Estimates of Fundamental Real Exchange Rates for the Five EU Pre-Accession Countries

Are there indications of real exchange rate misalignment in the case of the five pre- accession countries? Will stable real exchange rates, required by two of the Maastricht criteria, be in line with economic fundamentals in the pre-Economic and monetary union period in these countries? In order to address these questions, we employ the concept of the fundamental real exchange rate, taking into account the specific features of countries in the advanced stage of transition. The fundamental real exchange rate model approximates the integration gain with the impact of foreign direct investment on trade and allows for larger current account deficits if external debt is below a safety limit. The model coefficients are calibrated according to our previous econometric work. Sensitivity tests are used to deal with uncertainty about the baseline assumptions. According to the fundamental real exchange rates, there were signs of overvaluation for all the pre-accession economies, with the exception of Slovenia, at the end of 2001. The second main finding relates to the feasibility of stable real exchange rates in the pre- Economic and monetary union period. Stability of real exchange rates will not automatically be in line with economic fundamentals in the forthcoming period and, moreover, the fundamental real exchange rate s do not move in one direction in all the pre-accession countries. This finding suggests that some flexibility of exchange rates will be needed in the forthcoming period.