Estimates of the Fundamental Equilibrium Exchange Rate of

Kuna

Katja Gattin TurkaljCroatian National Bank

Introduction

Real Equilibrium Exchange Rates

• A “fair” value of a currency

• Getting the rate “right” is of great importance as the exchange rate influences competitiveness, price trends and other key macroeconomic variables.

• Various concepts of EER, depending on the definition of internal and external balance

FEER

• Fundamental equilibrium exchange rate

• FEER is the real effective er that secures internal and external balance for a country (or for a number of countries) simultaneously.

• Internal balance: NAIRU

• External balance: "sustainable" BoP position

FEER

• Advantages: does not require to much data, easily computed, and tested in the literature many times

• Drawbacks: normative elements, ad hoc definition of sustainable CA position, difficult to model trade, but…

• “Possibly the most popular of the underlying balance models” (Driver and Westaway, 2001)

Trade, capital flows and ER

in Croatia

Index of Real Exchange Rate

92

96

100

104

108

112

116

94 95 96 97 98 99 00 01 02 03 04

IREET ppi 97 eop

Nominal ER of Euro and USD

6.6

6.8

7.0

7.2

7.4

7.6

7.8

4

5

6

7

8

9

10

94 95 96 97 98 99 00 01 02 03 04

HRK_EUR HRK_USD

kuna

/eur

o

kuna/USD

PPI for Croatia, EU, and relative PPI

92

96

100

104

108

112

116

120

124

94 95 96 97 98 99 00 01 02 03 04

PPI97EUR PPI97HRV PPI97REL

Construction on IREER

ECU/EUR USD GBP CHF SIT

WEIGHTS 70,6 27,2 1,0 1,0 0,2

Export of goods and services

8

12

16

20

24

28

32

93 94 95 96 97 98 99 00 01 02 03 04

SHARE_EXPG_CP SHARE_EXPS_CP

in %

of G

DP

Imports of goods and services

-52

-48

-44

-40

-36

-11

-10

-9

-8

-7

93 94 95 96 97 98 99 00 01 02 03 04

SHARE_IMPG_CP SHARE_IMPS_CP

in %

of G

DP (go

ods)

in % of G

DP (services)

Destination of exports

in % of total exports 2004 cum 2004

TOTAL 100 eu15 51 eu25 65 65 of which -Austria 9 -Italy 23 -Germany 11 -Slovenia 7 Bosnia and Herzegovina 14 79 YU;Srbija and Montenegro 4 83 Russia 1 84 USA 3 87

Changes in trade patterns

• WTO 2000

• Bilateral agreements (first signed in 1996, by the end of 2004 25 agreements)

• EFTA 2001

• SAA 2001

• CEFTA 2003

• Return of export markets of former YU

Liberalization of capital flows

• New FX law in 2003

• Liberalization especially for firms

• Very few restrictions remain (some short-term flows, outflow of capital for residents, real estate, …) to be lifted by the end of SAA (2007)

Estimating FEER

Concepts of equilibrium ER

• market equilibrium: balances supply and demand of currency (Williamson)

• current equilibrium: consistent with the given or current fundamentals

• medium term equilibrium: consistent with the fundamentals at their equilibrium level

• long term equilibrium: in the long run, the capital stock and foreign debt are also endogenous and will be related, along with the real exchange rate, to long run fundamentals

Estimates of the EER

• PPP, HBS and NATREX are long-term concepts,

• On the short end, there are purely statistical approaches SVAR, BEER and CHEER

• FEER, DEER and PEER, refer to modeling the medium term equilibrium.

Estimating FEER

• Internal eq: potential GDP growth associated with low and "non-accelerating" inflation rate

• 1) Output gap

• 2) HP filter or BN decomposition

Estimating FEER

• External eq:

• 1) Macroeconomic balance approach (IMF)

• S(X)-I(Y)=CA (rer, Ybar)

• X and Y are arrays of explanatory variables (fiscal position, openness, population growth...)

• 2) "sustainable" current account position...

Estimate Trade balance

• and elasticities of imports and exports relative to the exogenous variables

• + +• + -

1131211 )ln(*)*ln()ln( RERorMYX

2232221 )ln()ln()ln( RERYM

Solve for FEER

• CA= X-M• FEER is the solution for RER in

• when CA, Y and Y* are replaced with their long term values

Y

eeCA

Y

CA RERYRERY

Y

)ln(*)ln()ln()ln(

%

131211232221

Estimate X and M equations…

DLOG(X) = -5.25 + 1.10*LOG(RER) + 3.44*DLOG(M*(-1)) + 4.58*DLOG(M) (-2.18) (2.12) (5.01) (12.16) R2=0.79 F-stat=53.9

DLOG(M) = 0.47 + 1.09*DLOG(Y) - 0.10*LOG(RER) (0.30) (4.18) (-0.29) R2=0.27 F-stat=8.54

Actual REER and FEER

95

97

99

101

103

105

107

109

111

113

115

2/95

.

4/95

.

2/96

.

4/96

.

2/97

.

4/97

.

2/98

.

4/98

.

2/99

.

4/99

.

2/00

.

4/00

.

2/01

.

4/01

.

2/02

.

4/02

.

2/03

.

4/03

.

2/04

.

4/04

.

reer

feer hpTB

feer TB 0%

feer TB -6,5%

Conclusion

• The drawback inherent in the FEER method, cannot be resolved within the framework of FEER

• Often, another method is used along with FEER to verify its findings (BEER)