CHAPTER 2.1 Real Exchange Rates in Central and Eastern European Countries Abstract. In Central and Eastern European Countries (CEEC), the empirical research in real exchange rates has been motivated by two basic factors: firstly, since the beginning of transition, a clear trend of real exchange rate appreciation has been observed in most of the transition economies. Given the absence of a general theory of transition, macroeconomists have inclined towards empirical research in order to explain this trend real appreciation; secondly, the empirical research in real exchange rates in transition economies has been partly related to the practical implementation of the exchange rate policy. In this respect, it should be noted that foreign exchange markets were absent in the former communist economies. As a result, in the early stage of transition, there was a high degree of uncertainty about the “appropriate” level of exchange rates. Therefore, in order to evaluate the nominal exchange rate policy, policy makers needed to find out, more or less precisely, the equilibrium level of real exchange rates. The paper aims at evaluating real exchange rates in CEEC applying the Purchasing Power Parity (PPP) approach, which is the established theory of equilibrium real exchange rates. The empirical research generally supports the presence of the Balassa-Samuelson effect in the transition economies and it is further developed in this paper. It is concluded that before the entry in ERM II, the New Member States will have to estimate, more or less precisely, the equilibrium real exchange rates. Otherwise, they will enter ERM II with nominal exchange rates, which are difficult to maintain. Keywords: real exchange rate, Purchasing Power Parity (PPP), productivity growth, Central and Eastern Europe. 81 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries Introduction The research interest in real exchange rates has grown since late 1970s, following the collapse of the Bretton Woods system of fixed exchange rates. Then, macroeconomists found that the combination of flexible nominal exchange rates and sticky prices resulted in highly volatile real exchange rates among the industrialized countries. This gave an impetus to the empirical research literature, focusing especially on the relevance of the purchasing power parity proposition (Froot, and Rogoff, 1994 provide a review of the literature). Later on, following the debt crisis of the early 1980s, real exchange rates played a central role in the macroeconomic adjustment process in the developing countries, thus, occupying the attention of the policy makers in these countries (For example, see Edwards, 1988 and 1989). Recently, there has been a growing research interest in real exchange rates among the transition economies, too (Égert, 2003 reviews the recent empirical research). In these countries, the empirical research in real exchange rates has been motivated by two basic factors: Firstly, since the beginning of transition, a clear trend of real exchange rate appreciation has been observed in most of the transition economies. Given the absence of a general theory of transition, macroeconomists have inclined towards empirical research in order to explain this trend real appreciation. Secondly, the empirical research in real exchange rates in transition economies has been partly related to the practical implementation of the exchange rate policy. In this respect, it should be noted that foreign exchange markets were absent in the former communist economies. As a result, in the early stage of transition, there was a high degree of uncertainty about the “appropriate” level of exchange rates. Therefore, in order to evaluate the nominal exchange rate policy, policy makers needed to find out, more or less precisely, the equilibrium level of real exchange rates. More recently, the empirical research of real exchange rates in transition economies has been related to the accession of these countries to the European Union. Although the membership in the European Union does not automatically require that these countries should abandon their national currencies and adopt the Euro, yet, one of the convergence criteria refers to the exchange rate policy. More specifically, following the accession to the European Union, the New Member States are normally expected to join the new Exchange Rate Mechanism (ERM II) as a precondition to the adoption of the Euro. Approaching that point, one issue emerges high on the policy agenda - the central parity of the national currencies against the Euro, which these countries would have to maintain during their membership in the ERM II. Obviously, the “appropriateness” of the central parity of national currencies would eventually reflect the equilibrium real exchange rates, since neither individual countries nor the European Union would like to risk with maintaining exchange rates that are widely seen as unsustainable. 1. Real exchange rates in transition economies - basic empirical facts Regarding the real exchange rate dynamics in transition economies, the most striking feature is the trend real appreciation - a common phenomenon, observed in most of these countries, which is well documented in the literature (for example, see Braumann, 1998, Halpern and Wyplosz, 1997, Égert, 2003, and Égert and Lommatzsch, 2003). Figure 1 illustrates the dynamics of CPI-based real exchange rates in selected countries from Central and Eastern Europe. 82 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries 140 Bulgar ia Romania 160 140 120 100 80 60 40 20 0 120 100 80 60 40 20 0 Czech Republic 120 140 100 120 100 80 80 60 60 40 40 20 20 0 0 160 140 120 100 80 60 40 20 0 Slovakia Hungary Poland 140 120 100 80 60 40 20 0 Source: IMF, International Financial Statistics, May 2005. Figure 1. Real exchange rates in selected Central and Eastern European countries (2000 = 100) Figure 1 reveals the trend real appreciation commonly observed in transition economies. The only exceptions from this trend are Romania and Slovakia, where the real exchange rate has remained stable throughout the analysed period. However, even in Romania, there is a notable trend real appreciation since 1993, i.e. when the initial devaluation is excluded. As for the size of the appreciation, it is biggest in Poland and Bulgaria, where the real exchange rates have increased around three times. Romania, also, has experienced huge real appreciation since 1993 - the real exchange rate has increased more than twice. The magnitude of the real appreciation is similar in Hungary, whereas the Czech Republic has seen slightly less real appreciation. Interestingly, the trend real appreciation has been a common phenomenon for countries with different exchange regimes. Generally, there are two basic factors causing the trend real appreciation in transition economies (Halpern and Wyplosz, 1997, pp. 437-438): first, at the very beginning of the transition process, the exchange rates in these countries were largely undervalued for reasons 83 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries related to the process of liberalization. When the price and exchange rates controls were lifted, these countries experienced huge inflation rates followed by large devaluations, which in most cases were excessive, resulting in undervalued currencies. Therefore, given the initial undervaluation, real exchange rates had to appreciate in order to correct the initial disequilibrium. Second, the trend real appreciation was seen to represent an equilibrium phenomenon during the transition process, for several reasons, such as: rapid productivity gains arising from the increased economic efficiency, the growth of services, the increase in public utility prices, nonmonetary financing of fiscal deficits, the surge of foreign capital inflows, the improved terms of trade, and the Balassa-Samuelson effect. 2. The Purchasing Power Parity Purchasing Power Parity (PPP) is the oldest theory of equilibrium real exchange rates. It is based on the Law of One Price, which states that foreign and domestic goods must trade at the same price, expressed in a single currency. If this law holds for each individual good, then the nominal exchange rate will equate the domestic and foreign price index: P = E × P* (1) where P is the domestic price level, E is the nominal exchange rate, i.e. the price of the foreign currency expressed in the domestic currency, and P* is the foreign price level. Dividing the above expression by the domestic price level, we obtain the real exchange rate identity: E × P* Q= P (2) As can be seen from the real exchange rate identity, the PPP hypothesis implies that the real exchange rate is constant an equal to 1. This is certainly questionable, although it should be noted that PPP is a theory of long-run exchange rates, so that it could be relaxed by allowing that, in the short-run, the real exchange rate need not be constant. 120 100 80 60 40 Source: Eurostat yearbook, 2004. Figure 2. GDP per capita in PPP, 2004 84 Slovakia Slovenia Poland Hungary Lithuania Latvia Estonia Czech Republic 0 EU-15 20 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries Although PPP is a very simple approach to equilibrium real exchange rates, it is still used as a benchmark in every empirical study. Froot and Rogoff (1994) discuss the various methods for testing the PPP hypothesis and provide a detailed review of the empirical literature. They distinguish three stages of PPP tests, with the latter ones relying on the modern econometric techniques, such as unit root tests, ARIMA and cointegration. Given the different level of development, it is not surprising that PPP does not hold in Central and Eastern European economies, where the price level is much lower as compared to the euro area. The lower price level implies that real exchange rates in these countries are higher than 1 and that both real and nominal exchange rates are undervalued compared to that given by PPP. For example, Égert (2003) calculates the nominal and real exchange rates implied by PPP for several Central European countries as well as for the Baltic countries, and finds that the real exchange rates ranges from 1.67 in Slovenia to 2.48 in Latvia, i.e. they are much higher than the theoretical value of 1. Similarly, Burgess, Fabrizio and Xiao (2003) note that prices in the Baltics are 50% lower than the price level in the euro area, implying significant deviation from PPP (real exchange rates higher than 2). Also, Simon and Kovács (1998), find that PPP does not hold in Hungary. 120 100 80 60 40 20 Slovakia Slovenia Poland Hungary Lithuania Latvia Estonia Czech Republic EU-15 0 Source: Eurostat yearbook, 2004. Figure 3. Comparative price levels, 2002 There is a number of reasons why PPP does not hold in transition economies: 1) PPP is based on some assumptions that might not be valid empirically, such as: perfect competition in the domestic and foreign markets, no transportation costs, no tariffs and other trade barriers, and perfect capital mobility. 2) This theory is based on the law of one price, which is a necessary but not sufficient for PPP to hold. For instance, even if the law of one price applies for every individual good, the differences in the consumption baskets between the domestic and foreign economy will result in a deviation from PPP. Given that transition economies and western industrialized countries are at different level of economic development, it is quite natural that production and consumption patterns will differ. 3) There is another problem related to the composition of the consumption baskets - the presence of non-tradable goods. As noted above, PPP depends crucially on the law of one price, which certainly doesn't apply to some goods that are not subject to international trade. Given that these goods could have large weights in the price index; this would result in a deviation from the PPP hypothesis. Indeed, this is the most important reason that PPP does not hold for countries at different level of development. In this regard, it is well known that the prices of services are much lower 85 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries in the countries at lower stages of development. This empirical fact is related to the socalled Balassa-Samuelson effect, which provides an explanation of the most important reason for the deviations from PPP. 4) The rejection of the PPP hypothesis in transition economies may be due to the short span of data employed in the empirical research. In this regard, it is well known that PPP is regularly validated when large samples (covering long periods of 100 or 200 years) are used. In fact, as Froot and Rogoff (1994, pp. 11-12) demonstrate, in the case of bilateral exchange rates and slow reversion to equilibrium, a sample of 72 years is needed in order to confirm the PPP hypothesis at the usual confidence level of 5%. 3. Real exchange rates and productivity growth The usual explanation of the trend real appreciation in the transition economies is given by the famous Balassa-Samuelson effect, which attributes the real exchange appreciation to the productivity differential between the domestic economy and its main trading partners. The Balassa-Samuelson model predicts that high growing countries will experience trend real appreciation, which appears as an equilibrium phenomenon and, hence, it doesn't harm its competitiveness. This is a two-sector model, where the domestic economy produces two goods: tradables and non-tradables. As for the tradable goods, it is assumed that the domestic economy is a price taker in the world market, i.e. the prices of these goods are given exogenously. At the same time, this implies that the PPP hypothesis applies to the sector of tradable goods. As for the labour market, the Balassa-Samuelson model assumes that wages in the tradable sector are determined on the basis of productivity. At the same time, it is assumed that wages tend to equalize across the economy in the sense that wages in the nontradable sector are linked to the wages in the tradable sector. Moreover, the prices of nontradables are determined in the domestic economy, depending on the wages in this sector. Within this framework, in the fast growing economies, where productivity growth is higher compared to the main trading partners, the real exchange rate will appreciate due to the relatively higher increase in the prices of non-tradables. The main driving force behind this trend real appreciation is the relative productivity differential prevailing between the domestic economy and its trading partners. Since the productivity sector is generally less productive than the tradable sector, and the wages are ultimately linked to the productivity in the latter sector, it implies that unit labour costs in the non-tradable sector will rise, leading to an increase in the prices of non-tradables relative to the prices of tradables. As a result, the real exchange rate will appreciate. However, note that the trend real appreciation will occur as long as the domestic economy experiences higher sectoral productivity differential compared to its trading partners, even if the productivity level in its trading partners is higher. 7 6 5 4 3 2 1 0 1997 1998 1999 2000 2001 Euro area 2002 2003 2004 CEE countries Source: IMF, World Economic Outlook, October 2005. Figure 3. Output growth, 1997-2004 (in percentage points) 86 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries The attractiveness of the Balassa-Samuelson effect for the transition economies comes from the fact that it is able to explain the dynamics of real exchange rates in the fast growing countries during their catching-up process towards the high-income countries. At the outset of the transition, the former communist economies had very low level of income compared to the industrialized countries of the European Union and even now, this gap remains quite large (Figure 3). At the same time, after the transformation recession was over, the advanced transition economies have generally experienced higher growth rates compared to the old members of the European Union. All this opens enough room for the Balassa-Samuelson effect to be at work. The empirical research generally supports the presence of the Balassa-Samuelson effect in the transition economies. For example, Halpern and Wyplosz (1997) show that the trend real appreciation observed in the transition economies is an equilibrium phenomenon arising from the productivity growth, which leads to an increase in the relative prices of nontradables. In addition, the presence of the Balassa-Samuelson effect has been tested empirically in numerous studies, such as: Braumann (1998), Burgess, Fabrizio and Xiao (2003), Cincibuch and Podpiera (2004), Crespo-Cuaresma, Fidrmuc and MacDonald (2003), Égert and Lommatzsch (2003), Flek, Marková and Podpiera (2002), Jazbec (2001), Kovács (2002), Rother (2000), and Simon and Kovács (1998). Égert (2003) provides a comprehensive review of the empirical studies on the importance of the Balassa-Samuelson effect in transition economies. Undoubtedly, these studies reveal a consensus on the relevance of the Balassa-Samuelson effect, although there are huge differences regarding the magnitude of the effect. For instance, some studies reveal that the trend real appreciation in transition economies is a result of the Balassa-Samuelson effect; other studies find that this effect is able to explain only a portion, at best 50%, of the observed real appreciation, while some of them show that this effect is of marginal importance in explaining the trend real appreciation. 4. Beyond the Balassa-Samuelson Proposition One of the main assumptions built into the Balassa-Samuelson model is that PPP holds for the tradable goods. In this case, the real exchange rate based on producer prices is constant, so that the trend real appreciation stems entirely from the increase in the relative price of nontradables. However, it was mentioned that there were strong arguments against the validity of PPP in transition countries. Hence, if it comes that PPP does not hold in the tradable good sector, the possibility arises that part of the trend real appreciation can be explained by the increase in the price of domestically produced tradables relative to those produced abroad. At the same time, this would imply that the Balassa-Samuelson effect is able to explain only a portion, if any, of the trend real appreciation. As a consequence, when the Balassa-Samuelson effect is examined empirically, the appropriate procedure would be to test the PPP proposition, too in order to distinguish between the above two effects. For instance, the real exchange rate identity from equation (2), expressed in log form, can be defined as: q = e + p* - p (3) If all the goods in the consumption basket are grouped as tradables and non-tradables, the consumer price index in the domestic economy can be decomposed as follows: p= apT + (1 - a)pNT (4) where pT and pNT are the prices of the tradable and nontradable goods, respectively, and a < 1 is the share of tradables in the consumption basket. 87 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries Accordingly, the consumer price index in the foreign economy can be expressed as: p* = a*p*T + (1 - a*)p*NT (5) Substituting (3) and (4) in (3) and re-arranging, we obtain: q = (e + pT* - pT) + (1 - a)(pT - pNT) - (1 - a*)( p*T - p*NT) (6) For simplicity, we can assume that a = a*. In that case: q = (e + pT* - pT ) + (1 - a)[(pT - pNT) - ( p*T - p*NT)] (7) As can be seen, the real exchange rate can be decomposed in two parts, with the first expression representing the real exchange rate of the tradable goods, while the second part captures the Balassa-Samuelson effect. Again, note that, within this analytical framework, the Balassa-Samuelson effect is able to explain only a portion of the real exchange rate movements, with the rest being explained by the tradables’ prices effect. In fact, the above scenario could be quite realistic in transition economies. In fact, the raw data on real exchange rates clearly show that in Central and Eastern European countries both PPI-deflated and CPI-deflated real exchange rates have appreciated since the beginning of the transition process. Moreover, in some countries these two measures of real exchange rates have moved closely together, having been virtually indistinguishable. There are several reasons why the price of domestically produced tradables could rise, causing the PPI-based real exchange rate to appreciate (Égert, 2003, pp. 45-46): 1) First, given that these goods were undervalued in the initial phase of the transition, their appreciation could represent an equilibrium phenomenon. 2) Second, the inflows of Foreign Direct Investment in transition economies create a pressure for appreciation of the nominal exchange rate, reflecting the expected future productivity gains. 3) Third, the price of domestically produced tradable goods may rise due to the increase in the price of non-tradable components, used in their production. 4) Fourth, part of this appreciation could reflect the bias in measuring the inflation rate, which could be higher compared to the industrialized countries. 5) Finally, most of the appreciation of the PPI-based real exchange rate may be related with the transformation process. Initially, domestic tradable goods were of a poor quality and design compared to those produced abroad, so that the consumers preferred the foreign well-known brands. However, as a result of the post-privatization restructuring, often related with the inflow of foreign capital, domestic companies have succeeded to improve the quality and the reputation of their products. This has shifted the consumer preference towards domestic tradables and the increased demand has pushed their prices up. The importance of relative tradable prices in explaining the real exchange rate dynamics in transition economies has found empirical support in Burgess, Fabrizio and Xiao (2003), Cincibuch and Podpiera (2004), Égert, and Lommatzsch (2003), Kovács (2002), Loko and Tuladhar (2005), Flek, Marková and Podpiera (2002). In addition, the relevance of the Balassa-Samuelson effect in transition economies could be questioned on another ground - the role of regulated prices. In the BalassaSamuelson model the linkages between productivity growth in the tradable goods sector, the prices of non-tradables and the real exchange rate appreciation are driven by the market 88 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries mechanism. However, in the empirical testing of the Balassa-Samuelson effect, non-tradables are usually represented by the Consumer Price Index (the overall index or a portion of it), which includes many services whose prices are regulated or set administratively by the government. For instance, this is the case with the prices of energy, water supply, local transportation, communication services etc. At the outset of transition, these services were largely undervalued and then, their prices have been gradually increased in a series of discrete changes, approaching the level prevailing in the developed countries. Of course, these changes in regulated prices were reflected in the overall price index, causing the CPI-based real exchange rate to appreciate. As noted above, the problem is that, speaking precisely, this appreciation does not represent the Balassa-Samuelson effect, because it is not driven by market forces. 5. Equilibrium real exchange rates The equilibrium real exchange rate can be defined as the real exchange rate that results in a simultaneous internal and external equilibrium in the economy. In this context, internal equilibrium means that the market for non-tradable goods clears in every single period now and in the future, while economy attains an external equilibrium when the current account balances are compatible with the sustainable capital flows in the long run. However, it should be noted that, when talking about equilibrium real exchange rates, we don't think of a single constant value for the real exchange rates. In fact, this interpretation of equilibrium real exchange rates is implied by PPP and it is not realistic. Generally, the equilibrium exchange rate is a variable that changes as a function of the changes in its determinants, such as: terms of trade, the openness of the economy, capital flows, productivity growth, the composition of government consumption, private investment and savings decisions etc. Although the equilibrium exchange rate is not an observable variable, it can be calculated empirically. The usual econometric procedure is to model the real exchange rate as a function of several variables (the so-called fundamentals) and, thus, to obtain the values of the long run coefficients. However, the values obtained from this equation don't represent the equilibrium real exchange rate, since it is a function of the equilibrium, i.e. sustainable values of the fundamentals, not their current values. Therefore, in the empirical estimation of equilibrium real exchange rates, it is necessary first to find out the equilibrium values of the fundamentals and then, using the estimated long run coefficients, to obtain the equilibrium exchange rates. Finally, comparing the current with the equilibrium values of the real exchange rates, one can estimate the real exchange rate misalignment, i.e. the degree of undervaluation or overvaluation of the currency. As noted in the Introduction, much of the empirical research of real exchange rates in transition economies has been related to the accession of these countries to the European Union and the expected participation in ERM II. Quite naturally, in order to determine the central parity of their currencies against the euro, the new Member States would need information about the equilibrium real exchange rates. Halpern and Wyplosz (1997) were the first to estimate the equilibrium exchange rates in transition economies for the first half of the 1990s. Using dollar wages as a proxy real exchange rate, they compare their current values with those obtained from the empirical model and find that the real exchange rates were in equilibrium in Croatia, Slovenia, The Czech Republic, Hungary and Poland. In some countries, such as: Bulgaria, Romania and Russia, their estimates suggest significant undervaluation. Recently, there have been some more studies attempting to estimate the equilibrium exchange rates and the resulting misalignment for the New Member States. For instance, Burgess, Fabrizio and Xiao (2003) show that, in 2002, the real exchange rates in Estonia and Lithuania were modestly 89 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries undervalued, with the extent of undervaluation ranging from 4.5% and 8.5%, and from 2.5% to 8.25%, respectively. The estimates for Latvia are ambiguous, but, generally, they find undervaluation of approximately 5% for all three countries. On the basis of the econometric exercise, Braumann (1998) estimates the equilibrium real exchange rate in Slovakia for the 1990-97 period, which doesn't suggest any serious misalignment. Mídkova, Barell and Holland (2002) calculate the equilibrium exchange rates for five accession countries Slovenia, Hungary, Poland, The Czech Republic and Estonia. They find that, at the end of 2001, there were signs of overvaluation for all these countries, except for Slovenia, but the extent of overvaluation was rather small, ranging from 5% to 10%. Égert and Lommatzsch (2003) attempt to estimate the degree of misalignment for the acceding countries, employing time series-based methods as well as panel-cointegration. However, their estimates differ sharply depending on the estimation methods, the specification of the empirical model, the base year etc. For example, the time series-based estimates suggest average appreciation of 5% in the Czech Republic, 9.5% in Hungary, and 13.5% in Poland. On the other side, the panel-cointegration technique produces different estimates: real appreciation between 17% and 33% in the Czech Republic, and between 20% and 31% in Slovakia. In Slovenia and Poland, the real appreciation ranges from 1% to 12% and from 1% to 8%, respectively. For Hungary, the estimates are indecisive. Also, the studies on equilibrium exchange rates reviewed by Égert (2003) reveal very large differences between the estimates for individual countries, depending on the base year, the estimation period, the composition of the sample, the estimation technique, the choice of variables etc. 6. Implications for the exchange rate policy As mentioned above, much of the recent research on real exchange rates in transition economies is related with the process of accession to the European Union. Although, the membership into the European Union is not automatically translated into a membership into the monetary union and adoption of the euro, the New Member States are normally expected to join ERM II. In this regard, the Maastricht Treaty requires that these countries maintain stable exchange rates for at least two years and this precondition represents part of the convergence criteria. Furthermore, the central parity maintained during the membership in ERM II will determine the irrevocable conversion rate to the euro. This means that the dynamics of real exchange rates will bear strong implications for the exchange rate policy of the New Member States in the following period. Since these countries will have to fix the central parity of their currencies against the euro, it is obvious that this parity should be sustainable in the sense that it should not be neither undervalued nor overvalued. Therefore, before the entry in ERM II, the New Member States will have to estimate, more or less precisely, the equilibrium real exchange rates. Otherwise, they will enter ERM II with nominal exchange rates, which are difficult to maintain. For example, in case the central parity is undervalued, the central bank will face huge problems in attaining low inflation, thus, endangering the entry into the monetary union. On the other hand, if a country set the central parity at an overvalued level, its maintenance could worsen its competitiveness, which, in turn could produce two negative effects: First, the prolonged loss of competitiveness would hurt the country's growth with serious negative effects on the real convergence. Second, in the presence of liberalised capital account, the worsening of the country's external position might trigger devaluation expectations and provoke speculative attacks. As a result, the country might have problems in meeting the exchange rate criterion on its way towards the monetary union. 90 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries Conclusions Since the beginning of the transition process, a trend of real exchange rate appreciation has been observed in most of the CEE economies, due to two basic factors: first, given the initial undervaluation, real exchange rates appreciated in order to correct the initial disequilibrium. Second, the trend real appreciation was seen to represent an equilibrium phenomenon during the transition process, for several reasons, such as: rapid productivity gains arising from the increased economic efficiency, the growth of services, the increase in public utility prices, non-monetary financing of fiscal deficits, the surge of foreign capital inflows, the improved terms of trade, and the Balassa-Samuelson effect. The usual explanation of the trend real appreciation in the transition economies is given by the Balassa-Samuelson effect, which attributes the real exchange appreciation to the productivity differential between the domestic economy and its main trading partners. The empirical research generally supports the presence of the Balassa-Samuelson effect in the transition economies, although there are huge differences regarding the magnitude of the effect. Some studies reveal that the trend real appreciation in transition economies is a result of the Balassa-Samuelson effect, other studies find that this effect is able to explain only a portion of the observed real appreciation, while some of them show that this effect is of marginal importance. In this context, it is argued that much of the trend real appreciation comes from increase in the prices of tradable goods, with another part reflecting the effect of regulated prices. Recently, a number of studies have attempted to estimate the equilibrium exchange rates and the resulting misalignment for the New Member States. However, there are large differences between the estimates for individual countries, depending on the choice of the base year, the estimation period, the composition of the sample, the estimation technique, the choice of variables etc. Much of the recent research on real exchange rates in CEE economies is related with the process of accession to the European Union. Although, the membership into the European Union is not automatically translated into a membership into the monetary union and adoption of the euro, the New Member States are normally expected to join ERM II. Since these countries will have to fix the central parity of their currencies against the euro, it is obvious that this parity should be sustainable in the sense that it should not be neither undervalued nor overvalued. Therefore, before the entry in ERM II, the New Member States will have to estimate, more or less precisely, the equilibrium real exchange rates. Otherwise, they will enter ERM II with nominal exchange rates, which are difficult to maintain. For example, in case the central parity is undervalued, the central bank will face huge problems in attaining low inflation, thus, endangering the entry into the monetary union. On the other hand, if a country set the central parity at an overvalued level, its maintenance could worsen its competitiveness, with serious negative effects on the real convergence. References Braumann, Benedikt (1998), “Competitiveness and the Trade Deficit in Slovakia”. In “Slovak Republic: Recent Economic Developments”. IMF Staff Country Report No. 98/60, June. Burgess, Robert, Stefania Fabrizio and Yan Xiao (2003), “Competitiveness in the Baltics in the Run-Up to EU Accession”. IMF Country Report No. 03/114, April. Cincibuch, Martin and Jirí Podpiera (2004). “Beyond Balassa-Samuelson: Real Appreciation in Tradables in Transition Economies”. Czech National Bank Working Paper No. 9, December. Crespo-Cuaresma, Jesús, Jarko Fidrmuc and Ronald MacDonald (2003), "The Monetary Approach to Exchange Rates: Panel Data Evidence for Selected CEEECs”. Oesterreichische Nationalbank, Focus on Transition, 2, pp. 138-151. Edwards, Sebastian (1988), “Real and Monetary Determinants of Real Exchange Rate Behavior”, Journal of 91 Chapter 2.1. Real Exchange Rates in Central and Eastern European Countries Development Economics, Vol. 29, pp. 311-341. Edwards, Sebastian (1989), “Exchange rate misalignment in developing countries”, Research Observer, Vol. 4, No 1, January, pp. 3-21. Égert, Balázs (2003), “Assessing Equilibrium Exchange Rate in CEE Acceding Countries: Can We Have DEER with BEER without FEER? A Critical Survey of the Literature”, Oesterreichische Nationalbank, Focus on Transition, 2, pp. 38-106. Égert, Balázs and Kirsten Lommatzsch (2003), “Equilibrium Real Exchange Rate in Acceding Countries: How Large Is Our Confidence (Interval)?” Oesterreichische Nationalbank, Focus on Transition, 2, pp. 107137. Flek, Vladislav, Lenka Marková and Jirí Podpiera (2002), “Sectoral Productivity and Real Exchange Rate Appreciation: Much Ado about Nothing?” Czech National Bank Working Paper No. 4, December. Froot, Kenneth A. and Kenneth Rogoff (1994), “Perspectives on PPP and Long-Run Exchange Rates”, NBER Working Paper No. 4952, December. Halpern, László and Charles Wyplosz (1997), “Equilibrium Exchange Rates in Transition Economies”, IMF Staff Papers Vol. 44, No 4, December, pp. 430-461. Jazbec, B. (2001), “Determinants of Real Exchange Rates in Transition Economies”, Oesterreichische Nationalbank, Focus on Transition, 2, pp. 43-57. Kovács, Mihály András, Ed (2002), “On the Estimated Size of the Balassa-Samuelson Effect in Five Central and Eastern European Countries”, NBH Working Paper, 5, July. Loko, Boileau and Anita Tuladhar (2005), “Labour Productivity and Real Exchange Rate: The BalassaSamuelson Disconnect in the former Yugoslav Republic of Macedonia”, IMF Working Paper, WP/05/113, June. Rother, Philipp (2000), “The Impact of Productivity Differentials on Inflation and the Real Exchange Rate: An Estimation of the Balassa-Samuelson Effect in Slovenia”. In “Republic of Slovenia: Selected Issues”, IMF Staff Country Report No. 00/56, April. Simon, András and Mihály A. Kovács (1998), “Components of the Real Exchange Rate in Hungary”, NBH Working Paper, 3, March. Mídková, Katerina, Ray Barell and Dawn Holland (2002), “Estimates of Fundamental Real Exchange Rates for the Five EU Pre-Accession Countries”, Czech National Bank Working Paper No. 3, December. 92 View publication stats