Real Exchange Rate Dynamics in Transition Economies

Real exchange appreciation has been a common feature in transition economies since the launching of stabilization and reform programs at the beginning of the 1990s. Previous literature has described this phenomenon as an equilibrium adjustment that followed a sharp undervaluation at the start of the reforms. This Paper argues that real appreciation had different sources over time and across countries. Building on a simple analytical framework, the Paper disentangles these differences and stresses the role of structural reforms and factor reallocation in determining the behavior of the real exchange rate. The empirical results show that the nature of the real appreciation was significantly different in the countries of the Former Soviet Union (FSU), except for the Baltic countries, and in Central and Eastern Europe. The role of structural change and transitional reallocation of resources across sectors diminishes through time, and stabilizes around the fifth or sixth year into the transition. The dynamics of the real exchange rate in several Central-Eastern European countries (CEE) in the process of accession to the European Union, can be now assimilated to that of previously acceding countries such as Spain, Portugal, and Greece, with the Harrod-Balassa-Samuelson effect playing a dominant role at later stages of transition. The Paper concludes by discussing the implications for exchange rate policy for transition economies and potential drawbacks of the Maastricht criteria once CEEs enter the European Union.