Real exchange rate appreciation and loss of competitiveness . Case of Latvia

The study explores the phenomena of Latvian real exchange rate appreciation during transition in order to assess if repeatedly heard assertions of overvalued lats and its harming effect on country’s competitiveness are empirically validated. To this end real effective exchange rate of ten major trade partners, including both advanced and transition economies at different stages of their restructuring, has been examined to find out if its dynamics can be explained by fundamentals. Theoretically approach is a synthesis of similar literature on advanced, developing and transition economies. Empirically it is assumed that actual real exchange rates converge to their equilibrium level, following an error correction mechanism. For estimations data of monthly frequency has been used. The research finds that real effective exchange rate appreciation is an equilibrium phenomenon and can be well explained by institutional and structural adjustment, and gains in economic efficiency in general. In spite of a rather short sample, it has been possible to establish a stationary error correction vector, which indicates that the implied relationship is stable over the examined transition period. Our result shows that real effective exchange rate can be supported by the current structure of Latvian economy, and thus supplies no justification for nominal devaluation. * Economics Department Queen Mary and Westfield College Mile End Road London E1 4NS UK e-mail: [email protected] JEL Classification numbers: E52, F31, F41, P52 Acknowledgements I thank Duo Qin for advise and very helpful comments. Thanks also go to Alf Vanags, Anders Paalzow and Helmuts Ancans. Of course, mistakes are my own. The research was made possible thanks to the support from Queen Mary and Westfield College, Stockholm School of Economics in Riga and ORS Awards Scheme. The paper was presented at the Second Seminar of “Managing Economic Transition in Eastern Europe”, 24 May 2000, University College London, School of Slavonic and East European Studies. Thanks to seminar participants for useful suggestions. Real exchange rate appreciation and loss of competitiveness. Case of Latvia Martins Kazaks