Academic journal article Journal of Economic and Social Studies

Real Exchange Rate and Real Economic Fundamentals in Transition Economy of Bosnia and Herzegovina (BH)

Academic journal article Journal of Economic and Social Studies

Real Exchange Rate and Real Economic Fundamentals in Transition Economy of Bosnia and Herzegovina (BH)

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Evidence of nonstationarity in Real Exchange Rate (RER) was the basis of work which viewed Equilibrium Real Exchange Rate (ERER) as driven by real economic fundamentals in transition economies. Pons and Lacasta (2003) have used error correction equation and have estimated long-run cointegration equation of the ERER and the corresponding dynamic error correction specification which strongly corroborated the model and produced fairly consistent results across the countries under study. Utilizing the error correction method and corresponding dynamic error specification Omerbegovic (2005) has found similar results for Bosnia and Herzegovina (BH).

The impact of the fundamentals on the RER behavior was suggested to be dependent on the time horizon studied (Egert, 2006).

In this paper, the relationship between RER and fundamental economic variables is examined using the methodology of co-integration and error correction model as found in Omerbegovic (2005) and Omerbegovic-Arapovic (2009). The findings suggest that there are changes in direction of relationship between certain fundamental variables and RER for BH depending on the sample period under consideration. This suggests that direction of relationship between fundamentals and RER is not stable over time.

The attempt to estimate ERER from observable data on RER and economic fundamentals of BH due to existing nonstationarity in RER has resulted in estimated slight RER overvaluation in 2005, that is, before the financial and economic crisis of 2007 (Omerbegovic, 2009). Utilizing same methodology this paper finds support of undervaluation of RER in the first half of 2012. Counterfactual estimation of fundamentals in order to estimate misalignment is resulting in RER undervaluation due to the observed changed direction of relationship between the resource balance variable and RER, so that improvement in resource balance variable is associated with required appreciation in RER, opposite to postulated theoretical relationship, suggesting that RER is not a significant transmission mechanism in achieving external balance.

The findings show that estimated RER misalignment based on co-integration methodology, which uses data over the period of serious external and internal disequilibrium in economy of BH, can't be determined from observable data on macroeconomic fundamental variables and RER behavior over the sample period, suggesting that RER misalignment in transition is difficult to detect using a time series methods. However, this does not mean that there are no pressures on RER due to fundamentals. Our findings also suggest that other factors, such as monetary phenomena should be examined as potential causes of RER nonstationarity in BH as Kanas (2009) has suggested that shifts between stationary and non-stationary epochs in RER behavior could be mainly determined by the monetary phenomena.

The paper starts by examination of RER nonstationarity by estimation of ERER of BH in order to test the hypothesis of RER misalignment in the middle of 2012 and establish the role of real fundamental variables in RER behavior. Firstly, the literature review on real exchange rate behavior and patterns of real exchange rate behavior observed in transition economies is presented. Section on methodology provides analytical framework used in calculating ERER for BH. It is followed by empirical analysis of estimation of RER misalignment in BH over the two different time horizons. The test of relationship between RER and economic fundamentals of BH extends time series analysis from Omerbegovic (2005) to examine the stability of relationship between real economic fundamentals and RER behavior enabling us to test the effect of time horizon on relationship between fundamental economic variables and RER for BH. Overall, we do not see a large explanatory power of fundamental variables in explaining RER fluctuation in the second period, which is consistent with findings of Kanas (2009) who suggests different phases of RER behavior, where RER could have entered stationary phase compared to the first period. …

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