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Prepared by Thomas Harjes.
Balassa (1964) and Samuelson (1964) argued that if a country’s productivity in the tradables sector increases relative to its trading partners’ (and relative to its own nontradables sector), its real exchange rate would appreciate.
Many studies refer to such an empirical long-run relationship as defining the equilibrium real exchange rate. In that setting, one option is to define the equilibrium exchange rate as the exchange rate consistent with both internal and external equilibrium (Edwards (1989)). However, as Isard and others (2001) point out, the derived estimates of equilibrium exchange rates are then conditional on assumptions about the equilibrium values of the explanatory variables which are difficult to establish for Romania over the past decade.
In the case or Romania, the degree of potential “undervaluation” of the real exchange rate is large when measured as U.S. dollar wages. Halpern and Wyplosz (1997) estimate that in 1996, Romania’s actual dollar wages were at about 25-35 percent of their equilibrium level.
Other variables include real public spending, the degree of openness and net foreign assets.
However, the accumulation of net foreign liabilities would require Romania to run a trade surplus in the future and may then require a real depreciation of the exchange rate.
There are various channels through which the terms of trade can affect the real exchange rate and in general, the overall effect is ambiguous. De Gregorio and Wolf (1994) show that in a small open economy model the terms of trade positively affect the real exchange rate if imperfect capital mobility is introduced.
Romania’s main advanced trading partners include: Austria, France, Germany, Greece, Italy, the Netherlands, the U.K. and the U.S.A. PPP conversion factors are provided by the World Bank.
As noted in Coorey, Mecagni and Offerdahl (1996), transition countries inherited a set of natural resource prices below world market prices and kept administered prices including public utility prices considerably below cost recovery levels in the beginning of the transition period. When these prices are raised toward world market prices and cost recovery levels, the measured real exchange rate appreciates. This effect can be captured by allowing for a deterministic time trend in the cointegrating equation.
If the regressors and the residuals are correlated, the t-statistics of standard OLS estimators are invalid. The Phillips-Hansen FMOLS estimation takes account of these possible correlations in a semi-parametric manner. In all cases in which the cointegrating equation includes a trend, a linear and alternatively a “root” trend has been included in the FMOLS estimation.
Figure 1 and Figure 2 show that both the real exchange rate and the productivity differential trend upward over the past decade. However, in some years and especially during the 1997-99 crisis the variables move in opposite directions and weaken the case for the productivity differential being a significant contemporaneous explanatory variable. The limited number of observations do not allow for a more elaborate model structure, including lagged variables or trying to control for the above event, that could yield a different outcome. Simply using one-period lags for the productivity differential did not change the outcome.
Standard OLS estimation led to the same results regarding the significance of the various explanatory variables.
Net capital flows were part of all significant cointegrating equations. However, they alone do not drive the results: regressing the real exchange rate on net capital flows only or net capital flows and a time trend yielded a poor fit and insignificant parameter estimates.