This Selected Issues paper reviews indicators for external competitiveness in Hungary. The paper examines recent developments in a range of indicators. These include regional comparisons of wage and unit labor cost developments, and standard indicators based on price and cost-based measures of the real effective exchange rate (REER). In addition, the paper discusses actual export performance and market shares, profitability indicators, and business survey results. The equilibrium exchange rate is estimated. The paper also analyzes financial sector regulatory governance in Hungary.


This Selected Issues paper reviews indicators for external competitiveness in Hungary. The paper examines recent developments in a range of indicators. These include regional comparisons of wage and unit labor cost developments, and standard indicators based on price and cost-based measures of the real effective exchange rate (REER). In addition, the paper discusses actual export performance and market shares, profitability indicators, and business survey results. The equilibrium exchange rate is estimated. The paper also analyzes financial sector regulatory governance in Hungary.

I. External Competitiveness in Hungary: A Brief Review of Indicators1

A. Introduction

1. Concerns about the competitiveness of the Hungarian economy emerged in recent years, in the context of rapidly increasing real wages, exchange rate appreciation, and a large current account deficit. Year-average real wages for the whole economy increased by about 10 and 13 percent in 2001 and 2002, respectively. This reflected the huge rises in the minimum wage in those years (over 90 percent), the high salary increases granted to the public sector in 2002 (50 percent for most employees), and the associated spillover into the private sector. Also during 2001–02, the forint appreciated sharply against the euro, raising concern about Hungary’s exports inside and outside the euro area, with the euro having started to strengthen against the U.S. dollar. While the current account deficit expanded from 6.2 percent of GDP in 2001 to 8.9 percent in 2003, net foreign direct investment (FDI) fell sharply, further raising concerns about the impact of deteriorating competitiveness on the current account and its sustainability in the medium term.2

2. That being said, the deterioration of competitiveness appears to have reversed during 2003. The forint depreciated by about 11 percent against the euro. Moderating wage growth in manufacturing, alongside steady improvements in productivity in that sector, further contributed to competitiveness gains. Despite the slow recovery of the external demand (especially from EU countries), export growth increased sharply in the second half of the year.

3. As no comprehensive method to assess competitiveness is available, this paper examines recent developments in a range of indicators. These include regional comparisons of wage and unit labor cost (ULC) developments, and standard indicators based on price and cost-based measures of the real effective exchange rate (REER). In addition, the paper discusses actual export performance and market shares, profitability indicators, and business survey results. The equilibrium exchange rate is also estimated. Recognizing that assessing competitiveness and the equilibrium exchange rate is fraught with difficulties, Appendix I highlights some shortcomings of individual indicators.

B. Wages and Unit Labor Costs—A Regional Comparison

4. On balance, gross wages in Hungary do not seem seriously out of line with regional competitors. In manufacturing, they were lower than the average for the Czech Republic, Poland, and Slovakia (CECs) until mid-2001 (Figure 1).3 Thereafter, Hungary wage growth increased faster than in the other CECs, before moderating in 2003. Of course, comparing wage levels across countries has problems because of different coverage, survey methods, and normal statistical error.4 That being said, the data suggest wages were only modestly higher than the average end-2003.

Figure 1.
Figure 1.

Hungary and other CECs: Gross Wages in Manufacturing, 1999-2003

(In euros, seasonally adjusted)

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Country authorities; and Fund staff calculations.1/ Unweighted average for the Czech Republic, Poland, and the Slovak Republic.

5. Taking into account differences in labor productivity, the conclusion that wages do not seem seriously out of line still seems to hold. As shown in Figure 2, although ULCs in Hungary relative to the other three CECs increased in 2001 and 2002, the decline in 2003 brought relative ULCs back to the level in the second half of 2001. The Magyar Nemzeti Bank, (MNB) has noted that wage moderation and increased productivity growth in Hungary, reflecting the pick up in manufacturing activity, alongside a decreasing number of employees, contributed to the decline in Hungarian ULCs.5

Figure 2.
Figure 2.

Hungary: Relative Unit Labor Costs, 2000-2003 1/

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Country authorities; and Fund staff calculations.1/ Hungary’s ULCs relative to the weighted average (export flows in goods from 1997-2001) of the ULCs of the Czech Republic, Poland and Slovakia.

C. Traditional Effective Exchange Rate Indicators

6. After depreciating for most of the nineties, the nominal effective exchange rate (NEER) appreciated substantially during 2001–02 (Figure 3). This occurred on the heels of the change in May 2001 in the monetary and exchange rate framework operated by the MNB—with the widening of the exchange rate band as the disinflation effort was stepped up. The nominal appreciation of the currency was, however, only one of the reasons for the appreciation of the pricebased real effective exchange rates, which started as early as 1999 and also reflected the positive inflation differential between Hungary and its trading partners.

Figure 3.
Figure 3.

Hungary: Price- and Cost-based REER, 1993-2003

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Hungarian authorities; and Fund staff calculations.

7. Part of the appreciation of the CPI- and the PPI-based REERs since 1999 can be attributed to equilibrium effects, which do not necessarily imply a loss in competitiveness. Estimates of the Balassa-Samuelson effect for different transition countries vary widely. For Hungary, the MNB estimated that historically the Balassa-Samuelson effects were in the range of 1 to 2 percent, suggesting that a significant part of the observed real appreciation of the price-based indicators was due to equilibrium effects6

8. Nevertheless, the appreciation of the ULC-based REER over the period 2001–02 showed a significant loss in competitiveness, albeit from a comfortable level.7 The appreciation of about 20 percent over this period reflected the substantial increases in wages in 2001 and 2002, accompanied by slower productivity growth, as evidenced by the steeper increase of the ULC-based REER compared with the NEER over the same period.

9. More recent developments in the ULC-based REER suggest a return to a broadly competitive level at end-2003. A weaker nominal exchange rate, and improved productivity growth in manufacturing somewhat in excess of wage growth, resulted in a depreciation of the ULC-based REER. In the third quarter of 2003, when the exchange rate was at Ft 260 per euro, the ULC-based REER was at about the same level as at end-1995 (Figure 4). This was a year in which the current account deficit was close to 4 percent of GDP (excluding reinvested earnings) and real export growth was very strong.

Figure 4.
Figure 4.

Hungary: ULC-Based REER, 1995-2003

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Hungarian authorities; and Fund staff calculations.

10. To shed some light on the conditions under which Hungary might strengthen or at least maintain its recently regained competitiveness position, the impact of different wage increases on the ULC-based REER is considered. Three scenarios are presented to quantify the impact of different assumptions on wage increases. The main assumptions are spelled out in Table 1, and Figure 5 shows the results. Under the baseline scenario, wages are assumed to grow by 8 percent in 2004, in line with the nominal gross wage increase for the private sector recommended by the National Interest Reconciliation Council (NIRC).8

Table 1:

Main Assumptions for ULC-based REER Projections

article image
Figure 5.
Figure 5.

Hungary: ULC-Based Real Effective Exchange Rate, 1999-2005 1/

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Hungarian authorities; and Fund staff calculations.1/ To facilitate estimates and projections of the ULC-based REER, this index was constructed for a subset of partner countries for which ULC data are more readily available. The group of countries, which accounts for the vast majority of Hungarian trade, comprises Austria, Belgium, France, Germany, Italy, Japan, the Netherlands, Switzerland, the United Kingdom, and the United States.

11. Under the baseline scenario, which also assumes a 6 percent wage increase in 2005, Hungary would show modest gains in competitiveness. By end-2005, the depreciation in the ULC-based REER would be by approximately 1½ percent compared with its end-2003 value. By comparison, under the more unfavorable scenario, the ULC-based REER would appreciate by 4 percent over this period (but would stabilize if the forint were at about Ft 270 per euro); and would depreciate by more than 6 percent under the more favorable scenario (stabilizing at an exchange rate of about Ft 245 per euro).

D. Export Performance, Market Share, and Profit Margin Indicators

12. Actual export performance has been improving. After increasing at double digits for several years, real export growth started to decline in 2001 (Figure 6). Reflecting lower external demand and the deterioration in competitiveness, export growth was sluggish through mid-2003. In contrast, export growth sharply increased in the second half of 2003, despite the slow recovery of the EU economies (in particular of Germany, Hungary’s major trading partner).9 The pick up in export growth seemed to be helped partly by the capacity of the Hungarian economy to shift activity from more labor intensive industry, such as light manufacturing, to less labor intensive activity, such us machinery assembling and car production (Table 2).

Figure 6.
Figure 6.

Hungary: Export Volumes, 1999-2003

(Year-on-year growth, in percent)

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Country authorities; and Fund staff calculations.
Table 2.

Commodity Pattern of Exports, 2001-03

(In percent of total exports)

article image
Source: Hungarian authorities.

13. Hungary has been very successful in penetrating the EU market. Until 2001, the country increased its share at a faster pace than the CECs’ average export share in the EU market (Figure 7). The relatively slower pace after that would be consistent with Hungary being in a more advanced stage in the convergence process towards the “natural” export share in the EU market. In fact, as shown by Jakab et al. (2001), Hungary was faster in the integration process than other CECs (Poland and the Czech Republic), approaching its potential trade flows already in 1997. This would help explain the faster pace of the other CECs in penetrating the EU market in more recent years, as they were catching up in the convergence process. The relative slowdown in market penetration may, of course, also have reflected some loss of competitiveness. However, the most recent data show this tendency reversing in the second half of 2003, suggesting competitiveness is again improving. Looking at other competitors in the EU market, Hungary increased its EU export market share much faster than the Asian countries until 2000; afterward its share increased approximately at the same pace.

Figure 7.
Figure 7.

Hungary: Market Shares, 1999-2003

(In percent)

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Direction of Trade Statistics; and Fund staff calculations.1/ The CECs include the Czech Republic, Hungary, Poland, the Slovak Repubic, and Slovenia.2/ Includes Bangladesh, Cambodia, China (Mainland, Hong Kong and Macao), India, Indonesia, Korea, Malaysia, Mongolia, Myanmar, Pakistan, Philippines, Singapore, Sri Lanka, Thailand, Tuvalu, and Vietnam.

14. Further evidence of a recent gain in competitiveness in the second half of 2003 comes from the fact that the pick up in exports and the increase in EU market share were accompanied by higher profit margins (Figure 8). While it is difficult to determine an appropriate benchmark for the level of profitability as proxied by the indicator used in the paper, profitability is clearly getting stronger. That indicator—the ratio of wage costs per employee to value added (in current prices) per person in manufacturing—suggests that, after declining for more than two years, profit shares increased in mid-2003. 10 Moreover, after two years of negative expectations, exporting firms in mid-2003 started to expect a positive change in export profitability (Figure 9), while also indicating that export profitability rose in 2003. 11

Figure 8.
Figure 8.

Hungary: Ratio of Wage Costs to Value Added, 1992-2003 1/

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Country authorities; and Fund staff calculations and estimates.1/ Data for 2003 are estimates.
Figure 9.
Figure 9.

Hungary: Changes and Expected Changes in Export Profitability, 1999-2004 1/

Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Source: Business survey “Report on the Business Climate of the Top 1500 Exporting Manufacturing Firms, 2004/1” by TARKI.1/ Data refer to the balance statistics indicating the difference between the share of ‘improving’ and the share of ‘deteriorating’ answers.

E. Equilibrium Real Effective Exchange Rate

15. This section reports the estimation results for the equilibrium exchange rate in Hungary, using the CPI-based REER. The estimation is based on a theoretical framework that incorporates two possible effects of real convergence on the equilibrium exchange rate. The first is the productivity convergence that, through the Balassa-Samuelson effect, would be associated with a real exchange rate appreciation, justified by the income and productivity gaps that Hungary still experiences with respect to the more advanced EU countries. The second is rooted in international and growth economics and relates to capital inflows and external disequilibria. The accumulation of current account deficits translates into an increasing burden of net foreign liabilities, which generate an increasing burden on the external current account that may lead to a disequilibrium that would eventually require an exchange rate adjustment.12 It is important to highlight that capital inflows, competitiveness gains, and productivity convergence are intertwined. On one hand, the return on capital in low-income countries with good economic prospects is expected to be higher than in mature economies, so that capital inflows are driven by expected productivity gains. On the other end, real productivity increases are the most powerful source of competitiveness gains, so that they would moderate the required exchange rate depreciations to deal with the increasing burden debt. These two fundamentals, which are associated with the internal and external equilibrium of an economy, are used to determine the real exchange rate:


where nfa represents the net foreign assets position and prod represents relative productivity differentials between the country and abroad. Estimation of the equilibrium exchange rate is then based on an unobserved components decomposition in a cointegration framework (the derivation of the model, the econometric framework, the data, and the results are described in Appendix II). The presence of a cointegration relationship is interpreted as evidence of a time-varying equilibrium exchange rate (Appendix III).13

16. The results (Figure 10) suggest that the equilibrium REER appreciated significantly since 1995 and that, after a protracted period of undervaluation, the REER started to be overvalued at end-2000. Over the sample period, from the first quarter of 1995 to the third quarter of 2003, the equilibrium exchange rate appreciated by almost 30 percent. The determinants of the equilibrium exchange rate suggest that this behavior reflected the pattern of productivity in the tradable sector relative to the nontradable one, and the accumulation of net foreign assets. After a protracted period of undervaluation, at the end of 2000, the REER started to appreciate with respect to its equilibrium rate and maintained an overvalued position for more than two years. These results would be in line with the findings of other recent studies of the equilibrium real effective exchange rate, including studies at the MNB, which show an overvaluation in a range of 2 to 10 percent in 2002 (Csajabok (2003) and Alberola (2003), among others).

Figure 10.
Figure 10.

Hungary: Real Effective Exchange Rate (REER) and Its Equilibrium (EREER), 1995-2003 1/ 2/


Citation: IMF Staff Country Reports 2004, 146; 10.5089/9781451817935.002.A001

Sources: Country authorities; and Fund staff calculations.1/ Seasonally adjusted data.2/ REER is calculated using data for 74 percent of the partner countries considered in the compilation of the REER published in the IMF International Financial Statistics.3/ An REER above the EREER indicates overvaluation.

17. After maintaining an overvalued position for more than two years, in the third quarter of 2003 Hungary’s REER appeared to be broadly aligned with its equilibrium rate. Although the results must be interpreted with considerable caution, given the limited availability of data, other statistical weaknesses, and other drawbacks highlighted in Appendix I, they seem to be consistent with the picture that emerges from the other indicators. At the end of 2000, according to the estimates here, the REER started to appreciate and was overvalued for more than two years, reaching a peak of overvaluation of more than 7 percent in the first quarter of 2002. Subsequently, the misalignments of the REER with respect to its equilibrium became smaller.

F. Concluding Remarks

18. Hungary’s external competitiveness deteriorated significantly in 2001-02. This is consistent with a range of indicators.

19. Also drawing on a range of indicators, competitiveness, having improved significantly during 2003, seemed to be approaching a broadly adequate level toward year end. In this regard, some comfort can be taken from the fact that the deterioration in 2001-02 was from a very comfortable level. Some comfort can also be taken from the improved outlook in the external current account deficit—though this also depends importantly on sustaining fiscal adjustment—and anecdotal evidence of rising FDI (for example, to expand existing production facilities and to use Hungary as a regional center). Estimates of the equilibrium REER, while not without several caveats, suggest the REER may have been close to its equilibrium in third quarter of 2003.

20. While positive signals are present, an appropriately competitive economy requires sound policies. Particularly important is wage moderation, with a view to avoiding wage growth out of line with productivity developments. The Government has an important role to play in this connection by showing the importance it attaches to wage moderation through its public sector wage policy—reflecting the need for durable fiscal adjustment over the medium term and as a signal to the rest of the economy. Moreover, with an appropriately competitive economy, Hungary would be in a good position to take advantage of the new trading opportunities that EU enlargement might offer.


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APPENDIX I: Hungary—Pros and Cons of Commonly–Used Indicators of Competitiveness

Real exchange rate indicators

1. The CPI-based measure is widely available, facilitating comparisons with other countries. It is also a broad-based indicator, including both goods and services. The main drawbacks are that such indices include a large number of nontraded goods and services, and exclude intermediate goods, which are an important component of traded goods; and the representative basket will vary across countries. In transition countries, the CPI can also be significantly affected by price liberalization and adjustments of administered prices.

2. The PPI-based measure retains the disadvantage that the basket varies across countries. However, the items in each basket are typically more representative of traded goods, including traded intermediate goods. But the PPI-based measure may not be a good measure of competitiveness as companies can price to market by squeezing profits in the short run.

3. The ULC-based measure is often thought to be the most appropriate for use as a competitiveness measure, because labor costs are an important component of production costs. But the measure misses some important aspects of actual production costs; a fall in unit labor costs that results from the substitution of capital for labor, for example, need not necessarily signal an improvement in underlying competitiveness. The measurement of productivity that underlies the ULC-based measure is difficult in practice, especially when used as a basis for cross-country comparisons, and typically highly sensitive to variations in the economic cycle.

4. The main difference between price- and ULC-based REERs stems from the Balassa-Samuelson effects, which should produce steady but sustainable increases in CPI-based REERs, but affect ULC-based REERs for manufacturing, where traded goods weigh heavily, relatively little. The usefulness of REER measures is can be according to their ability to explain actual trade flows. Marsh and Tokarick (1994), for example, find that for a range of advanced countries, trade flows are most closely correlated with ULC-based REER measures.

Profit share indicators

5. A measure of relative profit shares in the tradable-intensive sector of the economy is given by the ratio of wage costs per employee to value added (in current prices) per person in manufacturing. As opposed to the ULC-based REER, this indicator takes into account variations across countries in the price of tradable output (Lipschitz and McDonanld, 1991). However, this measures has some drawbacks. First, relative profit shares in manufacturing are not a good guide to differences in the rate of return on capital if there are significant differences in production technology. Comparison of profit shares between countries at roughly similar stages of development should be more meaningful, although different product mixes can distort level comparisons. Second, the aggregate indicators could hide large differences in profit shares within manufacturing industry.

6. Macro model-based and/or econometric estimates of equilibrium exchange rates. These techniques attempt to estimate time-varying equilibrium exchange rates as a function of economic fundamentals. The results from their application to transition countries need to be interpreted with particular caution due to structural changes in the relationships and the limited availability of long data series.

APPENDIX II: Hungary—Estimation of The Equilibrium Real Exchange Rate

1. The concept of long-run or equilibrium real exchange rate (EREER) has been widely addressed in the literature. One standard and traditionally used method of assessing currency evaluation is the purchasing power parity (PPP) hypothesis. This approach implies a constant equilibrium exchange rate, as it posits that there is an underlying tendency for movements in the nominal exchange rate to offset inflation differentials with country’s trading partners, such that deviations from the EREER will be transitory. However, long-run exchange rate deviations from its PPP equilibrium can be induced by several factors. Among others, technical progress, or more specifically, productivity differentials, which change the relative prices of tradable to nontradable goods in the economy, and the lack of perfect substitution between tradable goods produced in different countries. As a results, two main lines of research on determination of the real exchange rates were developed. The first emphasized the sectoral (tradable-nontradable) balance of the economy and the second dealt with the underlying net foreign assets position of the country.

2. In a given economy, productivity growth in the open or tradable goods sector is usually higher relative to that of the closed or nontradable goods sector. Under perfect labor mobility, wages tend to be roughly the some across sectors, and hence faster productivity growth in the tradable goods sector pushes up wages in all sectors. This in turn increases the prices of nontradable goods. As a result, in a two economy world, inflation would be higher in the economy with higher productivity growth, which would experience a secularly appreciating CPI-based real effective exchange rate. This is the Balassa-Samuelson hypothesis stripped to its bare essentials.

3. Whereas the Balassa-Samuelson hypothesis assumes that tradable goods produced in any two countries are perfect substitutes, and hence that the nominal exchange rate adjusts to changes in tradable prices in order to equalize prices when measures in a common currency, the lack of perfect substitution between traded goods may also lead to deviations from the PPP. Theories in this area have focused on the trade balance as the main determinant of the exchange rate, with capital flows being treated as exogenous shocks. With financial liberalization and the increasing volume of international trade in financial assets, modern exchange rate models emphasize financial-asset markets and the role of the exchange rate as one of many prices in the worldwide financial markets. Following these theories, the trade flows have still a useful role in asset-approach models, since trade flows have implications for financial-asset flows. In fact, the exchange rate must be consistent with a balance of payment position where a current account is financed by a sustainable flow of international capital. A country running a current account deficit or surplus will accumulate or de-cumulate net assets, and such imbalances would be due to the relevant propensities to save and invest in the respective countries, and it is assumed that such factors are not influenced by exchange market developments. In the long run, however, when agents’ assets are at their desired level, the current account should be balanced ((Mussa 1984), Frenkel and Mussa (1985)).

The Theoretical Framework and the Empirical Model

4. The model used follows that developed by Alberola and et al. (2002) and is based on the decomposition of the exchange rate into two different relative prices, the price of domestic relative to foreign tradable goods, and the relative prices of nontradable goods relative to tradable goods within each country. The first component captures the competitiveness of the economy and determines the evolution of the net foreign assets position, and it is therefore associated with the external equilibrium of the economy. The second component incorporates the concept of productivity differentials as in the Balassa-Samuelson hypothesis, and since these prices determine the allocation of resources within the economy, it is associated with the internal equilibrium of the economy. The long-run solution of the model represents an equilibrium value for the real exchange rate consistent with the internal and the external equilibria of the economy.

5. Assuming that there are two countries in the world, each producing a tradable good (T) and a nontradable good (N), the REER (q) in logarithm terms can be defined as


where p and p* are the domestic and the foreign consumer price indices (CPI), respectively, and s is the nominal exchange rate. For each country, the CPI, which is formed by prices of domestic and foreign tradable goods and nontradable goods, can be expressed as follows


where the as determine the share of each good in the consumer price index. Substituting these expression in (1), we obtain


where the weights of nontradable goods for the two countries are assumed to be the same, and the lack of perfect substitution between tradable goods between different countries is also considered. The latter expression indicates that the exchange rate is determined by two different components: the evolution of relative prices of domestic to foreign tradable goods, qx=(pT+spT*), which reflects the external dimension of the economy; and the behavior of nontradable goods relative to tradable goods across countries, q1=[(pNpT)(pN*pT*)], which relates the internal dimension of the economy. Thus, the equilibrium exchange rate (q¯) implies both external and internal equilibrium.

6. The external equilibrium. The external balance clears the tradable goods market, and is characterized by the achievement of a desired stock of net foreign assets. The evolution of the current account balance, which determines adjustments to the equilibrium, leads to an accumulation of net foreign assets. The current account balance (ca) is defined as the trade balance (x) plus the net income received or paid by residents (r*) on foreign asset holdings (nfa):

ca=x+r*nfa expressed in real terms. The trade balance depends on the evolution of the external real exchange rate,14 namely x=-γqx, and the current account adjusts to the difference between the current and the desired level of net foreign assets (Mussa (1984)), so that a current account surplus would reflect a net foreign asset position below the desired level


In the long run, and the equilibrium external exchange rate can be defined as follows


where the bars over the variables indicate long-run equilibrium values.

7. The internal equilibrium. The evolution of the internal real exchange rate is determined by the different behavior of sectoral relative prices between countries, which in turn are related to the evolution of sector productivity. Starting from the productivity

hypothesis, it can be shown that p¯Np¯T=μ+(prodTprodN)

where the prod’s are the average sectoral productivities. Neglecting constant terms, it follows that the equilibrium internal exchange rate can be expressed as follows


8. Putting together the external and internal equilibria concepts produces the equation for the equilibrium REER:


where v is speed of adjustment of net foreign assets to changes in relative prices, (k-k*) is the difference between measures of relative sector productivity at home and abroad ((where k=prodTprodNand k*=prodT*prodN*),and (z-z*) = demand shocks

9. The empirical model. The theoretical model has identified two main determinants of the real exchange rate (q) in the long-run: the stock of net foreign assets (nfa) and the relative sectoral productivities between countries (prod) and could be rewritten in the following form by factoring nfa:


10. In this form the equilibrium real effective exchange rate is a function of three variables, nfa, the difference between measures of relative sector productivity at home and abroad, and demand shocks. Abstracting from demand shocks we obtain our empirical model:


11. Since the main objective is to compute the equilibrium exchange rate as a function of its fundamentals, first the existence of a long-run relationship among the variables has to be established, and second the equilibrium levels of the determinants nfa and prod must be estimated. In order to determine the existence of a long-run relationship among variables (i.e. to test for cointegration), the Johansen procedure for cointegration is applied. To establish the equilibrium level of the REER, qt is assumed to fluctuate around its long-term value, but it is not permanently at that value. Moreover, in order to derive the equilibrium exchange rate, nfat and nt are allowed to deviate from their long-run values. From an empirical point of view, the three variables in the system are decomposed into transitory [q^t,nf^at,pro^dt] and permanent components [q¯t,nf¯at,pro¯dt], with the latter capturing the equilibrium of the system:


12. Bearing in mind that a unique decomposition between permanent and transitory components does not exist (see among other Maravall (1993) and Quah (1992)), the decomposition by Gonzalo and Granger (1995) is considered. The latter is based on the assumption that shocks to the transitory component (i.e., misalignments) do not affect the permanent component (i.e., the equilibrium).

13. Gonzalo and Granger (1995) derive a decomposition where the transitory component does not Granger-cause the permanent component in the long run and where the permanent component is a linear combination of contemporaneous observed variables. In other words, the first restriction implies that a change in the transitory component today will not affect the long-run values of the variables. The second restriction makes the permanent component observable and assumes that the contemporaneous observations contain all the necessary information to extract the permanent component. The decomposition is done using the identification implicit in the cointegration of the series. In particular, if cointegration exists amongst a number of variables, then the vector will have a common, or factor, decomposition (Stock and Watson (1988)). Gonzalo and Granger demonstrate that the common factor can be estimated if it is assumed to be a linear combination of the series under analysis and if it is further assumed that the residuals from this model do not have a permanent effect on the original series. The former assumption makes the common factor observable, while the second permits identification.

14. Analytically, consider a 3×1 vector xt=[qt, nfat, prodt], which under the null hypothesis of one cointegration vector admits the following representation:


where et is a vector white noise process with zero mean and variance Σ and Π is a 3×3 matrix, whose rank will determine the number of cointegration vectors. If cointegration exists, ∏ is not full rank (r<3, with r=1 in our case) and can be written as the product of two rectangular matrices, ∏= αβ, where β is the matrix whose columns are the linearly independent cointegrating vectors and α is the factor-loading matrix, indicating the speed with which the system responds to last period’s deviation from the equilibrium level of the exchange rate. Next, one can always define the orthogonal complements α and β as the eigenvectors associated with the unit eigenvalues of the matrices (I-α(αα)-1 α) and (I-β(ββ)-1β), respectively. The matrix α is formed by the vectors defining the space of the common stochastic trends, and therefore should be informative about the key “driving” variable(s) in each of the systems, while β gives the loadings associated with, i.e., the series which are driven by the common trends. Notice that αα=0 and ββ=0. If the vector x is of reduced rank, r, Gonzalo and Granger have demonstrated that the elements of x can be explained in terms of a smaller number of (3- r) of I(1) variables called common factors, ft, plus some I(0) components, the transitory elements, xt^:


15. The identification of the common factors may be achieved in the following way. If it is assumed that the common factors are linear combinations of the variables xt:


and if A1ft and x^t form a permanent-transitory decomposition of xt, then from the representation in (1), the only linear combination of xt such that x^t has no long-run impact on xt is:


16. This identification of the common factors allows to obtain the following permanenttransitory decomposition of xt


where the permanent and the transitory components are captured by the terms β(αβ)-1αxt and α(βα)-1βxt, respectively. Gonzalo and Granger (1995) show that the transitory components defined in this way will not have any effect on the long-run values of the variables captured by the permanent components. The identification of the permanent component with the equilibrium implies that




from where the estimation of the equilibrium exchange rate and its deviation directly follow.

The Data

17. The time period under consideration is 1995Q1-2003Q3 and data are quarterly (seasonally adjusted). The three following variables have been used in the analysis:

Real effective exchange rate (qt): CPI-based real effective exchange rate of the forint relative to a group of trading partners that represents the vast majority of Hungarian trade. The group comprises Austria, Belgium, Denmark, France, Germany, Italy, The Netherlands, Poland, Spain, and The United Kingdom.15 The variable is expressed in logarithms.

Net foreign assets (nfat) position is calculated by adding up the current account balances. The initial stock of net foreign assets is 1997Q1, as provided by the international investment position published by the MNB. The net foreign assets position is normalized by the GDP.

Relative sectoral productivities (tradable to nontradable goods) (prodt) are defined as the ratio of the labor productivity index of total industry without construction relative to the productivity index for the rest of the economy relative to the corresponding weighted average of partner country ratios, using the same weights as the ones applied to qt.16 The data source is Eurostat. The variable is expressed in logarithms.

Econometric results

18. The econometrics results are illustrated in Figure 10. The top panel reports the historic series of the real effective exchange rate and its equilibrium. The bottom panel displays the deviations from the equilibrium exchange rate along with the computed 95 percent standard error bands.17

19. On the basis of the cointegration results (Table), there is evidence of one significant cointegration vector for the system regarding the real effective exchange rate, the net foreign assets position and the relative productivity differentials. It must be noticed that the coefficient of the relationship are positive as expected.


Hungary. Cointegration Analysis Results

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20. The adjustment (or loading vector) associated to the cointegration vector is also reported in Table 1. The negative α coefficient in the exchange rate equation indicates that the exchange rate moves to close the gap of a disequilibrium by approximately 50 percent every approximately 14 quarters, or that most of the adjustment to a shock to the real exchange rate will be offset after almost seven years.

APPENDIX III: Hungary—The Concepts of Equilibrium and Integration and Cointegration

1. This appendix illustrates the link between the concept of economic equilibrium to those of integration and cointegration in time series econometrics.

2. Starting from the theory of the relative purchasing power parity (PPP), the derived equilibrium real exchange rate (q¯) would be:


3. In practice, this does not mean that the real exchange rate must be equal to its equilibrium value at every time period. Considering instead the following model for the real exchange rate (qt)


where vt captures all the stochastic properties of the real exchange rate at time t, one would expect that on average the real exchange rate be equal to its equilibrium value µ, that is


where E(.) is the expectations operation, with a bounded limit to the deviations of qt from µ, that is


4. This condition also ensures that, when qt at a given period is far from its equilibrium value µ, there will be a tendency for qt to approach µ in the next period. Notice that if vt follows a stationary process, I(0), then it will satisfy conditions (2) and (3). When those conditions are met, µ can be considered the equilibrium value of q.

5. Consider now that vt is better described by the following process


where for simplicity ηt is white noise with zero mean and variance σ2η, then




6. From expression (4) it follows that, as t increases, the variance of qt increases without bound, which in turn implies that qt may drift away from µ without bound. In other words, as time goes on, any value of qt would be feasible and therefore it does not make sense to talk about constant equilibrium.

7. Variables that are not stationary in levels but are stationary in differences are called integrated of order one, I(1). They have the characteristic of not returning to a constant equilibrium mean value. This characteristic does not necessarily imply that an equilibrium value does not exist, but instead that this equilibrium may be time varying.

8. Consider, for example, the model in Appendix II, with


where the bar indicates the fundamental of long-run equilibrium values of nfa and prod. Assume also that, although vt in expression (1) is I(1), one could express it as


9. Neglecting the constant term in expression (1), the actual real exchange rate would then follow:


if ut is I(0), then q will fluctuate around β1nfat + β2prodt, and a sensible hypothesis is that the equilibrium exchange rate is given by nfa and prod. In such a case, one would say that q, nfa, and prod are cointegrated with cointegration vector [1 -β12]. If on the contrary ut is I(1) then q might shift apart without bound from the linear combination given by nfa and prod. In such a case, one would say that q, nfa, and prod are not cointegrated and that this equilibrium hypothesis does not apply.

10. It is important to notice that, differently from the PPP theory, under which after a real exchange rate overvaluation one would expect an undervaluation of the same amount, time varying equilibria add the complication of future developments in the determinants of q (in this case nfa and prod). For example, a consistent finding would be that a currency is overvalued in time t+1, when at time t was undervalued and in time t+1 its observed real exchange rate remains unchanged. A reason for this finding is that the long-run value of the controlling variables has changed. Therefore, with a time-varying equilibrium, one would have to infer not only the likelihood of a movement due to the misalignment at time t, but also the possibility of changes in the long-run equilibrium values at time t+1. As a consequence, the degree of misalignment at a given time period may give only partial information on the misalignment in the next period. Based on the same argument, a currency that is showing a sustained appreciation (depreciation) could still be undervalued overvalued).


Prepared by Stefania Fabrizio.


These figures incorporate the new methodology, introduced at end-March 2004, for calculating FDI-related income and include reinvested earnings.


Slovenia is not included in the analysis because its gross wage and productivity levels, which are much higher than the ones in the other CECs, are thought to distort the comparison.


Eurostat has conducted a labor costs survey and tried to calculate monthly labor costs for EU countries and acceding countries on a comparable basis. However, data are available only for 2000. They showed that labor costs in Hungary were about at the same level as in the Czech Republic, much lower than in Poland, and higher than in Slovakia.


Quarterly Inflation Report, February 2004.


A 2001 Selected Issues paper examined external competitiveness in earlier years, and based on a range of indicators, concluded that Hungary was highly competitive at end-2000.


The NIRC is a tripartite group representing the government, employers, and employees.


Export growth continued to be strong into 2004. In January, real exports were 18.4 percent above their level in the previous year.


Based on the results of a detailed sectoral data analysis by the MNB (Report on Financial Stability—December 2003), manufacturing profitability stopped declining already in 2002.


This is based on the results of a periodic business survey among 1500 exporting manufacturing firms conducted in January 2004 by TARKI and sponsored by the Ministry of Finance and the Ministry of Foreign Affairs. The survey is conducted twice a year.


For a discussion of the balance of payments approach to the determination of the equilibrium exchange rate see, for example, Mussa (1984).


The power of cointegration tests is dependent on the length and time span of the time series available for estimation. The length available in the case of Hungary is limited and, therefore, results must be interpreted with caution.


An appreciation of the external exchange rate (qx>0) will worsens the competitiveness of the domestic products and consequently the trade balance, when the Marshall-Lerner condition holds.


The selection of partner countries was based on data availability.


From a theoretical point of view, total factor productivity should be considered, but due to the unavailability of reliable data for such a variable, data for labor productivity are used in the analysis.


Inspection of this panel suggests that the hypothesis that the real effective exchange rate was in equilibrium over the sample period cannot be rejected.


  • Quintyn, M., and M. W. Taylor, 2002, “Regulatory and Supervisory Independence and Financial Stability,IMF Working Paper 02/46, (Washington: International Monetary Fund).

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  • Udaibir S. Das, and M. Quintyn, 2002, “Crisis Prevention and Crisis Management: The Role of Regulatory Governance,IMF Working Paper 02/163, (Washington: International Monetary Fund).

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  • International Monetary Fund, 2002, Hungary: Financial System Stability Assessment Follow-up, including Reports on the Observance of Standards and Codes on the following topics: Monetary and Financial Policy Transparency, Banking Supervision, Securities Regulation, Insurance Regulation, and Payment Systems, IMF Country Report No. 02/112 (June).

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APPENDIX I: Aspects of Regulatory Governance 1/

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Sources: ECB, IMF, and national authorities’ websites.

Countries in sample are those with banking supervision authority outside of central banks. The following abbreviations have been used throughout the table, unless otherwise stated: CB is Central Bank, FSA is Financial Supervisory Authority, Dy. is Deputy, PM is Prime Minister, Gov. is Governor, Govt. is Government, HMT is Her Majesty’s Treasury, Parliam. is Parliament, Mngmt. is Management, MoEA is Minister of Economic Affairs, MoF is Minister of Finance, MoU is Memorandum of Understanding, Rep. is representatives/representing.

Very little information available on Denmark FSA. N.A. refers to unavailability of information.

Finland has two institutions responsible for supervision—the Finnish Financial Supervision Authority and Insurance Supervision Authority. There have been some recent amendments to the Act, but information on these is not available in English.


Prepared by P. Drummond (EUR), P. Madrid (MFD), and S. Mitra (MFD)


MNB has statutory responsibility for promoting stability of the financial system and the development of policies related to the prudential supervision of the financial system.


Article 1/A (1) c. The definition of “shortcoming” is not provided in the Act. The meaning of “to finish” is somewhat ambigious in this context, but seems to imply “to end” rather “to complete” the practice.


These agencies were chosen as the relevant peer group as supervisors within central banks may enjoy the independence from Government often granted monetary authorities. As this raises different issues from those examined in the Hungarian context, the focus of this paper is on agencies outside of central banks.


Typically non-executive bodies monitor financial accountability (e.g., budgets, financial statements, and internal controls), although the duty to assess efficiency is not always specified. FSAs with non-executive boards include those in Austria, Belgium, Estonia, Finland, Germany, Luxembourg, and the U.K.


This section is based on the analysis of Quintyn and Taylor (WP/02/46) and Das and Quintyn (WP/02/163).


See Das and Quintyn (D&Q), pp.7–8 and pp. 17–19, and Quintyn and Taylor (Q&T), pp. 27–30.


Features of independence, accountability and transparency are summarized below. Integrity reflects the mechanisms that ensure that staff can pursue institutional goals without compromising them to self-interest. See D&Q, pp. 8–12, for a fuller discussion of these elements of regulatory governance.


Core Principle 1 include CP 1.1: clear responsibilities and objectives; CP 1.2: operational independence; CP 1.3: suitable legal framework—grant/withdraw license and set rules; CP 1.4: suitable legal framework—enforcement; CP 1.5: suitable legal framework—supervisor legal protection; and CP 1.6: information sharing. See Q&T for a discussion of the features of independence.


MFP Code assessments that deal with accountability, include in particular: 5.1.3: broad modalities of accountability; 4.2: explain objectives and performance to public; 8.1: appear before a designated public authority; 5.1.4: procedures for appointment, terms of office and removal; 6.2 and 6.4: public consultation; and 5.2: relationship between financial agencies (including MoF).


See for example Box 1 on formal arrangements in Latvia that serve as a good example.


See IMF Country Report No. 02/112, June 2002.


The current supervisory authorities of Malta, Germany, Finland, Luxembourg, and the U.K. have been assessed under the FSAP. Estonia and Latvia also had FSAPs, but the assessments were done at the time their supervisory agencies were part of their central banks, so that their current financial sector authority structures have not been assessed. Other countries in the sample reviewed may also have structures and policies consistent with principles of effective supervision and good practices in transparency, but without a formal assessment it is difficult to say how effectively these are implemented.

Hungary: Selected Issues
Author: International Monetary Fund