SPECIAL TOPICS IN RESEARCH

CENTRALNA BANKA BOSNE I HERCEGOVINE ЦЕНТРАЛНА БАНКА БОСНЕ И ХЕРЦЕГОВИНЕ STI/03/07 ISSN 1840-2593 SPECIAL TOPICS IN RESEARCH NOMINAL AND REAL EFFECTIVE EXCHANGE RATE FOR BOSNIA AND HERZEGOVINA M.A. Sandra Hlivnjak July 2007

Issued by: Central Bank Bosnia and Herzegovina Department for the Economic Research, Statistics and Publications M.Tita 25, 71000 Sarajevo Phone: +387 (33) 278 225 Fax: +387 (33) 278 188 web address: www.cbbh.ba email: contact@cbbh.ba Council for the Economic Research: M.Sc. Kemal Kozarić Feriha Imamović M.Sc. Amir Hadžiomeragić Ph.D. Prof. Mila Gadžić Ph.D. Prof. Ljubomir Kovačević Peter Nicholl M.A. Sandra Hlivnjak The views expressed in this paper are those of the author and do not necessarily represent those of the Central Bank of Bosnia and Herzegovina or CBBH policy. JEL: C40, C43, F10 Keywords: REER, NEER Author e-mail address: shlivnjak@cbbh.ba ISSN 1840-2593 2

Content Introduction 4 I Acknowledgement and methodology for calculation of the nominal, real, nominal effective and real effective exchange rate 5 II Nominal and real effective exchange rate 9 Conclusion 13 Reference 15 3

Introduction It is well known statement that economic indicators attract a lot of attention, but especially those which are indicating international competitiveness of a single country. The purpose of this paper is to introduce two economic indicators nominal effective exchange rate and real effective exchange rate which are good indicators of countries competitiveness. In the future, the intention of the author is to form an equilibrium exchange rate for Bosnia and Herzegovina - BEER (Behavioural Equilibrium Exchange Rate) through an empirical model which will show the relationship between the real effective exchange rate and independent variables. In Bosnia and Herzegovina there is still a lot of problems that are an obstacle in defining such a relationship. Some of fundamental ones are: short time series, CPI is still not set as an index (so as a proxy author is using retail price indices), statistic series on tradables and not-tradables goods as a separate categories does not exist, to the further extend that it is still impossible to even confirm BS-effect 1 in Bosnia and Herzegovina. Bosnia and Herzegovina also has a rapidly changing economic structure so that even longer time series estimating the future from past events relationships will need to be dealt with the caution using judgment. For all these reasons, focus in the further text of the analyze will be on nominal and real effective exchange rate on its set up and movements. Central Bank of Bosnia and Herzegovina (CBBH) has published movements of NEER and REER during 2003 up till June 2005. During that period CBBH has considered only nine foreign trade partners in order to set up nominal and real effective exchange rate indices. In July 2005 all series were revised and CBBH now consider twenty trade partners in its NEER and REER indices. The reason for revision were changes in the market condition, as these changes are affecting the adequacy of indices and total participation of the main trading partners in the foreign trade of Bosnia and Herzegovina. 1 Balassa-Samuelson effect (BS-effect) 4

In the next section of the paper a proper definition of NEER and REER will be stated, acknowledgment of the methodology will be made, as well as short analyze of the movements in NEER and REER indices. I Acknowledgement and the Methodology for calculation of the nominal, real, nominal effective and real effective exchange rate Very important indicators for the evaluation of the macroeconomic external position and the competitiveness of countries that are an open market economy are: nominal exchange rate, real exchange rate, nominal effective exchange rate (NEER) and real effective exchange rate (REER). While creating the indices of NEER and REER, it is very important to take care about the following: nominal exchange rate, choice of foreign trade partners, weighting system and the base year. Different options for choice of weights are available as well as, different options for choice of price or cost index. In the literature as well as in practice, the best formulation has been accepted as following: overall trade weights, the CPI and a geometric average. This formulation has been used as the base for nominal and real effective exchange rate calculation for Bosnia and Herzegovina as well. Nominal exchange rate is the ratio of the local currency and the currency of the selected foreign country, meaning that price of one currency is expressed in another currency. So the BH rate of KM against EUR is defined at 1 KM for 0.51 EUR. Nominal exchange rate shows how many units of foreign currency it takes to buy one unit of domestic currency. Real exchange rate, between two countries that have different currencies, represent the measure which compare prices of goods and services of one country in relation to the another country uses that to correct the nominal exchange rate. Therefore the real exchange rate is the multiplication of the nominal exchange rate with the quotient of the inflation in two countries. The real exchange rate shows how many units of 5

foreign goods it takes to purchase one unit of domestic goods. The growth of the domestic real exchange rate represents the real deprecation of the domestic currency in relation to the foreign currency. This means that the purchasing power of KM regarding the foreign goods and services has decreased for relevant percentage of KM purchasing power regarding the local goods and services, i.e. BH goods and services are cheaper in comparison to foreign goods. Movement opposite to a real depreciation is a real appreciation. Nominal effective exchange rate (NEER) in BH is calculated according to the multilateral principle. According to this principle, nominal effective exchange rate represents the summary indicator for the change in nominal value of the local currency. NEER is the weighted average of several nominal exchange rates of the main trading partners (for certain month or year, taking into account a particular base period). The word effective represents the weighted average towards the group of countries, (main trading partners) whereby nominal exchange rate is used to express relation only towards one country. Nominal effective exchange rate is an index number where its decrease is a sign of appreciation and its rise a sign of depreciation. Real effective exchange rate (REER) is calculated from the nominal effective exchange rate which is corrected by the balance between the local economy and the inflation of the countries main trading partners. Therefore, when calculating the real effective exchange rate, the nominal exchange rate is deflated by relative prices or costs in the main trading partners. The index of the real effective exchange rate is used to analyze the influence of the exchange rate change on the competitiveness of the domestic economy. If there is an increase in real effective exchange rate index this means a drop in real KM value, but at the same time an increase in the competitiveness of the local products and businesses in the market of the main BH trading partners. The real effective exchange rate is expressed as an index number which shows the average increase appreciation (index below 100) or average decrease, depreciation (index above 100) compared to base year. Calculation of the nominal (NEER) and real (REER) effective exchange rate indices is based on the monthly data series. The time frame for the calculation covers April 2002 and the most resent monthly data available. 6

In order to calculate nominal and real effective exchange rate it is very important to take care about the following: nominal exchange rate, selection of the appropriate trading partners, participation of a trade partner in the total foreign trade exchange and the base year selection. In total twenty trade partners has been selected in order to set up an index. The applied rule was that total partners should have at least 85% participation in total foreign trade exchange. According to this rule BH 20 main trading partners are participating in total foreign trade exchange with 88.3% (Table 1). Those countries are: EU (Austria, Czech Republic, France, Germany, Hungary, Italy, Lithuania, Poland, Slovenia and The Netherlands), Croatia, China, UK, Macedonia, Romania, Russan Federation, USA, Serbia and Montenegro, Switzerland and Turkey. Table 1 Partner country BH April 02 - April 07 Imports from Exports to weight Croatia 5.1% 12.7% 20.1% Germany 3.0% 9.4% 14.1% Serbia and MN 3.9% 7.1% 12.4% Italy 3.8% 6.8% 12.0% Slovenia 2.8% 5.7% 9.6% Austria 1.3% 3.1% 5.0% Hungary 0.6% 3.2% 4.3% Switzerland 0.9% 1.4% 2.6% China 0.0% 2.1% 2.3% Turkey 0.1% 1.8% 2.2% France 0.4% 1.5% 2.1% USA 0.7% 1.2% 2.1% Czech Republic 0.2% 1.7% 2.1% Russian Federation 0.0% 1.7% 1.9% Poland 0.3% 1.3% 1.9% Romania 0.2% 1.3% 1.8% Holland 0.2% 0.8% 1.1% UK 0.4% 0.5% 1.0% Macedonia 0.2% 0.6% 0.9% Lithuania 0.3% 0.0% 0.4% April 2002 is set as the base year and the following formulas were used to set up indices. To calculate an index of the nominal effective exchange rate the geometric average approach has been applied using eleven nominal KM exchange rates 7

i w NEER t = 100 T i it where i = EUR, CNY, HRK, MKD, ROL, RUR, SRD, CHF, TRL, GBP, USD. Symbol ( T it ) represents the average nominal exchange rates between KM and main trading partner currencies (i) recorded in the month (t), and divided by the base period. Symbol ( w ) is the weighted average for the currency (i), while symbol ( ) i represents the operation of multiplication. In order to calculate overall trade weight the following formula has been used: I I U U i = v wi v wi where w + I total export of partner (i); U total import of partner (i); I+U = total trade v I I = I + export share; U v U U = I + import share; U I I i U U i wi = export weight of partner (i) i wi = import weight of partner (i) I U In order to calculate an index of the real effective exchange rate the following formula has been used: REER t = i w P i P t it NEER t Symbol ( P it ) represents the base index of prices in month (t) for each country individually, while ( P t ) represents the index of domestic prices compared with the base period. In brief, REER was calculated as an index of NEER, adjusted by the relevant connection between weights and base index of prices of the main trading partner countries. Deflation has been done using CPI, published by the IFS, except for Bosnia and Herzegovina and Serbia where retail price indices were used, published by CBBH for BH, and for Serbia 1 by National Bank of Serbia. 1 In the whole calculation we used the data on total foreign trade exchange of BH with Serbia and Montenegro 8

II Nominal and Real Effective Exchange Rate Regular availability of NEER and REER on monthly basis will provide us with an opportunity for more detailed analyze of Bosnia and Herzegovina competitiveness. NEER will enable us to see how much KM has depreciated or appreciated toward each main trading partner individually and as a group indicator. REER will provide us with the measurement of change in competitiveness relative to the base year, not the level of competitiveness at any given time. Disadvantage of Bosnia and Herzegovina is that the availability of fairly comparable data series is very short and the availably of data is very limiting so that NEER and REER for the time being can be expressed only as monthly indicator. Series of yearly indicator is still short and quarterly indicator is still work in progress. Everything stated is a limiting factor for the analyze but till these conditions improves the focus for the analyze will represent only the available monthly data. So based on available information the following can be noticed: Table 2 Partners in foreign trade exchange Relative price index Bilateral weights / dec M4 2002 θ M12 2006 ex. rate / 2006 EU 1.00 0.96 1.00 48.4% Switzerland 1.00 0.92 0.92 2.6% China 1.00 0.89 0.70 2.3% UK 1.00 1.02 0.91 1.0% Croatia 1.00 0.98 1.01 20.1% Hungary* 1.00 1.09 0.95 4.3% Macedonia FYR 1.00 0.92 0.99 0.9% Romania 1.00 1.40 0.85 1.8% Russian Federation 1.00 1.43 0.79 1.9% Turkey 1.00 1.56 0.62 2.2% USA 1.00 0.99 0.67 2.1% Serbia and Montenegro 1.00 1.48 0.77 12.4% *This partner was analized outside EU as well. Total foreign trade exchange between Bosnia and Herzegovina and its main trading partners amounts to 88.3%. Highest participation in BH foreign trade exchange is with the EU with 48%, and the smallest Macedonia with 0.9%. 9

Prices in Bosnia are lower than prices of the six main trading partners being, UK by 2%, Hungary by 9%, Romania by 40%, Russian Federation by 43%, Turkey 56% and Serbia and Montenegro by 48% and higher with remaining from the Table 2, when compared to the base year, April 2002. Analyzing the bilateral exchange rates, the KM is stabile against EURO because of the Currency Board arrangement, and KM appreciated toward all its main trading partners except Croatia. KM appreciated the most toward TRY 38% and USD 13%, which means that purchasing power of KM in its base year, was weaker when compared to December 2006. In order to highlight the importance of the base year selection in following example base year will be change to April 2004 (Table 3). Once the base year has been changed a somewhat different picture can be noticed. Table 3 Partners in foreign trade exchange Relative price index Bilateral ex. weights / M4 2004 θ M12 2006 rate / Dec. dec 2006 EU 1.00 0.94 1.00 47.7% Switzerland 1.00 0.91 0.97 2.2% China 1.00 0.93 0.95 2.6% UK 1.00 0.98 0.99 0.8% Croatia 1.00 0.96 1.02 20.1% Hungary* 1.00 1.00 0.99 4.0% Macedonia FYR 1.00 0.94 0.99 1.0% Romania 1.00 1.08 1.19 2.1% Russian Federation 1.00 1.15 0.99 2.0% Turkey 1.00 1.13 0.87 2.3% USA 1.00 0.96 0.91 2.4% Serbia and Montenegro 1.00 1.22 0.89 12.8% *This partner was analized outside EU as well. Total foreign trade exchange of Bosnia and Herzegovina with its main trading partners amounts to 88.8%. EU by 47,7% still has the highest participation in foreign trade exchange while Macedonia by its 0.8% still has the smallest participation in foreign trade exchange as one of Bosnia and Herzegovina main trading partners. The total outlook of BH foreign trade exchange is now a bit different and that can be notice though some sort of more intensive trade exchange with China, Macedonia, Romania, Russian Federation, Turkey, USA and Serbia and Montenegro while somewhat smaller participation in Bosnia and Herzegovina foreign trade exchange is expressed through trade exchange with EU, Switzerland, UK and Hungary. 10

Prices in BH are still higher compared to almost its all main trading partners except Romania, Russian Federation Turkey, Serbia and Montenegro. Prices in Serbia and Montenegro are 22% higher then in BH compared to the base year, April 2004. Appreciation of KM was recorded towards almost all its main trading partners only except Romania and Croatia. The highest depreciation was recorded with ROL (Romanian Lei) by 19%. It can be concluded that purchasing power of KM in its base year April 2004, was weaker when compared to December 2006. When analyzing movements in NEER it has to be kept in mind that all the changes were mainly the result of changes in the exchange rate between euro and the currencies of main trading partners. The following graph shows movements of the real and nominal effective exchange rate indices for KM compared to the base period April 2002. 104.00 102.00 100.00 98.00 96.00 94.00 92.00 90.00 Nominal and real effective exchange rate for Bosnia and Herzegovina (04.2002=100) M4 2002 M6 2002 M8 2002 M10 2002 M12 2002 M2 2003 M4 2003 M6 2003 M8 2003 M10 2003 M12 2003 M2 2004 M4 2004 M6 2004 M8 2004 M10 2004 M12 2004 M2 2005 M4 2005 M6 2005 M8 2005 M10 2005 M12 2005 M2 2006 M4 2006 M6 2006 M8 2006 M10 2006 M12 2006 M2 2007 M4 2007 NEER_20 REER_20 Data analysis shows a very slight increase of the nominal effective exchange rate index, which is an indicator of depreciation of KM against the currencies of main trading partners in the given time period. NEER in April 2006 (measured by currencies of eleven main trading partners of BH) was 14 basis points above the level in March and 32 basis points above the 2006 average. Increase of REER index shows a smaller apreciation of real effective KM exchange rate in April 2006 2, which is an indicator of increased competitiveness of domestic economy on the market of main 2 In order to calculate REER, data on consumer price index were used, published by IMF in its monthly publication IFS. 11

trading partners. In April 2006, REER was 101 basis points above the level in March and 2.4 percentage points above the 2006 average. If analyze is focused on the month of April, there is a noticeable gap between REER and NEER of 8.1%. Such a wide gap is the result of differences in inflation and nominal exchange rate between BH and the main trading partners. The most obvious drop in REER index was in January 2006, as a result of VAT implementation. 12

Conclusion This paper is presenting the overview of theoretic approach to Real and Nominal Effective Exchange Rate indicators calculation for Bosnia and Herzegovina. Special attention is dedicated to statistical difficulties in calculation and still limited implementation of this approach in Bosnia and Herzegovina. In order to measure competitiveness of BH foreign trade position twenty partner countries which total foreign trade amounts to 88.3% was selected. Selected partners in foreign trade exchange totally import from BH 24.9% of goods and export to BH 63.4% of its goods. Only these numbers are indicator that BH has to work a lot in order to improve its competitiveness position. It is widely known statement that country s competitiveness improves when the relative price of its tradable goods declines. BH mostly trade with its raw materials (which are mostly natural wealth of the county like wood, coal and bauxite) so this cannot be the only long-term and permanent solution for the country. REER is an indicator which is mostly used to determine if there is a need for the exchange rate adjustment and that is why the adequate selection of the base year is so important especially in Bosnia and Hercegovina where comparative base is changing every year, so identification of a base year is also a problem. NEER and REER are just one of the options available for the measurement of countries competitiveness which have to be tracked and analyzed on a regular basis. It is also recommended that it is necessary to work on further development of indicators while at the same time working on the development of Bosnia and Herzegovina. Monthly data can presents only a temporary solution for the analyze and in meanwhile it is necessary to work on improvements of data series so that they can become adequate and confident for the future more detailed analyze with quarterly and yearly data series. 13

Improved statistics will help to better understand domestic and foreign preasures on the market, it will enable more data transformation and combinations with the data, as well as, alignment of methodology with more developed countries. All this is also needed in order to enable Bosnia and Herzegovina to have easier integration in EU market which is a common goal of all countries in the region. 14

Literature - BIS Economic Papers, Measuring International Price and Cost Cometitiveness, November 1993. - Bruno Solnik, International Investments, 2000. - ECB Monthly Bulletin, September 2004. - ECB, The update of the euro effective exchange rate indices, September 2004. - ECB, The Monetary Policy of the ECB 2004. - Havrylyshyn O and Saleh M. Nsouli, A Decade of Transition: Achievements and Challenges, IMF, 2001. - Isard, Faruqee, Kincaid and Fetherston, Methodology for Current Account and Exchange Rate Assessments, IMF, 2001. - IFS, International Financial Statistics, Various Issues, Monthly Publications - IMF, Macroeconomic Adjusment: Policy Instruments and Issues, August 1992. - Michael W. Klein, Mathematical Methods for Economics, 1998. - Thorvldur Gylfason, The Real Exchange Rate Always Floats, April 2002. 15