakia (increase in indirect taxation); February 1992 for Slovenia (tax reform). We also use monthly dummies to remove seasonal factors.

C. Results

Given our choice of variables, the equation to be estimated is found upon substitution of (12) into (11):25

(13)dλ=cα[λ1+c1(W1pY,1)c2(yl)1+c3(iLiD)1+c4l1c5u1]+c6de+c7diL+cdZt1+ϵ

where w is the log of the average wage, pY the log of the industrial price index, y the log index of industrial production, 1 the log of employment, u the log of unemployment, de the rate of appreciation, and iL and iD are, respectively, the credit and deposit interest rates. Vector dZt1 includes all lagged changes of the dependent and of all variables which appear inside the squared brackets.

The speed of adjustment term α and the other coefficients ci are expected to be positive. According to (12), increases in the real producer wage lead to a real depreciation while productivity has the opposite effects. Although we have found some theoretical ambiguity, we expect that the distortion terms are such that when the corresponding distortion is reduced (1 down, u up, iL - iD down) the real equilibrium exchange rate appreciates. The terms de and diL capture monetary and fiscal policy disturbances. The estimated equation follows from (13):

(14)dλ=cαλ1c1(Wt1pY,t1)+c2(yl)t1c3(iLiD)t1c4lt1+c5ut1+c6de+c7diL+cdZt1+ϵ

where c′i = α ci.

Table 4 presents the results. The coefficients for the constant and the various dummy variables are not reported. For each real exchange rate measure we present two regressions: in columns (1), (4) and (6) we estimate (14) directly as shown and add country-specific dummy variables to test for fixed effects. In columns (2), (5) and (7) we additionally test for country-specific estimates by interacting the country dummies with the right hand-side variables. In each case, as the result of an extensive search, we have eliminated the nonsignificant entries. At the bottom of the tables are indicated the cases where the slope coefficients are country-specific. Because most of them concern Croatia, we present in column (3) a regression based on data excluding this country.

Table 4.

Real Exchange Rate Dynamics

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Notes: Heteroskedastic-consistent standard errors and covariances. t statistics in parentheses. Seasonal, country, tax dummies not reported.

significant at 10, 5 and 1 per cent level, respectively.

significant at 10, 5 and 1 per cent level, respectively.

significant at 10, 5 and 1 per cent level, respectively.

Estimation periods: Croatia: 92:2 - 94:7 Hungary: 90:1 - 95:4 Slovak Republic: 92:1 - 94.9 Czech Rep.: 92:1 - 95:1 Poland: 90:1 - 95:4 Slovenia: 92:2-94:7

Column (2): country dummies interacted with coefficients. Significant coefficients:

λt-1: Croatia -0.16 (-4.6); λt-1 - It-1: Croatia, -0.11 (-2.13);

de: Croatia 0.013 (2.2) iLt-1 - iDt-1 Slovakia 0.0035 (1.9)

Column (5): country dummies interacted with coefficients. Significant coefficients:

Croatia: λt-1: -0.47 (-5.8), wt-1 - pt-1, 0.084 (2.2); diL, 0.000069 (7.3), It-1, 1.25 (5.0); and Czech Republic: Ut-1, -0.022(-1.7).

Column (7): country dummies interacted with coefficients. Significant coefficients:

w$t-1: Poland 0.44 (5.7); wt-1- pt-1: Hungary, -0.15, (-2.2), Slovakia, -0.33 (-3.0);yt-1- It-1: Croatia, -0.66 (-3.3); Czech Rep., 0.18 (5.2), Slovak Rep., 0.16 (3.1); Lt-1: Poland, 0.55 (3.4). Ut-1: Croatia -0.75 (-4.6), Poland -0.05 (-2.5), Slovenia 4).17 (-4.6).

We first comment on the properties of the regressions. In a rigorous interpretation of the tests, only the regressions reported in columns (1) and (7) can be accepted as free from misspecification. The other specifications show that most parameter estimates are stable across specification. The goodness of fit is highly satisfactory given that data are both cross-section and time-series. There are problems of heteroskedasticity and non-normality of the residuals.26 That a simple formulation, imposing identical coefficients on all countries in the sample, explains a surprisingly large proportion of the total variance supports the working assumption that the same forces systematically shape the evolution of the real exchange rate during the early transition phase under review.

The pattern of coefficient signs across the various regressions does not fully conform with the priors reflected in (14). For example, productivity in the traded good sectors appears with the correct sign for λ and μ but not in the case of the dollar wage. Conversely the coefficient of the real producer wage has the correct sign for μ and the dollar wage, but not for λ. The combination of the absence of a well-developed theory and data limitations suggest some possible explanations. First, mismeasurement is a serious issue. Industry probably weighs excessively in the real wage, which underestimates the fast-growing nontraded sector. This is a serious problem because theory emphasizes differences between the traded and the nontraded goods sectors. Second, we have already observed that our measures of distortions are problematic and not directly related to the theoretical concepts. Third, the theoretical effects of the distortions are open to some ambiguity.

Overall, the results from Tables 2 and 4 indicate that increases in labor productivity, and more generally gains in economic efficiency, result in a continuing appreciation of the real equilibrium exchange rate. The exact channel of this effect is not uncovered here, but its existence and strength warrant it being considered a stylized fact.

Another interesting result concerns the short-run effects of changes in the nominal exchange rate. The impact on the real rate λ is about 85 percent within a month (column (1)). How long does this effect last? The speed of adjustment α indicates a half-life of 19 months.27 Thus, exchange rate policy exerts a powerful and quite long-lasting influence on the real exchange rate. Given the size and significance of the other term capturing the role of nominal disturbances, the interest rate, this suggests that the nominal exchange rate may be a main reason why the real rate may have been systematically out of equilibrium during the transition period. In particular, this confirms the role of the initial undervaluation—established through a wholly different approach in Figure 3.

On the other side, the nominal exchange rate has a smaller effect on the dollar wage and no significant effect on the ratio of nontraded to traded goods prices. Thus, the high degree of absolute price stickiness implicit in the impact of the nominal on the real exchange rate translates into a high degree of relative price rigidity. In contrast, nominal wages are less sticky than prices: not only is the pass-through of the nominal exchange rate lower but the speed of adjustment is much higher, with a half life slightly above two months (column (7)).

Using the information collected in Table 1, we have attempted to test formally the hypothesis that the exchange rate regime does not matter. The hypothesis that the results change when the floating countries are excluded from the sample is rejected at any conventional level for λ, but not for the ratio of traded to nontraded goods prices nor for the dollar wage. However, these tests should be considered as provisional because the estimates over the sub-samples are quite unstable and generally not very satisfactory.

V. CONCLUSION

This paper proposes an interpretation of the evolution of the real exchange rate over the first five years of transition. The striking feature has been the process of continuing appreciation which has followed the—often deep—initial jump real depreciation. Our hypothesis is that, initially, the real exchange rate has overshot its equilibrium level and that the subsequent appreciation corresponds to the combination of a return to equilibrium and of a continuing real equilibrium appreciation. The equilibrium appreciation is explained by rapid gains in efficiency once markets drive prices and the allocation of resources.

This hypothesis is tested in a number of ways. A first approach is an original attempt at using international data to provide estimates of the equilibrium dollar wage, using data that precede the transition period.28 We use this approach to generate equilibrium dollar wages over the period 1991-96. The results support our hypothesis. Actual dollar wages have been converging to their equilibrium level, but this appears to be a slow process. Most importantly, the often very large increases in dollar wages observed over the first few years of transformation have not (yet) resulted in overvaluation.

The second approach is designed to explore in detail the dynamics of the actual exchange rate during the transition. The analysis is made delicate by the absence of a theory of the exchange rate in transition economies. The results are therefore less sharp and must be considered with caution. They confirm the longer run role of gains in effectiveness. They also show that the speed at which the real exchange rate converges to its equilibrium level is quite slow, even though wages appear to be much less sticky than consumer prices.

A number of policy implications emerge from this analysis. First, purchasing power parity is not an appropriate benchmark to gauge exchange rate policies in transforming economies. Real appreciation is the equilibrium outcome of a successful transformation. Indeed, transition will be complete when the real appreciation will stop. By then, price and wage levels in Central and Eastern Europe will have converged to levels not too different from those in Western Europe, which may be decades away.

Second, the need for a continuous real appreciation has important implications for the choice of exchange rate policies and regime. If the exchange rate is pegged to a Western currency (dollar, DM, ECU or any basket), the real appreciation will come through higher inflation than in the country to whose currency the peg is established. If the nominal exchange rate is allowed to float and appreciate, inflation can be brought down to low levels. Resisting a real appreciation is not only hopeless. It also leads to potentially speculative capital inflows and interventions which, if not sterilized, lead to faster money growth and eventually inflation. If sterilized, there can be a build-up of reserves fueling further inflows in an unending spiral. Even more destabilizing would be a policy of nominal depreciation, e.g., based on a PPP rule, which will lead to a dangerous cycle of inflation and depreciations.

Third, the choice of an exchange rate policy is tightly linked to the desired level of inflation. There are arguments for not aiming at zero or very low inflation rates in the early years of transition: public finance arguments in favor of a (moderate) inflation tax until the implementation of a tax reform which establishes a broad and fair base; macroeconomic arguments against a policy of nominal exchange rate appreciation given the uncertainty about the desired rate and the volatility of flexible rates; efficiency arguments in favor of sufficient inflation to allow for relative price changes without actually forcing some wages and prices to decline; and political economy arguments based on the likely difficulty of imposing continuous appreciation vis-à-vis such strong currencies as the DM. How much inflation is likely to be associated with a fixed exchange rate? In the first years, we have observed real appreciation ranging from 40 percent in four years (Czech Republic, Hungary) to 1,000 percent in Russia. Part of it was a correction of the initial undervaluation. The pace of transformation is also likely to slow down. A plausible guess is that real appreciation will continue for a while at a rate in the 10-15 percent per annum range, progressively declining.

Finally, the estimates presented here should not convey the feeling that the equilibrium exchange rate can be known with any degree of precision. The purpose was to provide ballpark estimates of the initial degree of undervaluation and a feel for what is a normal rate of real appreciation. The estimates rest on dramatically short time series and highly imperfect data.

List of countries used in Table 2;

Algeria, Botswana, Burundi, Cameroon, Egypt, Gambia, Ghana, Ivory Coast, Kenya, Malawi, Morocco, Nigeria, Sierra Leone, South Africa, Tanzania, Bahamas, Barbados, Canada, Costa Rica, Dominican Rep., El Salvador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Panama, USA, Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Guyana, Paraguay, Peru, Venezuela, Bangladesh, China, India, Israel, Japan, Jordan, Korea, Rep., Myanmar, Pakistan, Philippines, Singapore, Sri Lanka, Syria, Thailand, Austria, Belgium, Bulgaria, Cyprus, Czechoslovakia, Denmark, Finland, France, West Germany, Greece, Hungary, Ireland, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Romania, Spain, Sweden, Switzerland, Turkey, United Kindgom, U.S.S.R., Yugoslavia, Australia, Fiji, New Zealand, Papua New Guinea, Tonga, Western Samoa.

Equilibrium Exchange Rates in Transition Economies
Author: Lionel Halpern and Mr. Charles Wyplosz