Optimum currency areas, structural changes and the endogeneity of the OCA criteria: evidence from six new EU member states

Abstract

This article has two aims. The first aim is to assess the potential for an Optimum Currency Area (OCA) of six New Member States (NMS) of the EU (Bulgaria, the Czech Republic, Hungary, Poland, Romania and Slovakia) with the eurozone, by applying the theory of the Generalized Purchasing Power Parity (G-PPP). The second aim is to examine whether the introduction of the euro in 1999 and the policy decision of the six countries to join the eurozone, have created any forces fostering their convergence – evidence which would be in line with the theory on the endogeneity of the OCA criteria. Our findings indicate that G-PPP holds for the real exchange rates of the six NMS for the post euro period, and that the introduction of the euro and the choice of the six economies to participate in the EU did promote their integration.

Notes

¹ On the other hand, an opposite view states that economic integration creates incentives to exploit economies of scale, resulting in greater exposure to asymmetric shocks (Krugman and Venables, 1996).

² The idea that third country effects should be taken into account when testing for bilateral PPP is further developed in Sideris (2006a).

³ In particular: Enders and Hurn (1994) test for G-PPP using the exchange rates of a group which includes industrialized countries and countries of the Pacific Rim. Sarno (1997) tests for cointegration of the real exchange rates of a number of EMS countries for the period before the introduction of the euro. Bernstein (2000) assesses cointegration of the real exchange rates of a group of European countries. Antonucci and Girardi (2006) use the real exchange rates of 11 EMU countries and examine the effects of structural changes on the behaviour of the real exchange rates. Aggarwal and Mougoue (1993), Ogawa and Kawasaki (2003), Choudry (2005), Ahn et al. (2006), Kawasaki and Ogawa (2006) and Wilson and Choy (2007) use the concept of G-PPP in order to provide insights on whether East Asian countries should proceed to a monetary union. Neves et al. (2008) examine whether the Mercosur economies form an OCA.

⁴ Analysis of the behaviour of the real exchange rates is essential in the international economics literature. Stationarity of a bilateral real exchange rate implies that PPP holds between the two economies, evidence which, in turn, indicates that the two economies are well integrated. The real exchange rate also offers a measure of competitiveness between the two countries and can provide an equilibrium value for the nominal exchange rate.

⁵ A number of reasons have been offered in the literature to explain the empirical failure of PPP at its strong version (for a survey, see, inter alia, Taylor, 2006). The reasons include: problems due to productivity differentials – the Balassa–Samuelson effect – (see, inter alia, Lothian and Taylor, 2008) measurement errors, (see, inter alia, Taylor, 1988), aggregation problems (see, inter alia, Taylor, 2001), the effects of interventions in the foreign exchange markets, (see, inter alia, Sideris, 2008), the effects of home bias (Mylonidis and Sideris, 2008).

⁶ Following Juselius (2006), the trace test is more robust than the maximum eigenvalue test.

⁷ These findings are in line with those of the relevant literature: Angeloni et al. (2007) report that the real exchange rates of 10 NMS – which include the six CEECs – tend to converge in the post-1999 period. Candelon et al. (2007) provide estimates of fundamental-based real exchange rates of eight NMS and indicate that their differences from the observed rates tend to disappear in the period 1999–2003. Horvath (2007) finds out that a group of NMS – including the six CEECs – are well aligned with the euro area for the period 1999–2004. Crespo-Cuaresma et al. (2005) report that equilibrium exchange rates – estimated using the monetary model – tend to be relatively stable in the period 1994–2002.

⁸ This may cause some doubts on the necessity of this rate for the G-PPP relationship; still, the cointegrating space is not fully specified, so we do not investigate this issue further.

⁹ For the effects of interventions on the behaviour of the nominal and real exchange rates of a number of CEEC economies see, inter alia Egert (2007) and Sideris (2008).

¹⁰ The role of regulated prices is shown to be significant for the behaviour of the real exchange rates of Hungary and Slovakia in MacDonald and Wojcik (2004).

¹¹ A summary of the exchange rate policy measures pursued in Hungary and Poland in the period 1990–1999 is presented in, inter alia, Dibooglu and Kutan (2001).