Asymmetries, productivity and capital account effects in the determination of the Real Exchange rate: the case of Transition Economies

Transition Economies appear to be subject to the Balassa-Samuelson (BS) effect in many studies. This implies that their currencies experience a prolonged appreciation in real terms as their convergence goes on. However, in the existing literature, little attention has been given to the relation between the capital account and the BS effect. In this paper we show that the significance of the latter depends crucially on the composition of the capital account. Long-run investment (FDI) enhances productivity, while porfolio investment (PI) leaves the latter unaffected. We show that the larger the FDI relative to PI, the greater the contribution of productivity in the determination of the real exchange rate in the long-run. This is not the case, though when FDI and PI move close to each
other, as a percentage of GDP. We find that a long-run relationship exists between the real exchange rate, productivity differential, the real interest rate differential and the capital account. Moreover, those variables cointegrate in a nonlinear fashion.