PMA WORKING PAPER
WP/11/02
ESTIMATION OF THE EQUILIBRIUM
REAL EXCHANGE RATE IN THE
OCCUPIED PALESTINIAN TERRITORY
Saed Khalil and Michel Dombrecht
PALESTINE MONETARY AUTHORITY
® Palestine Monetary Authority
WP/11/02
PMA Working Paper
Research and Monetary Policy Department
Estimation of the Equilibrium Real Effective Exchange Rate in the Occupied
Palestinian Territory
Prepared by Saed Khalil* and Michel Dombrecht†
October 2011
Abstract
This paper aims at estimating the equilibrium real effective exchange rate (ERER) in the Occupied
Palestinian Territory (OPT). Engle-Granger and the fully modified ordinary least squares methods are used
to estimate ERER. Main results of this paper show that the real effective exchange rate (REER)
appreciation in OPT is associated with productivity differential, share of private investment in GDP, and
remittances as a share of GDP. Results show that the highest contributor in REER appreciation is the
share of private investment in GDP, followed by productivity differential, while remittances played a
minor role in REER appreciation. Exchange rate misalignment show high fluctuations at the beginning of
the sample period, then less fluctuation afterwards with zero reversion mean.
© October, 2011
All Rights Reserved.
Suggested Citation:
Palestine Monetary Authority (PMA), 2011. Estimation of the Equilibrium Real Exchange Rate in the
Occupied Palestinian Territory.
Ramallah – Palestine
All Correspondence should be directed to:
Palestine Monetary Authority (PMA)
P. O. Box 452, Ramallah, Palestine.
Tel.: 02-2409920
Fax: 02-2409922
E-mail: [email protected]
www.pma.ps
JEL Classification Numbers: C22; E22; E25; F31
Keywords: Exchange rate; Equilibrium exchange rate; Autoregressive; Co-integration
Authors’ E-mail addresses: [email protected]; [email protected]
*
†
Palestine Monetary Authority.
University of Antwerp, Belgium and Hogeschool Universiteit Brussels, Belgium.
ii
Contents
I. INTRODUCTION ...................................................................................................................... 1
II. RECENT DEVELOPMENTS................................................................................................. 2
III. THE EQUILIBRIUM REAL EFFECTIVE EXCHANGE RATE .................................. 4
LITERATURE REVIEW ......................................................................................................................... 4
DETERMINANTS OF THE REAL EXCHANGE RATE ............................................................................ 6
DATA AVAILABILITY ........................................................................................................................... 10
THE ECONOMETRIC METHODOLOGY .............................................................................................. 10
INTERPRETATION OF THE RESULTS ................................................................................................. 13
IV. CONCLUSION ....................................................................................................................... 17
REFERENCES ............................................................................................................................... 18 iii
I. Introduction
Real (effective) exchange rates are defined as nominal (effective) exchange rates
between the currencies of countries adjusted for changes in the relative prices of these
countries.
They therefore can be considered to be an indicator of the country's
competitiveness and as a determinant of the current account balance.
If nominal exchange rates were to converge quickly to their Purchasing Power
Parity (PPP) levels, real exchange rates would follow a stable and stationary path. But it
has been widely recognized, based on the statistical observations of real exchange rate
behavior, that deviations from PPP are generally large and long lasting. These deviations
and the implied large swings in real exchange rates may be the consequence of lack of
international arbitrage in the goods and services markets, transportation costs, tariffs,
non-tariff barriers, information costs, and lack of labor mobility. These frictions certainly
play a role but it should also be recognized that relative price movements are only one
factor that affect current account balances. Real exchange rates may therefore reflect
other factors such as supply and demand factors and policy measures.
This paper aims to explain the observed movements of the Real Effective
Exchange Rate (REER) in OPT. The OPT economy will probably undergo transitions to
a more stable environment in which the income generation is more diversified and more
endogenous as compared to the current situation where income transfers from abroad
play the major role. A major issue in this respect concerns the implication of these
transitions for the Equilibrium Real Exchange Rate (ERER). An analysis of the driving
forces of the REER may therefore provide useful information for the formulation of the
future monetary policy strategy.
This paper uses the (reduced form) exchange rate equation to assess ERER. This
approach estimates the long-run cointegrating relationship between the real exchange
rate and its fundamentals suggested in the literature by Edwards (19986, 1989, and 1994),
Elbadawi (1994), Montiel (1997), Williamson (1994), and others.
1
Saed Khalil and Michel Dombrecht Results show that REER appreciation is associated with productivity
differentials (PDIF) with respect to OPT’s trading partners, private investment share in
GDP (PINV), and received remittances from abroad as a share of GDP (REMIT). These
results tend to indicate that PINV has been the most important driving force of the
REER appreciation, followed by PDIF and that REMIT has only played a minor role.
Exchange rate misalignment ranged between -4.94 percent in 1998 and 4.40 in 1999 with
zero mean reversion during the period, which reflects the long-run convergence tendency
of actual REER towards ERER in OPT.
The rest of the paper is organized as follows. The next section presents the recent
developments in effective exchange rates in OPT. Section III talks about the ERER in
OPT. In this section we summarize the literature on ERER, introduce the econometric
methodology and results, and then interpret these results. Section IV concludes.
II. Recent developments
OPT currently has no domestic currency and instead three foreign currencies are,
mainly, used for daily transactions, saving, borrowing, pricing, and accounting purposes.
These three currencies are NIS, USD, and JD. Thus PMA is deprived of using monetary
and exchange rate policies, which are needed to stabilize the economy such as inflation,
unemployment, current account, not to mention external competitiveness. In this section
we will provide a descriptive analysis of the CPI-based REER calculated by PMA staff
and documented in Dombrecht and Khalil (2011). It is worth mentioning that because
CPI in OPT is calculated in NIS, NIS is used as an anchor currency in calculating REER
for OPT.
One of the major indicators that present a country’s external competitiveness is
the REER. NEER in OPT has appreciated significantly since 2005 (figure 1). The
difference between REER and NEER indicates that inflation in OPT relative to its
trading partners contributed to the appreciation of the real exchange rate during this
period. The appreciation of NEER since 2005 indicates that NIS appreciated against
OPT trading partners’ currencies.
2
Estimating of the ERER in the OPT Figure 1 Exchange rate and consumer price developments in OPT
(Index: 2005 = 100)
130
125
120
115
110
105
100
95
REER
NEER
M5 2011
M1 2011
M9 2010
M5 2010
M1 2010
M9 2009
M5 2009
M1 2009
M9 2008
M5 2008
M1 2008
M9 2007
M5 2007
M1 2007
M9 2006
M5 2006
M1 2006
M9 2005
M5 2005
M1 2005
90
CPI
Figure 2 REER in OPT and some selected countries
(Index: 2005 = 100)
130
120
110
100
90
80
70
OPT
Israel
Euro Area
UK
US
M4 2011
M11 2010
M6 2010
M1 2010
M8 2009
M3 2009
M10 2008
M5 2008
M12 2007
M7 2007
M2 2007
M9 2006
M4 2006
M11 2005
M6 2005
M1 2005
60
China
Figure 2 shows the CPI-based REER in OPT and some of OPT trading partners
(Israel, Euro Area, UK, US, and China)3. REER started to diverge between the selected
countries after the mid of 2007. China and Israel REER appreciated more than OPT
3
Source: IMF. Data on REER for Jordan, Egypt, and other neighboring countries is not available.
3
Saed Khalil and Michel Dombrecht REER while it depreciated in UK and US. The Euro area REER appreciated until the end
of 2009 before it depreciates afterwards, but remains broadly stable compared with the
other countries—suggesting that Euro area inflation rates were kept in line with those in
partner countries.
III. The Equilibrium Real Effective Exchange Rate
This paper aims at estimating a reduced form equilibrium real exchange rate
equation. The estimation of the ERER consists of two stages:
•
Stage 1: Estimating a reduced form relationship between the real exchange rate
and a set of fundamental variables.
•
Stage 2: Deriving an equilibrium level for the real exchange rate from the
estimated econometric relationship
Although the first stage is statistical, economic theory helps guiding the choice of
fundamentals and assessing the plausibility of the results. The second stage is based on a
theoretical macroeconomic model, where the equilibrium real exchange rate is defined.
Before going to the first stage we’ll survey the literature on the equilibrium exchange
rate, and then we’ll provide a theoretical description of the fundamental variables.
Literature review
Economists have developed several methodologies to assess equilibrium exchange
rates. Isard (2007) describes six different approaches used by economists to estimate
equilibrium exchange rates. The first approach is the Purchasing Power Parity (PPP)
approach. PPP hypothesis has two main variants. The absolute PPP hypothesis states that
the exchange rate between the currencies of two countries should equal the ratio of the price
levels of the two countries. The relative PPP hypothesis states that exchange rate changes are
related to the difference in inflation rates. The second approach is PPP adjusted for
Balassa-Samuelson and Penn effects. Balassa-Samuelson and Penn effects come from
4
Estimating of the ERER in the OPT the observation that consumer price levels in richer countries are systematically higher
than in poorer ones4.
The third approach is the macroeconomic balance framework. This framework
focuses on the requirements for achieving internal and external balance simultaneously.
The fourth approach is assessment of the competitiveness of the tradable goods sector.
This approach looks more narrowly at the performance of the tradable goods sector of
the economy and ask how well it is competing at the prevailing real exchange rate. The
fifth approach is assessments based on estimated exchange rate equation. This
approach is an econometric estimation of reduced form exchange rate equations. The last
approach is assessments based on general equilibrium models.
The above different methodologies sometimes generate different quantitative
estimates of equilibrium exchange rates (Isard, 2007). In this paper we are assessing the
ERER based on a reduced form exchange rate equation. The estimation of ERER depends
upon the fundamentals that determine the equilibrium real exchange rate. Most of the
empirical work related to the estimation of the factors driving the REER and the
calculation of ERER in emerging countries is based on a model developed by Edwards
(1986, 1989, and 1994).
Edwards’ models explore the long-run co-movements of the real exchange rate
with variables such as the terms of trade, productivity, net foreign assets, the fiscal
balance and measures of openness of the trade and exchange system. Edward finds that
only real (fundamental) variables influence the ERER in the long run. However, in the
short run changes in monetary shocks can be important determinants. Montiel (1997,
1999) and Baffes et al (1999) use co-integration techniques to estimate the equilibrium
exchange rate. Montiel (1997) suggests that the co-integration technique is a superior
method of estimating the real exchange rate over the PPP methodology.
Many studies have failed to find a statistical link between real exchange rates and
fundamentals. Edison and Melick (1999) failed to find cointegration between real
4
An economic model predicting these effects based on the assumption that productivity or productivity
growth-rates vary more by country in the traded goods' sectors than in other sectors (the Balassa–
Samuelson hypothesis).
5
Saed Khalil and Michel Dombrecht exchange rates and real interest rate differentials, and Rogoff (1996) found a mixed
empirical track record of the Balassa-Samuelson effect on real exchange rates.
Williamson (1994) advocated that the usage of reduced-form single equations for
developing countries, as large models using the multi-dimensional approach, may not be
appropriate for these countries due to their small economies. The value of this approach
depends upon how well the regression results conform to theoretical priors about
variables that ought to have significant explanatory power, as well as on whether the
estimated coefficients on those variables are consistent with prior beliefs about their
signs and approximate magnitudes (Isard, 2007).
Determinants of the real exchange rate
Economic literature has identified several factors as potential medium to log-run
determinants of equilibrium exchange rates. These fundamentals are reviewed briefly
below.
•
Terms of trade (tot) is constructed as the ratio of exports price deflator to
imports price deflator. An increase in terms of trade is expected to affect ERER in
two different ways. The first effect is the substitution effect, which improves the
current account and as a consequence exchange rate appreciates. The second
effect is the income effect, which means that the improved relative price will
increase domestic income and thus, domestic consumption of imported goods
increases and as a result the equilibrium real exchange rate must depreciate to
restore equilibrium. The final net effect of an increase in terms of trade depends
upon which effect dominates the other.
•
Productivity (prod) proxied by relative GDP per capita compared to foreign
trading partners. This variable captures the well-known Balassa-Samuelson
effect. Countries with higher productivity growth in the tradable sector
experience higher relative prices of nontradables and therefore an exchange rate
appreciation without losing competitiveness.
6
Estimating of the ERER in the OPT •
Government consumption (gcons) as a share of GDP. An increase in
government consumption biased toward nontradables creates higher demand for
nontradables (relative to the tradable sector). This greater demand boosts the
relative prices of nontradable goods, causing the equilibrium real exchange rate to
appreciate. However, if the increase in overall government consumption is biased
toward the tradable sector, an increase in spending will cause the exchange rate
to depreciate. The final effect depends upon where government consumption is
biased to.
•
Government investment (ginv) as a share of GDP. Investments might have high
import content and thus a negative impact on the trade balance and as a
consequence exchange rate depreciates. This variable may also capture
technological progress and thus positive impact on the exchange rate. Therefore
the overall impact of government investment on the exchange rate is ambiguous.
•
Private investment (pinv) as a share of GDP. Similar to the government
investment, pinv’s effect on the exchange rate is ambiguous.
•
Remittances (remit) as a share of GDP. The recent empirical literature is
inconclusive on the relationship between worker remittances and the exchange
rate (see for example Rajan and Subramanian (2005); Li and Rowe (2007);
Elbadawi et al. (2008); Lee et al. (2009); Mongardini and Rayner (2009); and
Barajas et al. (2010)). Remittances generally can be spent on tradables and
nontradables. Only spending that increases the demand in the nontradable sector
would lead to an appreciation of the exchange rate. If remittances are used to
increase competitiveness and ease supply constraints in the nontradable sector,
the real exchange rate would depreciate.
•
Aid flows (aid) as a share of exports. An increase in aid flows improves the
external balance and thus causes the exchange rate to appreciate.
•
The severity of trade restrictions, proxied by openness (open) to trade, is defined
as the sum of exports plus imports as a share of GDP. In the Palestinian case,
7
Saed Khalil and Michel Dombrecht trade restrictions can be proxied by number of closure days on trade (closure).
Protection of domestically produced goods via restrictions on cross-border trade
(e.g. import tariffs and nontariff barriers) or the increase in closure leads to
higher domestic prices and thus equilibrium real exchange rate appreciation.
Consequently, lifting existing trade restrictions should cause the exchange rate
to depreciate.
•
Net foreign assets (nfa) as a share of GDP, a proxy for the country’s net external
position. An increase in capital inflows from abroad implies higher demand for
domestic currency, thus causing the exchange rate to appreciate.
Figure 3 shows the evolution of some ERER determinants during 1997 – 2010.
The figure shows that most of REER determinants show some fluctuations during the
examined period. Terms of trade, productivity relative to trading partners, private
investment as a ratio of GDP, workers remittances as a ratio of GDP, and openness as a
ratio of GDP declined after 2000 as a result of the Israeli measures after the outbreak of
the second Intifada on September 2000. Restriction on movements of labor and trade
within OPT and between OPT and Israel and other countries led to a decline in
productivity and worker remittances, and to an increase in costs of production and
export prices, thus affecting negatively private investments.
Foreign aid fluctuates depending upon the political situation in OPT. Most of
foreign aid goes for the support of the government budget; some of it goes for
development activities like infrastructure and capacity building of the Palestinian
institutions. Government consumption as a ratio of GDP increased until 2003 after
which it declined until 2006 before it grew at lower rates. Openness declined after 2000
as a result of what we mentioned above regarding the restrictions imposed by the Israeli
forces on the movements of labor and trade.
8
Estimating of the ERER in the OPT Figure 3 REER and its determinants in OPT
1.12
120.00
1.04
RE E R (2005=100)
2005
2007
2009
2005
2007
2009
2005
2007
2009
2.40
2001
1997
2009
2007
0.80
2005
80.00
2003
0.88
2001
90.00
1999
0.96
1997
100.00
1999
tot
2003
110.00
0.31
0.27
0.20
0.18
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
0.26
0.18
1997
2009
2007
2005
2003
2001
1999
1997
0.10
9
2003
2001
remit (ratio of GDP)
2003
pinv (ratio of GDP)
2001
0.42
0.34
gcons (ratio of GDP)
1997
2009
2007
0.15
2005
0.00
2003
0.19
2001
0.60
1999
0.23
1997
1.20
1999
prod (2005=1)
1999
1.80
Saed Khalil and Michel Dombrecht 0.40
1.10
1.00
2009
2007
2005
2003
open
1997
2009
2007
0.70
2005
0.00
2003
0.80
2001
0.10
1999
0.90
1997
0.20
2001
aid (ratio of GDP)
1999
0.30
Data availability
The major constraint in estimating the reduced-form relationship between the
real exchange rate and its determinants is the availability of data, particularly in
emerging countries. The time series does not exceed 14 years, which is not very
satisfactory when annual data are employed. Data used in estimating the ERER have
different time frequency, REER is available in monthly frequency while its determinants
are available on annual basis. Thus we choose to estimate the ERER based on annual
data.
Our sources include PCBS, PMA, and IMF’s International Financial Statistics
(IFS). Data on exports, imports, GDP both in constant and current prices, consumer
price index for OPT, remittances, government consumption and investment were
compiled from PCBS. Data on REER, foreign aid, and net foreign assets were compiled
from PMA. Regarding net foreign assets only a few number of annual data are available
and thus we chose to exclude this variable from our analysis. Data on exchange rates,
GDP per capita, and consumer price indices of our trading partners were compiled from
IFS. Data on private investment were estimated by PMA staff.
The econometric methodology
There is an abundant applied empirical literature that estimates reduced form
equations for the REER in many countries, not least in emerging market economies.
10
Estimating of the ERER in the OPT Most of these papers use co-integration tests among which the two-step Engle-Granger
(EG) (1987) and Johansen’s Vector Error Regression (VER) (1991 and 1995) are the two
most popular ones. Recently, a number of authors used Autoregressive Distributed Lag
(ARDL) models to test for the existence of level variables equations (Pesaran and Shin
1999 and Pesaran et al 2001).
The ARDL approach is based on the estimation of a conditional single equation
Error Correction Model (ECM). A Wald or F-test together with a t-test are used to test
the presence of a vector in terms of the levels of the variables entering in the model.
Unfortunately this approach cannot be applied to the estimation of the REER in OPT
because of an insufficient number of observations in the available annual data set.
The limited sample size of the available data is even more restrictive as to the use
of the Johansen’s VER, which needs even more observations as compared to the ARDL
approach. Therefore the analysis for OPT is for the time being based on two alternative
estimation methods: the EG and the Fully Modified OLS (FMOLS) co-integration
estimation and testing.
The EG approach is based on the estimation and testing of a co-integration vector
using Static OLS (SOLS) and Phillips-Ouliaris (PO) (1990) residual based co-integration
tests. After exploring different REER theories on OPT data, the following long run
equation was estimated using SOLS (equation 1, standard error between parentheses):
LREER = -0.061 + 0.034*LPDIF – 0.255*LPINV + 0.148*LREMIT
(0.0597) (0.0156)
(0.0314)
Adjusted R-squared = 0.83 DW = 2.08
(0.0339)
No. of Observations = 14
Where,
LREER
= Log of real effective exchange rate,
LPDIF
= Log of productivity differentials,
LPINV
= Log of private investment as a share of GDP, and
LREMIT
= Log of remittances as a share of GDP.
11
(1)
Saed Khalil and Michel Dombrecht DW
= Durbin-Watson statistic for serial correlation (close to 2 means no serial
correlation)
Applying an Augmented Dickey-Fuller (ADF) test on the residuals of this
equation rejects the null hypothesis of the presence of a unit root in these residuals as
shown in table 1. The same result is obtained using a Phillips-Perron (PP) test on the
same residuals.
Table 1 Unit root test of equation (1) residual
P-Value
Residual of eq. (1)
ADF-test
PP-test
0.0155
0.0195
We can therefore conclude that there exists a long run equilibrium relationship
between the REER on the one hand and:
•
The productivity differential between OPT and its main trading partners;
•
The share of private investment in GDP;
•
The remittances received from abroad.
As an alternative we use the Phillips and Hansen (1990) FMOLS estimator that
eliminates problems caused by correlation between the co-integrating equation and the
stochastic regressors innovations (equation 2). The results are very close to those
obtained using SOLS.
LREER = -0.047 + 0.034*LPDIF – 0.274*LPINV + 0.167*LREMIT
(0.0368) (0.0096)
(0.0193)
Adjusted R-squared = 0.82 DW = 2.15
(2)
(0.0209)
No. of Observations = 14
Long-run covariance estimate (Bartlett Kernel, Newey-West fixed bandwidth =
3.00
Hansen’s instability test (Hansen, 1995) does not reject the null hypothesis that
the series are co-integrated as shown in table 2.
12
Estimating of the ERER in the OPT Table 2 Hansen's instability test for co-integration of eq. (2)
Lc statistic
0.416782
Stochastic
Trends (m)
3
Deterministic
Trends (k)
0
Excluded
Trends (p2)
0
Prob.*
> 0.2
*Hansen (1992b) Lc(m2=3, k=0) p-values, where m2=m-p2 is the number
of stochastic trends in the asymptotic distribution
We conclude from all this that a long run equilibrium relationship exists in OPT
between the REER and the mentioned variables of productivity differentials, share of
private investment in GDP and received remittances from abroad as a share of GDP. In
the interpretation of the results we will focus on the results obtained from the two-step
EG approach, knowing that the results obtained with the FMOLS are very similar.
We provide here the unit root tests of all variables used in the equations above.
ADF- and PP-tests show that all variables are stationary on the first difference
(integrated of order one I(1)). Unit root tests for the first difference of all variables are
highly significant except for D(LREMIT), which is significant on 10 percent level.
Table 3 Unit root tests for LREER, LPDIF, LPINV, and LREMIT
P-Value
ADF-test
PP-test
LREER
0.9573
0.9177
D(LREER)
0.0020
0.0020
LPDIF
0.1537
0.1718
D(LPDIF)
0.0005
0.0006
LPINV
0.6239
0.7048
D(LPINV)
0.0057
0.0017
LREMIT
0.2336
0.4636
D(LREMIT)
0.0783
0.0783
Interpretation of the results
To obtain a more precise view on what drives the REER in OPT, we calculated
the contributions of the explanatory variables in the estimated long-run equilibrium
equation (see table 4). The cumulated sum of percentage changes in the REER since
13
Saed Khalil and Michel Dombrecht 1998 till 2010 was 18.4 percent. Productivity differential accounted for 2.6 percentage
points of this accumulated REER appreciation, whereas the private investments and
remittances accounted for 12.2 and 0.6 points respectively. In terms of percentages the
accumulated appreciation over this period was due to productivity for 13.9 percent of
this appreciation while relative private investment activity and received remittances as a
share of GDP contributed respectively for 66.1 percent and 3.0 percent of the total
appreciation. The remainder of 17.0 percent was caused by deviations of the REER from
its estimated equilibrium values (misalignment).
These results tend to indicate that the share of private investment in total
economic activity has been the most important driving force of the REER appreciation
over this period, followed by the productivity differential and that remittances have only
played a minor role. We will discuss each of these factors in a bit more detail.
Table 4 The contributions of the explanatory variables in the estimated long-run equilibrium
equation
DLREER
CDLPDIF
CDLPINV
CDLREMIT
DLREERMIS
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
0.339932
3.323717
0.335346
3.142441
-4.36555
2.147723
1.70153
1.780911
1.66201
1.341224
5.822274
-0.56531
1.743149
1.696427
4.644868
-3.80353
1.920126
-2.40684
0.567903
0.247116
1.217915
-1.39549
-0.54156
-2.10335
2.466781
0.05249
-1.31595
-6.18081
5.226245
9.548183
0.801438
-1.89261
7.059466
-3.34439
-2.95568
5.87107
3.322917
0.047367
-4.02389
4.902595
0.459291
-5.02152
-4.87422
-1.93729
2.118305
-2.24674
1.950045
3.101316
-0.58539
2.680326
-1.72804
1.731134
-4.94314
4.400367
3.934154
-3.45165
-0.82286
1.35413
-3.35831
1.957336
2.911868
-3.4029
1.922381
-1.35141
3.983413
Sum
18.4094
2.56286
12.16335
0.5498
3.133383
Share
18.4094
13.92148
66.07144
2.986516
17.02056
Where,
DLREER
= Change in logarithm of the variable,
14
Estimating of the ERER in the OPT CDLPDIF
= Contribution of the change in the log of productivity differentials in the
total rate of change of REER,
CDLPINV
= Contribution of the change in the log of private investment in the total
rate of change of REER,
CDLPDIF
= Contribution of the change in the log of remittances in the total rate of
change of REER,
DLREERMIS = REER misalignment,
Sum
= Sum of annual changes, and
Share
= Average contributions of each variable to the total rate of change of
REER.
As was observed, the REER in OPT has appreciated by some 20 percent from
1998 till 2010, which implies that measured in common currency the consumer prices in
OPT have outpaced by some 20 percent those in the main trading partners (of which
Israel represents by far the largest share). Normally, this could endanger OPT’s
competitiveness on the international and domestic markets, unless it was caused by
equilibrium factors which prevent this appreciation from hurting OPT’s overall
competitiveness. It turns out that the observed appreciation of the REER in OPT went
along with a significant decline over this period in the share of private investment in
total GDP (see figure 3). According to the estimated long-run equilibrium relation, the
share of private investment has a negative effect on the ERER. This effect is well
documented in the literature. For example, Chudik and Mongardini (2007) argue that
investments in low- and middle-income countries have high import content and thus a
negative effect on the trade balance. The relatively strong decline over this period of the
share of private investment expenditure has compensated for any negative effects of the
declining price competitiveness. It should be added of course that if OPT would
stimulate and be able to expand the private sector capital stock to enhance economic
growth, this might require a more stable REER.
15
Saed Khalil and Michel Dombrecht Labor productivity in OPT has not moved a lot relative to the main trading
partners (among which Israel has the dominant weight). This effect is the so called
Balassa-Samuelson effect and has been found to exert a significant positive effect on the
ERER in almost all countries under investigation. But given the absence of a clear
improvement in relative productivity in OPT, its effect on the ERER has been very
modest.
Also the role played by remittances was limited. Remittances in percentage of
GDP is currently lower than the levels observed in the period before 2000. In the
literature the effect of remittances on the ERER was found to be relatively small in other
countries as well (Barajas et al, 2010; Combes et al, 2011) and its effects on the ERER are
found to be inconclusive (Weber and Yang, 2011).
Overall, the results found for OPT are well in line with those observed in many
other countries.
We have computed the degree of misalignment which is simply the percentage
deviation of actual REER from equilibrium REER (ERER). Misalignment is shown in
table 4 last column and figure 4. Positive deviations (misalignment) reflect the
appreciation (overvaluation) of actual REER relative to ERER, while negative deviations
indicate the depreciation (undervaluation) of actual REER relative ERER. Exchange rate
misalignment ranged between -4.94 percent in 1998 and 4.40 in 1999 with zero mean
reversion during the period, which reflects the long-run convergence tendency of actual
REER towards ERER in OPT.
Exchange rate misalignment is estimated at about 4 percent in 2010, which
implies that the current REER is higher than the ERER. This may be due to the fact that
2010 data are preliminary and subject to change, particularly the explanatory variables
(PDIF, PINV, and REMIT). Several empirical studies find that high levels of
misalignment between the real exchange rate and the ERER are associated with periods
of macroeconomic instability, while lower levels of misalignment correspond to better
economic performance (see for example Ghura and Grennes, 1993; Elbadawy, 1994; and
Haussman et al., 2005).
16
Estimating of the ERER in the OPT Figure 4 REER, ERER, and Misalignment (in percent)
5.00
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
0.5
REER
2009
2007
2005
2003
2001
1997
ERER
1999
-5.00
2009
2007
2005
2003
2001
1999
1997
0.00
Misalignment
IV. CONCLUSION
This paper estimated the equilibrium real effective exchange rate (ERER) for
OPT. We used two alternative methods to estimate the ERER for OPT, the two-step
Engle-Granger (EG) and the Phillips and Hansen (1990) FMOLS estimator. The
outcomes are of both methods very similar. Data availability and the limited number of
observations were crucial in the choice of the method of estimation and in the choice of
the explanatory variables.
The main result of this paper is that there is a long-run relation between REER
on one hand and productivity differentials (PDIF), private investment as a share of GDP
(PINV), and received remittances as a share of GDP (REMIT) on the other hand. Results
tend to indicate that the share of private investment in total economic activity has been
the most important driving force of the REER appreciation over the sample period,
followed by the productivity differential, which has a more modest effect on the REER.
Remittances as a share of GDP only played a minor role. These results indicate that
stimulating and expanding the private sector requires a more stable REER.
Exchange rate misalignment show high fluctuations in the first two years of the
sample period, followed by low fluctuations in the following years. The year 2010 shows
a relatively high overvalued REER relative to ERER. This may be due to the fact that
17
Saed Khalil and Michel Dombrecht 2010 data are preliminary and subject to change. The fluctuations in the exchange rate
misalignment are associated with the macroeconomic instability in the past decade.
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