The Academy of Economic StudiesThe Academy of Economic StudiesThe Faculty of Finance, Insurance, Banking and Stock ExchangeThe Faculty of Finance, Insurance, Banking and Stock Exchange

Doctoral School of Finance and BankingDoctoral School of Finance and Banking

Dissertation paperDissertation paper

Real Exchange Rate Misalignments and Trade Real Exchange Rate Misalignments and Trade Competitiveness.Competitiveness.

The Case of RomaniaThe Case of Romania

MSc Student Zmeu OlegMSc Student Zmeu OlegCoordinator Professor MoisCoordinator Professor Moisăă Alt Altăărr

Bucharest 2010Bucharest 2010

I.I. The aims of the paperThe aims of the paper

1.1. Choosing the variables that determine Choosing the variables that determine the behavior of the real equilibrium the behavior of the real equilibrium exchange rate (REER)exchange rate (REER)

2.2. Estimating the equilibrium exchange Estimating the equilibrium exchange rate rate

(the BEER model)(the BEER model)

3.3. Calculating the real exchange Calculating the real exchange misalignments (RERM)misalignments (RERM)

4.4. Choosing the proxies of trade Choosing the proxies of trade competitivenesscompetitiveness

5.5. Determining the impact of RERM on Determining the impact of RERM on trade competitiveness – a VAR approachtrade competitiveness – a VAR approach

Importance of real exchange rate Importance of real exchange rate misalignmentsmisalignments

• Could be used to predict future shifts of the exchange Could be used to predict future shifts of the exchange rate (Aguirre, Calderon, (2005));rate (Aguirre, Calderon, (2005));

• May underline the need to adjust the exchange rate;May underline the need to adjust the exchange rate;

• A likely prelude to financial crisis (Krugman (1979), A likely prelude to financial crisis (Krugman (1979), Kaminsky and Reinhart (1999));Kaminsky and Reinhart (1999));

• May affect economic growth (Edwards (1989));May affect economic growth (Edwards (1989));

• May boost the economic growth, as was the case of May boost the economic growth, as was the case of Japan and Germany and more recently, China (Dooley Japan and Germany and more recently, China (Dooley et al. (2003)).et al. (2003)).

II.II. Literature reviewLiterature review

• The relationship between real exchange rate misalignments and trade The relationship between real exchange rate misalignments and trade competitiveness was predominantly conducted on countries that record competitiveness was predominantly conducted on countries that record great share of exports in GDP;great share of exports in GDP;

• Balassa (1990) explores the relationships between RERM and the Balassa (1990) explores the relationships between RERM and the exports of four African countries (Tanzania, Kenya, Ghana and Ivory exports of four African countries (Tanzania, Kenya, Ghana and Ivory Cost) during 1974 – 1981. He finds that exports are highly responsive to Cost) during 1974 – 1981. He finds that exports are highly responsive to RERM;RERM;

• Ghura and Grennes (1993) run regression between RERM and other Ghura and Grennes (1993) run regression between RERM and other macroeconomic indicators (saving, exports, investments). The result of macroeconomic indicators (saving, exports, investments). The result of their study confirm the economic theory. The exchange rate – an their study confirm the economic theory. The exchange rate – an important variable in measuring the relations with abroad.important variable in measuring the relations with abroad.

• Söderling (2000) proves that overvalued currency of Cameroon in the Söderling (2000) proves that overvalued currency of Cameroon in the 1980s were responsible for a worsening in total exports by 30 – 50%.1980s were responsible for a worsening in total exports by 30 – 50%.

• Sekkat and Varoudakis (2000) demonstrated that inconsistent Sekkat and Varoudakis (2000) demonstrated that inconsistent macroeconomic policies and RERM are responsible for overvaluation.macroeconomic policies and RERM are responsible for overvaluation.

• Fukunishi (2004) explores the relationships between real exchange rate Fukunishi (2004) explores the relationships between real exchange rate misalignments and exports competitiveness. He proves that most misalignments and exports competitiveness. He proves that most currencies of Sub-Saharan countries were largely overvalued since their currencies of Sub-Saharan countries were largely overvalued since their independence in early 1960s. Overvalued currencies discouraged independence in early 1960s. Overvalued currencies discouraged exports and accounted for a peak of 90% misalignment of exchange rate exports and accounted for a peak of 90% misalignment of exchange rate during 1980s.during 1980s.

DataData

• Quarterly data used were obtained from Eurostat. The missing Quarterly data used were obtained from Eurostat. The missing time series were obtained from the site of National Bank of time series were obtained from the site of National Bank of Romania (www.bnr.ro).Romania (www.bnr.ro).

• The period covered is Q1 2000 – Q4 2009.The period covered is Q1 2000 – Q4 2009.• All time series were seasonally adjusted using Census X12 All time series were seasonally adjusted using Census X12

method developed by U.S Census Bureau and implemented in method developed by U.S Census Bureau and implemented in EViews 6. The price indexes (CPI, export unit value, import unit EViews 6. The price indexes (CPI, export unit value, import unit value) have fixed base 2000 = 100.value) have fixed base 2000 = 100.

• The stock and flow variables (imports, exports, net foreign assets, The stock and flow variables (imports, exports, net foreign assets, final consumption expenditure of households) are normalized to final consumption expenditure of households) are normalized to GDP.GDP.

• Exchange rate RON/EUR is expressed as units of domestic Exchange rate RON/EUR is expressed as units of domestic currency per unit of foreign currency. currency per unit of foreign currency.

Choosing the “fundamentals”Choosing the “fundamentals”

The stationarity of the determinants factors was checked.The stationarity of the determinants factors was checked.• Productivity differential – stationary (not included)Productivity differential – stationary (not included)• Final Government consumption expenditure – stationary (not Final Government consumption expenditure – stationary (not

included)included)• Real interest rate differential – stationary (not included)Real interest rate differential – stationary (not included)

ADF and PP unit root tests on ADF and PP unit root tests on fundamentalsfundamentals

VAR Lag Order Selection CriteriaEndogenous variables: L_RER TOT OPEN CONS Exogenous variables: C Date: 06/09/10 Time: 21:49Sample: 2000Q1 2009Q4Included observations: 37

Lag LogL LR FPE AIC SC HQ

0 -104.81 NA 0.004212 5.881631 6.055784 5.9431 -30.0305 129.34* 0.000177 2.704349 3.575115* 3.0113*2 -13.0448 25.708 0.000173* 2.651071* 4.218451 3.20363 -0.78132 15.9094 0.000231 2.853044 5.117037 3.6512

* indicates lag order selected by the criterion LR: sequential modified LR test statistic (each test at 5% level) FPE: Final prediction error AIC: Akaike information criterion SC: Schwarz information criterion HQ: Hannan-Quinn information criterion

Choosing the VAR length Roots of Characteristic PolynomialEndogenous variables: L_RER TOT OPEN CONS Exogenous variables: C Lag specification: 1 1Date: 07/02/10 Time: 23:00

Root Modulus

0.849754 - 0.080980i 0.853604 0.849754 + 0.080980i 0.8536040.534102 0.5341020.118045 0.118045

No root lies outside the unit circle. VAR satisfies the stability condition.

VAR stability

ADF and PP unit root tests

Series

Numberofcoint.relations Eigenval. Trace test statistic

Maximum eigenvalue test statistic

     Computed

val.5% critical

val. p-val.Computed

val.5% critical

val. p-val.

l_rer opentot cons

None 0.6140 58.8722 47.8513 0.0033 36.1778 27.5844 0.003

At most 1 0.2983 22.6924 29.7907 0.2613 13.4616 21.1312 0.410

At most 2 0.1691 9.2377 15.4971 0.3441 7.0399 14.2646 0.484

At most 3 0.0561 2.1999 3.8416 0.1384 2.1959 3.8416 0.138

Johansen Cointegration Test and Vector Error Johansen Cointegration Test and Vector Error Correction EstimatesCorrection Estimates

The Johansen Cointegration Test demonstrates that there are The Johansen Cointegration Test demonstrates that there are only one cointegration relations between the variables only one cointegration relations between the variables included in the test – the null hypothesis of the existence of at included in the test – the null hypothesis of the existence of at most one cointegration relation cannot be rejected at the 5% most one cointegration relation cannot be rejected at the 5% significance level.significance level.

The fundamentalsThe fundamentals

0.9

1.0

1.1

1.2

1.3

1.4

1.5

00 01 02 03 04 05 06 07 08 09

Trend Terms of Trade

65.0

67.5

70.0

72.5

75.0

77.5

80.0

82.5

85.0

00 01 02 03 04 05 06 07 08 09

Trend Openess

60

62

64

66

68

70

72

00 01 02 03 04 05 06 07 08 09

Final consumption expenditure of houseoldsTrend

The long-run equilibrium of the The long-run equilibrium of the determinants was captured determinants was captured using the Hodrick-Prescott using the Hodrick-Prescott filter.filter.

After adjusting the cointegration vector with respect to real After adjusting the cointegration vector with respect to real exchange rate, the following expression is obtained:exchange rate, the following expression is obtained:

• All the coefficients are statistically significant.All the coefficients are statistically significant.• The increase of the terms of trade is translated into an The increase of the terms of trade is translated into an

appreciation of the real exchange rate.appreciation of the real exchange rate.• The degree of openness is positively related wit real The degree of openness is positively related wit real

exchange rate – an increase of openness determines the exchange rate – an increase of openness determines the depreciation of domestic currency.depreciation of domestic currency.

• A hike of final consumption expenditures of households A hike of final consumption expenditures of households appreciates the domestic currency.appreciates the domestic currency.

• The RERM are calculated according to the formula:The RERM are calculated according to the formula:

Table 5Table 5 - - real exchange rate (RER)real exchange rate (RER)

and equilibrium exchange rate (REER)and equilibrium exchange rate (REER)

• Periods of overvaluation: 2000 – 2002, middle of 2004 – first quarter Periods of overvaluation: 2000 – 2002, middle of 2004 – first quarter of 2008of 2008

• Periods of undervaluation: 2002 – middle of 2004, first quarter of Periods of undervaluation: 2002 – middle of 2004, first quarter of 2008 – last quarter of 20092008 – last quarter of 2009

• The positive values (values above the red line) represent The positive values (values above the red line) represent overvaluation.overvaluation.

1.0

1.1

1.2

1.3

1.4

1.5

1.6

00 01 02 03 04 05 06 07 08 09

REER RER-.08

-.04

.00

.04

.08

.12

.16

00 01 02 03 04 05 06 07 08 09

Table 6Table 6 – real exchange – real exchange rate misalignmentsrate misalignments

Measures of competitivenessMeasures of competitiveness

• Real exchange rateReal exchange rate- An increase of the RER (a depreciation) is associated with an An increase of the RER (a depreciation) is associated with an

improvement of a nation’s competitiveness, as the domestic improvement of a nation’s competitiveness, as the domestic product prices expressed in foreign currency decrease;product prices expressed in foreign currency decrease;

- On the other hand, a decrease of the RER (an appreciation) On the other hand, a decrease of the RER (an appreciation) may not necessarily imply that domestic competitiveness may not necessarily imply that domestic competitiveness worsened. It may reflect a convergence process.worsened. It may reflect a convergence process.

• Export growth and market shareExport growth and market share Drawbacks:Drawbacks:

- International trade is not a zero-sum game;International trade is not a zero-sum game;- The exports could be increased through devaluation and The exports could be increased through devaluation and

keeping wages at low levels (Porter, 1990).keeping wages at low levels (Porter, 1990).• Current account balance (criticized by Krygman, Current account balance (criticized by Krygman,

1994):1994):- Prior posting large trade deficits, many countries have run Prior posting large trade deficits, many countries have run

trade surplus in order to regain investors’ confidence (case of trade surplus in order to regain investors’ confidence (case of Mexico in the early 90s);Mexico in the early 90s);

• Production cost (cost of labour, with the well known Production cost (cost of labour, with the well known ULC);ULC);

• Global Competitiveness IndexGlobal Competitiveness Index

Merchandise export and ULC growthMerchandise export and ULC growth

• The ULC has decreased constantly since 2000, pointing towards The ULC has decreased constantly since 2000, pointing towards an improvement of domestic competitiveness.an improvement of domestic competitiveness.

• On the other hand, the merchandise exports share in GDP On the other hand, the merchandise exports share in GDP remained stable during this period at approximately 26% of GDP.remained stable during this period at approximately 26% of GDP.

0%

5%

10%

15%

20%

25%

30%

35%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

-10%

0%

10%

20%

30%

40%

50%

Merchandise exports (%GDP ) lhs. ULC growth over previous period - rhs.

VAR Lag Order Selection CriteriaEndogenous variables: EXP_GOODS_DEV REER_MISALIGNExogenous variables: C Sample: 2000Q1 2009Q4Included observations: 37

Lag LogL LR FPE AIC SC HQ

0 118.8192 NA 0.00 -6.31455 -6.22747 -6.283851 146.2434 50.40138 0.00 -7.58073 -7.3195 -7.488632 155.1665 15.43* 0.00 -7.846* -7.411* -7.69*3 159.1085 6.39238 0.00 -7.8437 -7.23416 -7.62881

* indicates lag order selected by the criterion LR: sequential modified LR test statistic (each test at 5% level) FPE: Final prediction error AIC: Akaike information criterion SC: Schwarz information criterion HQ: Hannan-Quinn information criterion

Roots of Characteristic PolynomialEndogenous variables: EXP_GOODS_DEV REER_MISALIGN Exogenous variables: C Lag specification: 1 1Date: 07/02/10 Time: 23:13

Root Modulus

0.673650 - 0.098793i 0.680856 0.673650 + 0.098793i 0.680856

No root lies outside the unit circle. VAR satisfies the stability condition.

The VAR stability

Choosing the VAR length VAR estimates

The variables included are merchandise exports deviations and the real exchange rate misalignments.

The VAR length is 1 lag and the stability condition is fulfilled.

The impulse-response function of exports merchandise deviations to shock in real exchange rate misalignments

Impulse-response function and forecast variance decompositions - important ways of assessing the relative importance of a shock in real exchange rate in accounting for variation in trade competitiveness at various time horizons.

-.02

-.01

.00

.01

.02

.03

.04

.05

2 4 6 8 10 12 14 16 18 20

Response of EXP_GOODS_DEV to REER_MISALIGN

Response to Cholesky One S.D. Innovations ± 2 S.E.

The impulse-response function shows that a positive shock in real exchange rate misalignments, perceived as an appreciation process induces an increase of merchandise exports deviations (translated into a fall of merchandise exports).

A maximum 1.8% impact of real exchange rate misalignments on merchandise exports deviations is recorded on short-run (up to 4 quarters). Also, the impact is significant on short-run. On medium and long-run the impact is decaying away, but the result is not statistically significant.

0

20

40

60

80

100

2 4 6 8 10 12 14 16 18 20

Percent EXP_GOODS_DEV variance due to REER_MISALIGN

Variance Decomposition

Variance of merchandise export deviations due to RER misalignments (%)

The real exchange rate misalignments appear to be responsible for 40% of merchandise exports’ variance on long-run.Even if considered with the short-run significance of the impulse-response, the real exchange rate misalignments determine around 20% of the variance of the merchandise exports deviations.

• I have encountered some special issues related to ULC.I have encountered some special issues related to ULC.• Even if the results obtained running the VAR approach were Even if the results obtained running the VAR approach were

inconclusive, if a Johansen cointegration were run, a inconclusive, if a Johansen cointegration were run, a cointegration relation between the variables included would cointegration relation between the variables included would results.results.

The ULC deviations have no The ULC deviations have no unit rootunit root

The Johansen cointegration test between ULC deviations and real exchange rate misalignments

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of ULC_MIS to REER_MISALIGN

Response to Cholesky One S.D. Innovations

The impulse-response function of the cointegrated VAR

The shock on real exchange rate misalignments and the ULC deviations’ response confirm the results obtained earlier: a positive shock in real exchange rate misalignments (an appreciation) determines a fall of ULC deviations (perceived as a decrease of ULC and improvement of competitiveness).

Concluding remarksConcluding remarks

• The signs of the determinants are in line with economic The signs of the determinants are in line with economic theory and the coefficients are statistically significant.theory and the coefficients are statistically significant.

• In the covered period, the real exchange rate was well In the covered period, the real exchange rate was well misaligned compared to its long-run value.misaligned compared to its long-run value.

• The real exchange rate was misaligned by 4% during The real exchange rate was misaligned by 4% during 2009.2009.

• Competitiveness is positively related to a depreciation Competitiveness is positively related to a depreciation currency.currency.

• The exports should not be encouraged through currency The exports should not be encouraged through currency depreciation. Increasing productivity and quality, depreciation. Increasing productivity and quality, becoming more competitive through prices and costs is a becoming more competitive through prices and costs is a more appropriate strategy. It could also serve as the more appropriate strategy. It could also serve as the fundament for a sustained economic development.fundament for a sustained economic development.

• The real exchange rate should stay as close as possible The real exchange rate should stay as close as possible to its equilibrium level in order to avoid the economic to its equilibrium level in order to avoid the economic distortions.distortions.

ReferencesReferences

Aguirrea, A. and C. Calderón (2006), “The Real Exchange Rate Misalignments and Economic Performance”, Central Bank of Chile, Working Paper No.315, April

Astaha, S.G. and SN. Huda (2002), ”Exchange Rate Misalignment and International Trade Competitiveness: A Cointegration Analysis for South Africa”, 2002 Annual Forum, Trade and Industrial Policy Strategies

Boltho, A. (1996), “The Assessment: International Competitiveness”, Oxford Review Of Economic Policy, Vol. 12, No.3

Driver, R. L. and P. F. Westaway (2004), “Concepts of Equilibrium Exchange Rates”, Bank of England, Working Paper No.248

Dumitru, I. (2006), “The Equilibrium Exchange Rate in Romania”, MPRA Paper No.10631, posted 19

Edwards, S. (1987), “Exchange Rate Misalignments in Developing Countries”, NBER Working Paper, No.442

Égert, B. and K. Lommatzsch (2004), “Equilibrium Exchange Rates in the Transition: The Tradable Price-Based Real Appreciation and Estimation Uncertainty”, William Davidson Institute, Working Paper No.676, April

Égert, B. (2005), “Equilibrium Exchange Rates in South Eastern Europe, Russia, Ukraine and Turkey: Healthy or (Dutch) diseased?”, Economic Systems, No.29 pp. 205–241

Fukunishi, T. (2005), “International Competitiveness of Manufacturing Firms in Sub-Saharan Africa”, Institute of Developing Economies, Discussion Paper No.2

Grant, R. M. (1991), “Porters’s Competitive Advantage of Nations’: An Assessment”, Strategic Management Journal, Vol. 12, pp. 535-548

Harberger, A. C. (2004), “The Real Exchange Rate: Issues of Concept and Measurement”, Paper Prepared for a Conference In Honor Of Michael Mussa

Hodrick, R. J. and E. C. Prescott (1997), “Postwar U.S. Business Cycles: An Empirical Investigation”, Journal of Money, Credit and Banking, Vol. 29, No. 1, pp. 1-16

Kemme, D. and M. R Saktinil (2006), “Real Exchange Rate Misalignment: Prelude to Crisis?”, Economic Systems, No. 30, pp. 207–230

Kipici, A. N. and M. Kesriyeli (1997), “The Real Exchange Rate Definitions and Kipici, A. N. and M. Kesriyeli (1997), “The Real Exchange Rate Definitions and Calculations”, Central Bank of the Republic of Turkey, Research Department, Calculations”, Central Bank of the Republic of Turkey, Research Department, Publication No.97/1Publication No.97/1

Krugman, P. (1994), “Competitiveness - A Dangerous Obsession”, Foreign Affairs, Krugman, P. (1994), “Competitiveness - A Dangerous Obsession”, Foreign Affairs, vol. 73, No.2vol. 73, No.2

MacDonald, R. (2000), “Concepts to Calculate Equilibrium Exchange Rates: An MacDonald, R. (2000), “Concepts to Calculate Equilibrium Exchange Rates: An Overview”, Economic Research Group of the Deutsche Bundesbank, Discussion Overview”, Economic Research Group of the Deutsche Bundesbank, Discussion Paper 3/00Paper 3/00

Moise, A., L.L. Albu, I. Dumitru, and C. Necula (2006), “Estimation of Equilibrium Moise, A., L.L. Albu, I. Dumitru, and C. Necula (2006), “Estimation of Equilibrium Real Exchange Rate and of Deviations for Romania”, Study within the CEEX Real Exchange Rate and of Deviations for Romania”, Study within the CEEX Programme – Project No.220Programme – Project No.220

Rano, S. U. (2007), “Real Exchange Rate Misalignment: An Application of Rano, S. U. (2007), “Real Exchange Rate Misalignment: An Application of Behavioral Equilibrium Exchange Rate (BEER) to Nigeria”, MPRA Paper No. Behavioral Equilibrium Exchange Rate (BEER) to Nigeria”, MPRA Paper No. 10376, posted 09, September10376, posted 09, September

Reinhart, C. and G. Kaminsky (1999), “The Twin Crises: The Causes of Banking Reinhart, C. and G. Kaminsky (1999), “The Twin Crises: The Causes of Banking and Balance of Payments Problems”, MPRA Paper No.14081, posted 14and Balance of Payments Problems”, MPRA Paper No.14081, posted 14

Rogoff, K. (1996), “The Purchasing Power Puzzle”, Journal of Economic Rogoff, K. (1996), “The Purchasing Power Puzzle”, Journal of Economic Literature, Vol. XXXIV, pp. 647-668Literature, Vol. XXXIV, pp. 647-668

Sekkat, K. and A. Varoudakis (1998), “Exchange-Rate Management and Sekkat, K. and A. Varoudakis (1998), “Exchange-Rate Management and Manufactured Exports in Sub-Saharan Africa”, OECD Development Centre, Manufactured Exports in Sub-Saharan Africa”, OECD Development Centre, Working Paper No.134, MarchWorking Paper No.134, March

Siggel, E. (2007), “International Competitiveness and Comparative Advantage: A Siggel, E. (2007), “International Competitiveness and Comparative Advantage: A Survey and a Proposal for Measurement”, CESifo Venice Summer Institute 2007Survey and a Proposal for Measurement”, CESifo Venice Summer Institute 2007

Stein, J. L. and G. Paladino (1999), “Exchange Rate Misalignments and Crises”, Stein, J. L. and G. Paladino (1999), “Exchange Rate Misalignments and Crises”, CESifo Working Paper Series, Working Paper No.205, NovemberCESifo Working Paper Series, Working Paper No.205, November

Terra, C. and F. Valladares (2010), “Real Exchange Rate Misalignments”, Terra, C. and F. Valladares (2010), “Real Exchange Rate Misalignments”, International Review of Economics and Finance, No.19, pp 199-144International Review of Economics and Finance, No.19, pp 199-144

World Economic Forum, Global Competitiveness Report 2009 – 2010, Geneva, World Economic Forum, Global Competitiveness Report 2009 – 2010, Geneva, 20092009

Zanakis, S. H. and I. Becerra-Fernandez (2004), “Competitiveness of Nations: A Zanakis, S. H. and I. Becerra-Fernandez (2004), “Competitiveness of Nations: A Knowledge Discovery Examination”, European Journal of Operational Research, Knowledge Discovery Examination”, European Journal of Operational Research, No. 166, pp. 185–211No. 166, pp. 185–211