Sultanija Bojceva Terzijan, MSc.Sultanija Bojceva Terzijan, MSc.National Bank of the Republic of National Bank of the Republic of

MacedoniaMacedonia

30.05.2008, Skopje

Conference Conference “ “Competitiveness of the South Eastern European Countries and Competitiveness of the South Eastern European Countries and Challenges on the Road to EU “Challenges on the Road to EU “

REAL EXCHANGE RATE DYNAMICS IN REAL EXCHANGE RATE DYNAMICS IN REPUBLIC OF MACEDONIA: OLD WISDOMS REPUBLIC OF MACEDONIA: OLD WISDOMS AND NEW INSIGHTSAND NEW INSIGHTS

Outline:Outline:

Republic of Macedonia road to EURepublic of Macedonia road to EU Real convergenceReal convergence Nominal convergenceNominal convergence

Competitiveness and real exchange rate Competitiveness and real exchange rate dynamics in RMdynamics in RM

Estimation of the equilibrium real exchange Estimation of the equilibrium real exchange rate (REER) for Macedonian Denarrate (REER) for Macedonian Denar

Republic of Macedonia road Republic of Macedonia road to EUto EU

Stabilization and Association Agreement with EU, Stabilization and Association Agreement with EU, April 2001April 2001

Interim Agreement on Trade and Trade Issues -Interim Agreement on Trade and Trade Issues -into force from June 1into force from June 1stst 2001 2001

Submission of the membership application , Submission of the membership application , March 2004March 2004

Submitted Questionnaire to the Government of Submitted Questionnaire to the Government of RM, October 1RM, October 1stst 2004 2004

Positive opinion from European Commission for Positive opinion from European Commission for RM candidacy, November 2005RM candidacy, November 2005

RM was granted candidate status, December 17RM was granted candidate status, December 17thth 2005 2005

Real ConvergenceReal Convergence

Slow real Slow real convergenceconvergence Absence of FDI, new Absence of FDI, new

technology and technology and know-howknow-how

Negative external Negative external and domestic and domestic shocksshocks

Intensified in 2007Intensified in 2007 Real GDP growth Real GDP growth

rate of 5,1%rate of 5,1%

Real Convergence – continues Real Convergence – continues

Contribution of the production factors to Contribution of the production factors to GDP growthGDP growth Total factor productivity dominates as in all SEE Total factor productivity dominates as in all SEE

countriescountries

Source: IMF Article IV, 2005Source: IMF Article IV, 2005

Stylized fact: the absolute price level of less Stylized fact: the absolute price level of less developed countries is bellow the euro area developed countries is bellow the euro area averageaverage

Macedonia fits this pattern as wellMacedonia fits this pattern as well

Lower absolute levels of price parities towards Lower absolute levels of price parities towards Germany, Italy, SloveniaGermany, Italy, Slovenia

Nominal ConvergenceNominal Convergence

Nominal Convergence - Nominal Convergence - continuescontinues

Price level convergence (EU 27=100)Price level convergence (EU 27=100)

Potential sources of upward Potential sources of upward inflation pressuresinflation pressures

Balassa-Samuelson effect from the supply Balassa-Samuelson effect from the supply sideside

Adjustment in regulated pricesAdjustment in regulated prices

Cost-push factors from non-tradable Cost-push factors from non-tradable intermediates (distribution sector, business intermediates (distribution sector, business services sector, rents)services sector, rents)

Higher quality and reputation of Higher quality and reputation of domestically produced goodsdomestically produced goods

Real exchange rate dynamics in Real exchange rate dynamics in RMRM

Analysis based on a paper Analysis based on a paper “Real exchange “Real exchange rate dynamics in Macedonia: Old wisdoms rate dynamics in Macedonia: Old wisdoms and new insights”and new insights”

Motivation: Motivation: Explain reason Explain reason

for depreciation for depreciation of MK REERof MK REER

Try to link it to Try to link it to productivity productivity developments – developments – the B-S effect the B-S effect

Balassa-Samuelson effect in Balassa-Samuelson effect in MacedoniaMacedonia Starting point: Starting point:

productivity productivity differential bears differential bears a link to the a link to the relative prices – relative prices – domestic conceptdomestic concept

Prices increased Prices increased due to other due to other factors than the factors than the B-S effectB-S effect change in

administrative prices since 2000

B-S effect in Macedonia – B-S effect in Macedonia – continues continues

If potentially there is a link from productivity to relative prices the share of non-tradables in the CPI basket is crucial (Engel’s law)

B-S effect in Macedonia – B-S effect in Macedonia – continues continues

Fairly limited Fairly limited contribution to total contribution to total CPICPI

The steady rise of The steady rise of services from 2000 services from 2000 have negligible have negligible influence on the CPIinfluence on the CPI

The CPI index has The CPI index has strong co-movement strong co-movement with goods price with goods price inflationinflation

Tradable, non-tradable and overall price inflation in Macedonia

B-S effect in Macedonia – B-S effect in Macedonia – continues continues

Balassa-Samuelson effect bleeds from two Balassa-Samuelson effect bleeds from two wounds:wounds:

Rises in service prices were not connected to Rises in service prices were not connected to developments in the productivity differential in developments in the productivity differential in Macedonia from 1997 to 2005Macedonia from 1997 to 2005

Service price inflation has potentially little impact on Service price inflation has potentially little impact on headline inflation - modest weight of services in final headline inflation - modest weight of services in final household expenditureshousehold expenditures

Empirical evidence indicates non existence of domestic Empirical evidence indicates non existence of domestic B-S effectB-S effect

Real exchange rate dynamics in RMReal exchange rate dynamics in RM

REER - official series; REER1_EU5 - with MK CPI REER - official series; REER1_EU5 - with MK CPI weights, weights, REER2_EU5 - with average EU 5 CPI weightsREER2_EU5 - with average EU 5 CPI weights

““Composition Composition puzzle” solved puzzle” solved and new REER and new REER series were series were constructedconstructed

Low goods price Low goods price inflation and inflation and high service high service price inflation price inflation in foreign in foreign benchmark benchmark overestimates overestimates the depreciation the depreciation of REERof REER

Real exchange rate dynamics in Real exchange rate dynamics in RMRM Continual Continual

decline of the decline of the MK productivity MK productivity relative to the relative to the foreign trade foreign trade partnerspartners

Slow catching-Slow catching-up process, up process, contrary to the contrary to the most transition most transition countries – countries – increase of increase of productivity gap productivity gap relative to relative to abroadabroad

Real exchange rate dynamics in Real exchange rate dynamics in RMRM

Co-movement of the Co-movement of the new REER series new REER series and the productivity and the productivity differentialsdifferentials

Possible explanations:Possible explanations:

The (inverse) The (inverse) quality effectquality effect

Non-tradable Non-tradable component of component of tradable pricestradable prices

Estimation of a behavioral equilibrium Estimation of a behavioral equilibrium exchange rateexchange rate

Method: OLS, E-G ARDL DOLS  Model 1 Model 2 Model 3 Model 1 Model 2 Model 3 Model 4 Model 5ECT  -0.5**  -0.47**  -0.47**  -0.23**  -0.30**  -0.30**  -0.46**  -0.46**UR  -4.86**  -6.48**  -7.29**  -4.24**  -4.21**  -4.31**  -5.44**  -5.45**F-test       4.70** 5.59** 5.89**    Const  -0.43**   0.37  -3.06**  -0.15**  -1.96** 0.02 -0.01proddiff1             0.12**  proddiff2 0.18**      0.41**       0.14**proddiff3   0.19     0.63**      proddiff4     0.09*     0.25**    gcon_diff  0.06**  0.14** 0.07* 0.12** 0.25** 0.09**    open 0.04   -0.04 0.29**   0.18**    nfa    -0.02**     0.04**      rel.prices             0.14** 0.13**Notes: * and ** indicate statistical significance at the 10% and 5% levels, respectively

The productivity The productivity variable has a positive variable has a positive signsign

Increases in public Increases in public expenditures lead to expenditures lead to real appreciation real appreciation through the relative through the relative price of tradable price of tradable goods. goods.

Rise/fall in openness Rise/fall in openness is reflected in real is reflected in real exchange rate exchange rate appreciation appreciation /depreciation (a /depreciation (a surprising finding)surprising finding)

Productivity, government consumption and the openness Productivity, government consumption and the openness variables - fairly robust both in terms of sign and sizevariables - fairly robust both in terms of sign and size

Misalignment of Macedonian Misalignment of Macedonian REERREER

According to the three models, there is According to the three models, there is not significant misalignment of MK not significant misalignment of MK DenarDenar

ConclusionConclusion

Macedonia in process of catching up growthMacedonia in process of catching up growth Real convergence might induce risk for Real convergence might induce risk for

meeting nominal criteriameeting nominal criteria B-S effect has a very limited role in the B-S effect has a very limited role in the

Macedonian caseMacedonian case The (inverse) quality effect, or the non-The (inverse) quality effect, or the non-

tradable component of tradable prices - two tradable component of tradable prices - two possible explanationspossible explanations

REER in line with its fundamentals, absence REER in line with its fundamentals, absence of significant misalignment of MK Denarof significant misalignment of MK Denar

Thank you for your attention

ReferencesReferences

1. Bogoev, J., Bojceva, T. S., Egert, B. and Petrovska M. (2007), "Real exchange rate dynamics in Macedonia: Old wisdoms and new insights, The Open-Access, Open-Assesment E-Journal, Vol. 2, 2008-12.

2. DeBroeck, M. and T. Slok (2006), "Interpreting real exchange rate movements in transition economies", Journal of International Economics, 68(2), pp. 368-383.

3. 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.

4. Égert, B., Halpern, L. and R. MacDonald (2006) Equilibrium exchange rates in transition economies: Taking stock of the issues, Journal of Economic Surveys, 20(2), 253-324.

5. Gutierrez, E. (2006), "Export Performance and External Competitiveness in the Former Yugoslav Republic of Macedonia", IMF Working Paper No. 261.

6. Loko, B. and A. Tuladhar (2005), "Labor Productivity and Real Exchange Rate: The Balassa-Samuelson Disconnect in the Former Yugoslav Republic of Macedonia", IMF Working Paper No. 113.

7. Mihaljek, D. and M. Klau (2004), "The Balassa-Samuelson Effect in Central Europe: A Disaggregated Analysis", Comparative Economic Studies, 46(1), 63-94.