FX misalignment in emerging Europe

Several emerging European currencies are significantly undervalued, but how far can these currencies appreciate before impacting competitiveness? Patricia Bartholomew sees room ahead for substantial appreciation in the Romanian, Czech and Hungarian currencies

The challenge facing emerging European transitional economies is to maintain export competitiveness in an environment of real currency appreciation. Loosely, real exchange rate appreciation results from a situation where a country’s inflation rate is higher than the rate at which its currency devalues relative to its trading partners. Now, a decade after the start of transition, we ask how near emerging European countries’ exchange rates have come to their respective equilibrium values or, alternatively, what scope remains for further appreciation?

The problem we face is how to estimate the medium-term equilibrium exchange rate equation. We reject the usual methodologies of taking the REER (trade-weighted real equilibrium exchange rate) value in a reference year in which the country is assumed to be in internal and external equilibrium, because there is no year in which we can assume equilibrium for the transitional economies. Instead, we opt for a model comparing price competitiveness in tradable products. Here, we choose to compare actual manufacturing wages in US$ to estimated equilibrium wages in US$ to get an idea of the extent of under- or over-valuation of the local currency.

This index [actual wages to estimated equilibrium wages] shows that all transition countries can sustain continued appreciation of their currencies. All wages are far from their equilibrium levels, and all ratios show levels much greater than one, suggesting that all of the transitional countries can sustain currency appreciation in the medium term.

But correct comparison is with the countries’ trading partners. The interpretation of the index remains the same (ie, a number equal to one indicates an equilibrium value, and a number above one denotes that the actual value is below equilibrium). Again, all countries exhibit an undervalued currency. The extent to which the Russian rouble and Ukrainian hryvnia are undervalued has been cut considerably when controlling for the trade partners, but remains high. The new ratio may still overestimate Russian and Ukrainian competitiveness due to the greater dispersion of exports across individual trading partners.

For example, 38% of total Russian exports go to the Commonwealth of Independent States (CIS), although only Belarus is in the top six export partners. For Ukraine, approximately 60% of exports go to the CIS while only Russia is in the top six. Further, summing up the percentage of exports going to the top six export partners of total exports yields 37% for Russia and 45% for Ukraine, versus 65% for Hungary, 69% for the Czech Republic and 56% for Poland.

For the east-central European economies, the Czech Republic remains the most competitive with the new index. The index suggests that the koruna could appreciate by 48% over the medium term without affecting competitiveness (from an average US$ rate of 38.61 in 2000 to 19.9).

Hungary is the second most undervalued currency, with the index suggesting room for 43% real appreciation before competitiveness is fully eroded (from 282 to 161). The Polish zloty loses competitiveness under the new methodology, showing room for a mere 5.5% real appreciation before losing competitiveness over its trading partners. This suggests that the zloty has little room left to appreciate in the medium term. Slovakia shows a moderate scope for appreciation of about 23%.

Two caveats: the real appreciation could take the form of higher inflation rather than as an appreciated currency, and the model has little short-term predictive power.

If the increase takes place solely as an increase in local currency wages, we would then see no foreign exchange appreciation. However, we think it is more likely we would see some combination of higher wages in local currency and an appreciated currency.

This model should only be used as a guide for the medium-term direction of the currencies -- the analysis has little predictive power for short-term currency corrections. This is evidenced by the failure to flag the Czech koruna, Russian rouble and Ukrainian hryvnia as overvalued before their respective crises in 1997 and 1998. In this regard, we advise that investors still need to pay attention to the short-term factors that drive the currency market. The value of this model is in giving investors an idea of the direction in which the currencies will be trading over the medium to longer term. In this regard, we can expect substantial medium term appreciation of the Romanian leu, Czech koruna and Hungarian forint.

More moderate appreciation can be expected in the Slovak koruna, while the Polish zloty has largely exhausted its scope for appreciation. While the model suggests substantial appreciation potential for the Russian rouble and Ukrainian hryvnia, we hesitate to draw this conclusion, citing methodology deficiencies, and suggest extending the model to a larger percentage of export partners.