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Emergent Markets and Their Dilemmas: The Exchange Rate vs. Its
Equilibrium – To Be or Not To Be? Case Study on the EUR/RON
Currency (Romania)
Dana-Mihaela Haulica
The Academy of Economic Studies, Doctoral School of Finances, Romania
[email protected]
Abstract. We all aim the equilibrium; in our own, very personal understanding, of course. Whether it`s
about family, money, health and so on the equilibrium is a state in which we all dream to be at a
certain point in time. It`s well understood that a born rich person will have a higher target for this state
as well as a healthy young man will have a different understanding regarding the health equilibrium
than a 80 years old person. This principle is valid also for larger entities starting with small groups of
similar people and arriving to count in this discussion countries, international organizations etc. A
country aims to have enough resources to raise, educate and assist its citizens. In order to obtain this,
its representants use multiple sets of complex instruments. This article is about the Exchange Rate – a
variable that reflects the power of a country, the maturity of its markets, a variable that it is being used
as an important instrument for adjusting the trade balance, the GDP etc. If you are running an
emergent market its very likely to be key necessary to adjust some of the macroeconomic variables, to
bring them to sustainable values on a medium – long term. As mentioned before, one of the most
important instruments to do that is the Exchange Rate and its related monetary policy actions. So the
dilemma comes from the following: the Equilibrium Exchange Rate on a short term is given by the
current values of the macroeconomic variables that you have chosen to take in count (there are several
very popular models also for calculating the Equilibrium Exchange Rate as BEER and FEER). But, if
your goal is to adjust those macroeconomic values, you have to take action in the present to be able to
change something in the future so practically you would need to break the present equilibrium to
obtain a sustainable economy on a medium – long term. How this affects present economy and how
such a decision is being made – this is what this article aims to present.
Keywords: management, sustainable growth, abstract equilibrium exchange rate, sustainable economy,
monetary policy, emergent markets
1 Introduction
Analyzing a status in order to see if there is Equilibrium or not is not new. Neither putting under the
loop a larger entity with its specific characteristics and processes to further conclude if at least aims
for the Equilibrium.
BUT – if you take Romania that is an emergent market which is already pretty tricky, at the beginning
of the global crisis in 2008 and see what were its plans regarding a sustainable economic growth and
analyze how did Romanian markets and Romanian authorities played this game until present times
using a very important instrument – The Exchange Rate - this will HOPEFULLY return an interesting
result and also some fresh opinions on what will follow.
This article has 4 sections as it follows:
(1) Introduction – how is this study relevant and new?
(2) Variables that influence the exchange rate – a literature review,
(3) What is the equilibrium exchange rate?,
(4) Case study:
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Briefly – what this study wanted to see – was:
a. How close (far?) was Romania to the Equilibrium Exchange Rate (EUR/RON) having to face
many challenges starting with 2008;
b. Analyze the results: how did Romania used this instrument to achieve its long term goal
regarding the sustainable growth?
c. What are the recommended/rather possible further steps in regards to using/adjusting the
Exchange rate?
The used data is very fresh – by using values that include also the 2014 year, this article brings a new
overview on the macroeconomic policies that were applied in Romania in the 2008 – 2014 period and
helps also make an accurate comparison regarding the goals that Romania had before that start of this
period and how much were they materialized.
2 Variables that Influence the Exchange Rate – a Literature Review
2.1 Variables that Influence the Exchange Rate – a Literature Review
In what concerns the dynamics of the exchange rate, there have been along the way, many approaches
trying to explain the way this important instrument makes its moves in time.
These approaches had their roots in the most important economic currents that were born starting with
the 17th century.
In 1802, economist Henry Thornton assumed that more money equals more inflation and that an
increase in money supply does not necessarily mean an increase in economic output. He also stated
that the exchange rate is determined by the money supply available on the market and that, the surplus
of the money supply brings a depreciation of the currency.
Later, Fisher brought in discussion the existing relation between the interest rate differential and the
exchange rate. His theory stated that if we have a country, A, with an interest rate of 6% and another
country, B, that has an 10% interest rate, the expectations for the exchange rate are to change in the
future with 4% to equilibrate the difference in interest rates.
Monetarists said that a rapid increase in money supply leads to a rapid increase in inflation. Also, they
state that an increase in the level of prices determines an additional demand of money what leads to an
appreciation of the currency.
Starting with 1930, Keynes made popular his economic theories. He considered that the exchange rate
is influenced by the capital movements and by the commercial balance. An increase of the interest rate
makes investments on that market more attractive and this leads to a currency appreciation. On the
other side, an increase in prices may lead to a decrease in competitivity in comparison with the goods
of other countries.
The Mundell – Fleming model (1976) has Keynesian influence. This model states that the exchange
rate receives a strong influence from the payments balance that evolutes under the impact of the goods
market and the money market.
Later, based on the Mundell – Fleming model, Dornbusch and Fischer (1980), made a study on the
influence that the current account balance has on the exchange rate.
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Using the co integration method in 1997, MacDonald demonstrated the connection between the
exchange rate and the interest rate.
In 2000, Lane and Milesi – Ferretti demonstrated the important existing connection between the net
external assets and the exchange rate.
In what concerns the variables that influence the EUR/RON currency, some several solid and useful
studies has developed Adrian Codirlasu who analyzed the existing connection between the exchange
rate and the current account balance (2008), the impact that the productivity differential has on the
exchange rate (the Harrod Balassa – Samuelson effect in Romania, 2005).
2.2 Short Term and Long Term influencers of the Exchange Rate
In regards to the variables that affect the exchange rate, in time, studies have made a split in two: long
term influencing variables such as productivity differential, net external assets, terms of trade,
government consumption and short term influencing variables such as real uncovered interest parity,
expectations regarding economic growth, the degree in which an economy is open, capital`s market
maturity.
3 What is the Real Equilibrium Exchange Rate?
Depending on the time frame you can refer to the real equilibrium exchange rate as being on short
time, medium and long time. The real exchange rate takes in count the inflation also.
As MacDonald (1998) and Diver and Wesaway (2004) stated in their work, the formula for the real
exchange rate can be written using a series of explicative variables:
Qt = β1t * Z1t + β2t * Z2t + θt * Tt +
, where:
β1t, β2t are the coefficients of the equation;
Z1t, Z2t are the variables that influence the exchange rate;
Tt represents the transitory variables that influence the exchange rate on a short term;
, represents the error factor.
As this study aims to analyze the deviation of the real exchange rate on a short term from its
equilibrium we will continue using the adjusted formula:
Qt = β1t * Z1t + β2t * Z2t
This formula states that, supposing there are no transitory factors to influence the exchange rate
(arbitrage bubbles, errors of anticipation), the short term equilibrium is given by the current values of
the macroeconomic variables.
The further aim of this study is to compare the estimated real equilibrium exchange rate with the real
data, analyze the deviation and see whether the deviation is due to a certain macroeconomic policy
that aimed to break the present equilibrium for e medium – long term better.
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4 Case Study
4.1 Facts
From January 2008 to January 2009 the nominal Exchange Rate (EUR/RON) has grown with 14%
from 3.69 to 4.23. In the following years the maximum delta was 3%. Euro area CPI – got to almost
100% in 2014 from almost 104% in 2008. Romania`s CPI – got to almost 101% in 2014 from 130% in
2008. This aspect made the Real Exchange Rate to be far away from the nominal value due to
Romania`s struggle to deal also with inflation. Romania`s Trade Balance deficit decreased from 23000 mil EUR in 2008 to -5700 mil EUR in 2014. Romania`s External debt grew from 35000 mil
EUR in 2008 to 75000 mil EUR at the end of 2014. The Net External Assets of Romania rose at the
ending of 2014 to 95 mil EUR from 30 mil EUR at the beginning of 2008.
4.2 Scenario
Due to the general crisis that started in 2008 consumption has decreased drastically from all sources:
private, public and foreign.
In order to maintain a relative Equilibrium, the Romanian authorities had to create new policies to
sustain the getting out from the crisis process. Two of these instruments were making an agreement
with the IMF for borrowing money and the other one – betting on the depreciated exchange rate`s
sustaining role.
4.3 Case study
4.3.1 Methodology of research and used data:
In order to estimate the Real Equilibrium Exchange rate I have used the BEER model (MacDonald,
1998), under the following form:
Qt = β1t * Z1t + β2t * Z2t + θt * Tt +
, where:
β1t, β2t are the coefficients of the equation;
Z1t, Z2t are the variables that influence the exchange rate;
Tt represents the transitory variables that influence the exchange rate on a short term;
Tt is considered to be 0 when calculating the equilibrium exchange rate on a short term;
represents the error factor;
is also considered to be 0.
The BEER model implies that there is a set of macroeconomic variables that, put together in an
equation can determine the real equilibrium exchange rate with a good accuracy. Before choosing the
variables to be used in the equation I have been testing various macroeconomic variables to analyze
the strength of the relation that existed between them and the Exchange Rate. Trade balance, Net
international assets, Current account balance, EUR/USD Exchange Rate, Money Supply, External
debt, the Number of transactions on the exchange market, the Evolution of real medium wage, the
Evolution of unemployment rate, the Productivity differential, the Interest rate, the Terms of trade, the
Degree in which an economy is open and other variables were tested.
4.3.2
Results
The best results in individual testing had the current account balance, the terms of trade (nominal
currency), the interest rate, the money supply, the net external assets, the trade balance and the
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external debt, all these showing correlations with the exchange rate in an interval that took
approximate values between 10% and 25%. After testing different combinations of variables to
include in the BEER model, the chosen model, with the best empirical results, was the following:
Qt = c(1) + c(2)*Current account balance + c(3)*Terms of trade (eur/usd) + c(4)*External
debt + c(5)*Money supply1 + c(6)*Money supply2 + c(7)*Net external assets + c(8)*Trade
balance, where:
Current account balance = the monthly value of the current account balance between 2008 and
2014;
Terms of trade = monthly medium EUR/RON currency between 2008 and 2014;
External debt = the monthly external debt between 2008 and 2014;
Money supply1 = M1 as defined in the economy manuals taking monthly values between
2008 and 2014;
Money supply2 = M2 as defined in the economy manuals taking monthly values between
2008 and 2014;
Net external assets = the monthly value for net external assets between 2008 and 2014;
Trade balance = the monthly value for trade balance between 2008 and 2014;
c(1), c(2), c(3), c(4), c(5), c(6), c(7), c(8) = the coefficients of the ecuatuion.
The used time series where taken from the National Bank of Romania`s site, from Eurostat and from
the European Central Bank`s site. This model determines the evolution of the Real Exchange Rate
with a 54% success percent. The used series had a monthly frequency covering a period of 7 years.
The series were tested and adjusted for stationarity and also suffered seasonal adjustments. There were
other several good models but when taking in count all data: Schwartz Criterion, Akaike, Log
Likelihood and Sum squared residual, this model turned out to be the best.
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Figure 1: Results of the
t BEER model
m
Source: Own calculaations using the
t E-views program.
p
Figure 2: Real Exchaange Rate beetween 2008 – 2014:
REX
XR
5
4
3
2
1
0
-1
2008
20
009
201
10
2011
2012
2
m
Sourrce: Own callculations usiing the E-vieews program
236
2013
2014
This figure presents the values for the real exchange rate in the period 2008 – 2014. The used formula
for calculating the real exchange rate was:
Q = S * P*/P, where:
S = nominal exchange rate;
P*= foreign prices;
P = domestic prices.
Figure 3: Estimated Real Equilibrium Exchange Rate between 2008 – 2014
ECH_ALL
5
4
3
2
1
0
2008
2009
2010
2011
2012
2013
2014
Source: Own calculations using the E-views program
This figure presents the values of the estimated real exchange rate in the period 2008 – 2014 using the
BEER model adapted as presented before.
Practically, what this study wanted to achieve, was to first create an overview regarding the levels of
the two variables in the analyzed period for then be able to make a comparison. After making the
comparison to put some questions some in order to receive some answers.
(1) Why was the estimated real equilibrium exchange rate so far from the real value in the 2008 2012 period?
(2) What did the Romanian authorities to maintain that certain level of exchange rate and for
what reason?
(3) What is the continuation of these actions?
5
Conclusions and Interpretations
The Real Exchange Rate and the Equilibrium Exchange Rate have both values in the 0-5 interval; only
in the 2012 – 2014 period the two variables are closer one to another.
If we speak on the formula of the Real Exchange Rate:
Q = S*ForeignPrices/DomesticPrices, and take in count the big gap between the Euro CPI and
Romania`s CPI that had a much higher value in the 2008-2010 interval we can somehow relate the
lower values of the Real Exchange Rate in this period.
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Between 2008 and 2009 the nominal Exchange Rate has decreased by 14%; this means that having
less means to act and sustain the economic growth – Romania has played the depreciated currency
role.
Although in recession, Romania has managed to lower the Current Account Balance, the Trade
Balance deficits and to grow its Net External Assets.
The Real Exchange Rate calculated at a monthly frequency (on a short term) wasn`t most of the times
at its equilibrium but it sustained the bringing money to the state budget process.
Having to face, still, a lot of concurrence coming from abroad and having to deal with the developing
process of growing internal sources of production, Romania is still in the phase where it needs a good
price in exporting so, most probably, on a long term period that might take 5 to 10 years until we will
manage to grow productivity, bring new technology and increase production we will still need to use
the exchange rate as an instrument to bring money to the budget.
And, if we go even further with the interpretations, having a lack of structural instruments in the crisis
period, Romania had actually to choose was there, in front of our eyes: depreciated currency coming
from the economic reality and use it as an advantage.
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