Real exchange rates and transition economies

Transition economies appear to be subject to the Harrod-Balassa-Samuelson (HBS) effect in many studies. This implies that their currencies have experienced a prolonged appreciation in real terms as their convergence proceeded. In this paper we find that a long-run relationship exists between the real exchange rate, productivity differentials, real interest rate differentials and the capital account for six transition economies of Central and Eastern Europe, using monthly data over a period which extends from the early 1990s to the end of 2005. We find that there are two sources of appreciation of the currencies of these countries, namely the HBS effect and the capital account effect, and argue that their significance depends on the type of investment received by the countries. While long-run fixed direct investment (FDI) enhances productivity, porfolio investment leaves productivity unaffected, so the larger FDI relative to portfolio investment, the greater the contribution of productivity in the determination of the real exchange rate. Moreover, we find that while the variables are linked by a linear long-run equilibrium relationship, adjustment towards equilibrium is nonlinear and is represented by a smooth transition mechanism where the degree of equilibrium correction is a function of the sign and/or the size of the deviation from equilibrium. Interestingly, we find that a logistic smooth transition model fits well a larger number of countries, by allowing a different response of the real exchange rate to misalignments of different sign.