Foreign exchange rate policy implacations on competitiveness in by tyndale



                    FARKAS-FEKETE, MÁRIA – SÁGI, JUDIT


    By this study we follow the discussion initiated by prof. Magda in his article
“Exchange rate policy and the agriculture”, also reflecting to Lakner-
Podrudzsik “Does the depreciation of the forint mean a medicine or a placebo?”
    We argue that the real effective exchange rate – in case of small and open
economies, especially in the medium term – basically determines the competi-
tiveness of the economy as a whole, and the agriculture, as a part. In this paper
we analyse the effects of the forint exchange rate divergence from the equilib-
rium exchange rate and its volatility, in relation to the specifications of the agri-
cultural sector with possibilities to accommodate. In this sense we correspond to
prof. Csáki, saying that recent appreciation of the forint has clarified the insuffi-
cient competitiveness and weak effectiveness of the Hungarian agriculture.
    Key words: monetary policy, foreign exchange rate, parity

            INTRODUCTION                      fundamentals but mostly by the interest
                                              rate expectations of foreign investors.
    Hungary, during the previous years, –         Given this background, Hungary tends
in the scope of a prospective join to the     to be relatively more vulnerable to the
Economic and Monetary Union (“EMU”)           various consequences of exchange rate
– has been moving towards more exchange       fluctuations than are the EMU members.
rate flexibility; towards the EU exchange     The greater vulnerability arises from,
rate mechanism (“ERM-2”). Accordingly,        among other possible factors, the pattern
the exchange rate no longer plays the role    of consumption associated with relatively
of the main policy objective or the nominal   low incomes and the history of higher in-
anchor. At the same time, there seems to      flation. (According to the Engel’s law, in
be a trend towards the adoption of a more     countries of lower GNP the households
explicit inflation target.                    spend relatively more on foods. For ex-
    In fact the Hungarian foreign ex-         ample, in 2004 the proportion of foods
change rate policy is unclear and mislead-    within consumption was 13.4% in the
ing to financial markets. There is no cer-    EU-15 average, whereas 18.2% in Hun-
tainty in reasonably targeting the forint     gary. Source: EUROSTAT)
band: fixing the forint/euro conversion           It is generally accepted (see Ho, C.
rate at 245-250 makes the economic            and McCauley, R. N., 2003) that even un-
growth rate weaker, while, as opposite, an    der a strict construction of inflation target-
undervaluated forint conveys inflation        ing, exchange rate considerations can be
pressure. Moreover, the actual forint mar-    expected to play a more prominent role in
ket exchange rate is less affected by the     an emerging market economy, given the

greater sensitivity of domestic prices to                         Furthermore, these exchange rate move-
the exchange rate. Indeed, the experience                         ments have been associated with missed
of recent years shows that Hungary have                           inflation targets and non-credible mone-
suffered large exchange rate movements.                           tary policy.
                                                                                                  Figure 1

                                        Nominal HUF/EUR exchange rate

                                           HUF/EUR conversion rate







              4        1       6       2       6       3        8       5       9       4       1        6       2       7
            d0      d2       d0      d2      d0      d2      d0       d2      d0      d2      d1      d2       d1      d2
          01      06       12      05      11      04      10       03      09      02      08      01       07      12
        m       m        m       m       m       m       m        m       m       m       m       m        m       m
      99     99       99      00      00      01      01       02      02      03      03      04       04      04
    19     19       19      20      20      20      20       20      20      20      20      20       20      20

    Given the importance of the ex-                                   A generally accepted expression for
change rate, there is all the more need to                        the effective real exchange rate of coun-
understand better the nature of exchange                          try i (Ei) is given by
rate dynamics, and their impact on the                                                                        ϖ ij
economy, especially on agriculture. As a                                             Pit S ijt
                                                                                      n                   
                                                                        E it = ∏                         
consequence, since a certain degree of                                              
                                                                               j =1  P jt
                                                                                           *              
flexibility is going to sustain even within                                                               
the ERM-2, appropriate tools should be                            where Pi measures the domestic price
involved in hedging the FX risk.                                  level in country i; P*j the foreign price
                                                                  level in country j; Sij the relevant nominal
                                                                  exchange rate (defined as foreign currency
    We start by discussing which defini-                          per unit of domestic between countries i
tion of the exchange rate is convenient,                          and j); and ώij is the weight of country j in
whether it is nominal or real, and, if real,                      country i’s effective exchange rate index.
which price deflator is to be used. The                           As such an increase in Ei implies that the
nominal bilateral exchange rate is deter-                         currency has appreciated, or alternatively
mined directly in financial markets. How-                         that it has become less competitive.
ever, most theories of equilibrium ex-                                Definitions of the real exchange rate
change rate (see Driver and Westaway,                             include measures based on:
2004) refer to real effective measures of                         • Consumer price indices. This will be ap-
the exchange rate, albeit using different                         propriate if we are concerned with a com-
definitions of the relevant price index.
Gazdálkodás, Vol. XLIX. Special edition No. 12                                                        3

parison of price levels for goods bought by              Since these different price indices do
consumers in different countries.                    not move together in the short run or even
• The prices of tradable goods or output             necessarily in the longer run, there is no
prices. This will be used if we are con-             unique measure of the real exchange rate
cerned with the price competitiveness of             on which it is appropriate to focus.
goods exported by an economy.                            The Hungarian National Bank’s statis-
• The price of an economy’s exports                  tics include real-effective exchange rate
compared to the price of its imports.                calculations, using the consumer price in-
This gives a measure of a country’s                  dex (CPI) or the relative wage index. The
terms of trade, or the relative purchasing           former is relevant in the agriculture, with
power of domestic agents.                            respect that the labour is immobile in this
• Relative unit labour costs. This will be           sector. The following chart illustrates the
appropriate if we are focusing on the                real-appreciation of the Hungarian forint
cost competitiveness of an economy.                  during the period of 2000-2004. On the
• The ratio of tradable to non-tradable              basis of January 2000, the forint – in real
prices. This is appropriate for assessing            terms, deflated by the CPI – has appreci-
the real exchange rate within an economy.            ated by nearly 25%.

                                                                                               Figure 2

               The real-effective forint exchange rate during 2000-2004

                              Change of the REER CPI

                        n        l     n        l        n        l        n        l        n        l
                     .ja      .jú 1 .ja      .jú      .ja      .jú      .ja      .jú      .ja      .jú
                  00       00      0      01       02       02       03       03       04       04
                20       20      20     20       20       20       20       20       20       20







    DISCUSSION: WHY THE FOREIGN                      tions may be the most direct concern,
     EXCHANGE RATE MATTERS                           particularly for inflation targeting econo-
                                                     mies. However, there are also other rea-
    Why do policymakers, enterprises,                sons for concern. These include the im-
households, etc. care about exchange                 pact on the external sector, on the finan-
rate fluctuations? To begin with, the im-            cial stability and on the functioning of
pact on prices through trade and expecta-            FX markets.

     i. The effect of exchange rate               These external sector consequences
              on inflation                    of exchange rate fluctuations are ex-
                                              pected to be more relevant for economies
     Exchange rates can influence infla-      that are more open to and dependent on
tion through the prices of traded final       trade and foreign investments.
goods and imported intermediate goods,
and through their impact on inflation ex-               iii. Financial stability
pectations. There exists a long-standing
line of research on the influence of ex-          Exchange rate fluctuations can desta-
change rate changes on domestic prices –      bilise any economy’s financial system;
the so-called exchange rate pass-through.     however, the connection between the ex-
It is a stylised fact that emerging market    change rate and the financial fragility is
economies tend to experience higher           a complex one.
pass-through: they show a stronger link-          Concern for an unsustainable rise in
age between the exchange rate and do-         the currency ultimately leading to finan-
mestic prices, and a history of high infla-   cial instability is based on the following
tion even accentuates this linkage. The       stylised sequence. A real appreciation
reason is that prices of tradable manufac-    associated with large capital inflows can
tures and agricultural goods are com-         go hand in hand with a rapid credit ex-
paratively more susceptible to the influ-     pansion and increase in asset prices,
ence of the exchange rate than the prices     leading to an investment boom and asset
of non-traded services.                       price bubble. This overextension of the
     If the focus of monetary policy is       domestic financial system in turn makes
mainly on inflation, like in Hungary,         the economy vulnerable to a slowdown –
then it is surprising why monetary au-        or even a reversal – of capital inflows.
thorities devote less attention to the evo-   The real appreciation in the build-up
lution of the exchange rate and its influ-    phase can also adversely affect export
ence on domestic prices.                      competitiveness and investment in the
                                              external sector. A subsequent collapse of
           ii. External sector                asset prices can erode the balance sheets
                                              of banks and non-banks alike. Moreover,
    Besides their implications for infla-     a decline in the exchange rate in the face
tion, exchange rate trends and uncertainty    of capital outflows can hurt the solvency
in general can also be causes for concern     of firms with net foreign currency liabili-
via their potential impact on the external    ties. These financial consequences can
sector. For example, an overly underap-       also have real effects via the “credit
preciated exchange rate could affect an       channel”, as the decline in asset prices
economy’s external competitiveness (de-       and credit quality makes it difficult for
pending on price-sensitivity of the export-   firms to borrow and invest. Wealth ef-
ers and the importers), which could in        fects and unemployment can take a toll
turn impinge on the external balance, ag-     on consumption as the current accounts
gregate demand and growth. Persistence        adjust via import compression.
in such trends may, in the longer run, in-
fluence the incentives for investment and     iv. FX markets and interest rate levels
the allocation of resources among differ-
ent sectors. In addition, exchange rate           As discussed by prof. Magda, persis-
fluctuations may generate uncertainties       tent trends in the exchange rate can be a
that could impede trade.                      cause for concern with respect to the
Gazdálkodás, Vol. XLIX. Special edition No. 12                                        5

nominal interest rate. However, we em-        domestic currency; so is stressed to apply
phasise our worries about short-term ex-      for access funds in euros. So private enter-
change rate volatility, which may in-         prises, having financed by euro debts, are
crease the risk premium of forint de-         exposed to the movements in the euro-
nominated loans.                              forint exchange rate due to the currency
    In small foreign exchange markets,        mismatch deriving from euro repayment
excessive exchange rate volatility may        obligation and regular forint revenue.
contribute to illiquid market conditions,
typically characterised by wide bid-ask                      CONCLUSIONS
spreads and sudden jumps in prices. Fur-
                                                  Finally we shall stress that not only
thermore, small and illiquid foreign ex-
                                              the exchange rate level (besides other
change markets may also be prone to
                                              real-variables of the economy) is crucial
suffer from the absence of “two-way
                                              to market agents in agriculture, but there
risk” (ie when market participants tend
                                              is a certain point of the price and interest
to be on one side of the market with few
                                              rate uncertainties generated by the for-
willing to take the other side). Over the
                                              eign exchange rate movements.
long term, illiquid foreign exchange
                                                  One should be aware that the foreign
markets can affect the feasibility and ef-
                                              exchange rate is a depending variable in
fectiveness of market-oriented operating
                                              itself, the end result of the competitive-
procedures. Market functioning also af-
                                              ness within the economy and the agricul-
fects the validity of information exact-
                                              ture. In the short run, movements in the
able from market exchange rates and re-
                                              real exchange rate are determined by
lated asset prices (eg market expecta-
                                              changes in the nominal exchange rate. In
tions, assessment and pricing of risk) for
                                              the medium term the real exchange rate
the purpose of monetary policies. From
                                              is affected by indicators mainly associ-
the private sector’s point of view, the
                                              ated with the balance of payments and
lack of market liquidity is likely to com-
                                              by real shocks to the economy.
plicate – if not distort – agents’ pricing,
                                              Komárek, Čech, and Horváth (1) identi-
trading and risk management practices.
                                              fied several factors that should most af-
    Small and open economies with rela-
                                              fect the Eastern European countries’
tively high government debt often face
                                              nominal exchange rates prior to the eu-
volatile short-term interest rates, as a
                                              rozone entry. These are: (i) productivity
consequence of the volatility of their ex-
                                              growth and the wage-setting process in
change rates. In case of Hungary, higher
                                              the economy; (ii) the way in which fiscal
risk premium consisting of country and
                                              and monetary policy is pursued; (iii) the
currency risk increases the interest rate,
                                              stability of the financial sector; (iv) the
that is, the cost of external financing.
                                              problem of external (endogenous)
        v. Currency mismatch                  shocks; and (v) other factors.
                                                  Two main issues are involved in our
    Currency mismatch is a situation in       conclusions. The first is why the exchange
which the profile of actual and potential     rate matters, especially for enterprises in
foreign currency commitments is insuffi-      agriculture. The second is under what cir-
ciently matched by the profile of actual      cumstances and how they deal with the
and potential foreign currency cash flow      risk of exchange rate fluctuations in the
available at the corresponding time hori-     context of non-credible monetary policy.
zon. For example, the private sector in       We have found that agricultural enter-
Hungary can hardly borrow for long run in     prises, being more exposed to the influ-

ence of the exchange rate (in the absence     more from the enhanced FX risk of for-
of appropriate hedging instruments), suffer   eign trade and capital movements.


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Farkas-Fekete, Maria
Szent István University, Economics Department
H-2103 Gödöllı, Páter Károly u. 1; Hungary
Phone: ++ <36-28-522000>; Fax: ++ <36-28-522000/1956>
E-mail: <>

Sági, Judit
senior lecturer / PhD student
BBS College of Finance and Accountancy, Finance Department
H-1149 Budapest, Buzogány u. 10-12; Hungary
Phone: ++ <36-1-4696697>; Fax: ++ <36-1-4696624>
E-mail: <>

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