Long‐run determinants and misalignments of the real effective exchange rate in the EU
| Date | 01 November 2019 |
| DOI | http://doi.org/10.1111/sjpe.12206 |
| Author | Mariarosaria Comunale |
| Published date | 01 November 2019 |
LONG-RUN DETERMINANTS AND
MISALIGNMENTS OF THE REAL
EFFECTIVE EXCHANGE RATE IN
THE EU
Mariarosaria Comunale*
ABSTRACT
This paper explores the role of fundamentals, included in the transfer effect theory,
in explaining medium/long-run movements in the real effective exchange rates in the
EU over the period 1994–2012, together with an analysis of the misalignments. We
use heterogeneous, cointegrated panel frameworks in static and a dynamic setup.
We find that the coefficients of the determinants are extremely different across
groups and the transfer theory does not always hold. The core countries have been
undervalued for almost the whole period; the periphery has experienced high rates.
The misalignments in the CEECs are stillwide and reflect the catching-up process.
II
NTRODUCTION
Exchange rate assessment is becoming increasingly relevant for economic
surveillance in the European Union (EU). The persistence of different wage
and productivity dynamics among the Economic and Monetary Union
(EMU) countries or EU members with a fixed exchange regime to the euro,
coupled with the impossibility of correcting competitiveness differentials via
the adjustment of nominal rates, have resulted in divergent dynamics in real
effective exchange rates (REER) (Salto and Turrini, 2010). For new member
countries, abundant capital inflows after transition and during catching up
were often coupled with conspicuous current account deficits and price com-
petitiveness losses. The same holds for a number of countries in the periphery
of the euro area. As explained by Galstyan and Lane (2009), the long-run
behaviour of the REER is relevant in the context of the EMU to interpret the
competitiveness differentials across members having the same currency and
for new member countries which have planned to or have just joined the euro
area in order to determine the appropriate entry rate.
1
An assessment of the
*Bank of Lithuania
1
In contrast to Denmark and the UK, the new Member States do not have an opt-out
clause from the obligation to adopt the euro at some point in the future. Sooner or later, it
will therefore be necessary to assess what exchange rate might be best suited for entry to
ERM-II and for the irrevocable conversion rate (
Egert and Lommatzsch, 2005).
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12206, Vol. 66, No. 5, November 2019
©2018 Scottish Economic Society.
649
REER is key not only from an EMU perspective, but also for the whole EU.
This is because different fundamentals and misalignments in this rate can
influence the effectiveness of the common policies and the integration process.
The REER itself reflects not only the structure of production, development
and trade behaviour of a member, but also its exchange rate policy in case of
countries with flexible regimes.
2
This is the reason why we analyse a measure
of the ‘equilibrium’ exchange rate as a benchmark against which the actual
development of the exchange rate can be assessed (Maeso-Fernandez et al.,
2002).
Hence, this paper explores the role of economic fundamentals in explaining
long-run movements in the REER in the entire EU over the period 1994–2012
by using primarily a heterogeneous, cointegrated panel framework. To do so
and illustrate how a set of fundamentals influences the REER, we consider a
standard neoclassical small open economy model as in Lane and Milesi-Fer-
retti (2004), when both supply and demand factors affect the REER. Our the-
oretical and empirical model follows the ‘transfer problem theory’
3
and is the
main focus of the paper that is looking more at the role of the NFA position,
trade balance and current accounts and the way to rebalance them via REER.
In the context of the EU [including the Central Eastern European Countries
(CEECs)], this may be a key for REER dynamics and misalignments. In our
opinion, this is really relevant, given large changes in current accounts in the
considered period (1994–2012) which may have caused important changes in
REER in the medium/long run.
In addition, the paper provides an analysis of the misalignments of REER
for each Member State, based on the ‘equilibrium’ REER measure calculated
from the permanent component of the fundamentals and called behavioural
effective exchange rate (BEER) and also used by the IMF (Isard and Faruqee,
1998; Lee et al. 2008). The time span covers the transition periods for the
CEECs, the first stages of the EMU, the introduction of the euro and the cri-
sis. In this analysis, the EU includes overall 28 countries.
4
This paper contributes to the literature along several dimensions. Firstly, it
considers specifically the EU as an overall group of advanced and transition
countries using data updated to 2012, which includes the financial crisis and
the sovereign debt crisis in the EU. The analysis is not restricted to the cur-
rent euro area (Coudert et al., 2013; Fidora et al., 2017), but sheds light on
the REER determinants of possible new entrants (mainly EU-member
CEECs) and compares EMU countries with other advanced countries of the
2
For instance, we expect in the peripheral member countries an overvalued exchange rate
since the mid-2000s due to a worsening in productivity or in the external position (Coudert
et al., 2013). This is the reason why we analyse a measure of the ‘equilibrium’ exchange rate
as a benchmark against which the actual development of the exchange rate can be judged
(Maeso-Fernandez et al., 2002).
3
The theory states that in a non-zero net foreign asset (NFA) position, some real exchange
rate adjustments in a long-run perspective would be required to re-equilibrate the NFA.
4
The analysis is also conducted by analysing three different groups of countries separately:
core (close to Germany and highly rated), periphery (mostly Southern European countries)
and CEECs. Croatia is also included in the sample.
650 MARIAROSARIA COMUNALE
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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