## 1.     A Review of Equilibrium Exchange Rate Methodology

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### III. Introduction and objectives
- Purpose: quantify transition costs of euro adoption for new EU accession countries by estimating Sustainable Real Exchange Rates (SRERs) using economic fundamentals.
- Key variables used in SRER estimation: net external debt, net foreign direct investment (FDI), domestic and external demand variables.
- Two uses of SRER estimates:
  - Gap between observed real exchange rate and SRER signals currency misalignment, unsustainable macroeconomic policies, or both.
  - An unstable medium-term SRER projection signals a period of real exchange rate volatility requiring exchange rate adjustment or macroeconomic policy adjustment under a fixed regime.
- Principal conclusion preview:
  - A move toward the euro will require either tighter fiscal policies than under the float or much faster GDP and export growth.
  - Continuation of current policies under a peg would result in growing external disequilibria and real exchange rate misalignment.
- Model uncertainty emphasized: results are "model-specific" and "the existing literature does not offer a consensual model of equilibrium exchange rate determination."

### Methodology and model innovations
- Theoretical underpinning:
  - A simple dynamic IS-LM framework motivates real exchange rate developments in countries with large FDI inflows.
- Empirical approach:
  - The theoretical model is simplified for empirical estimation and simulation.
  - Simulations of 2004–09 equilibrium real exchange rate developments are conditional on projections from the National Institute Global Econometric Model (NIGEM).
- Distinguishing features relative to prior literature:
  - Medium-term misalignment estimates are not mean-reverting; real exchange rates may depart from equilibrium values during the five-year simulation period.
  - Robustness tested on several forerunners (current eurozone member countries).

### III. A MODEL OF FDI-DRIVEN REAL EXCHANGE RATES — key structure and insights
- Model setup (small open economy with FDI effects):
  - Core elements: LM, IS, production function, capital accumulation, debt accumulation, uncovered interest parity; notation preserved from source (log variables).
  - FDI (f) contributes to capital stock and increases output beyond capital accumulation due to productivity spillovers.
  - Capital accumulation declines with existing capital stock, real interest rate, and total debt (crowding out).
  - Debt accumulation influenced by FDI inflows and fiscal deficits; debt predetermined by initial level d.
  - Uncovered interest parity links real exchange rate dynamics.
- Qualitative dynamics and comparative statics:
  - Equilibrium is a “saddle point”; unique convergent path in (k, c) space.
  - Permanent increase in FDI:
    - Domestic currency appreciates and capital stock increases.
    - Real appreciation is instantaneous with some overshooting; capital stock jumps up.
    - First-round output and net-export effect ambiguous; thereafter higher capital boosts output.
  - Increase in initial total debt:
    - Appreciates the currency, lowers equilibrium capital stock via FDI outflow; steady-state output declines.
  - Permanent increase in foreign demand (y*):
    - Domestic currency appreciated; steady-state capital stock unchanged.
- Conceptual implication:
  - FDI delivers additional growth effects and can dominate net-foreign-asset forces in exchange rate determination.
  - FDI-dependent economies are vulnerable to changes in indebtedness.
  - Mean reversion is not imposed: SRER path and exchange-rate dynamics can display slow adjustment and long-lasting misalignment.

### IV. EMPIRICAL EVIDENCE — SRER model and calibration
- Scope: SRER estimates for forerunners (Greece, Portugal, Spain) and latecomers with floating exchange rates (Czech Republic, Hungary, Poland, Slovenia).
- Empirical framework:
  - Normative-target SRER framework with trade equations linking exports/imports to fundamentals (real exchange rate, terms of trade, domestic/foreign activity), explicitly incorporating FDI-driven integration gains.
  - SRER solved to make asset-stock external balance consistent with country-specific sustainable external debt targets.
- Core empirical structure:
  - Export function parameters: α1 (real exchange rate), α2 (foreign demand), α3 (FDI stock).
  - Import function parameters: β1 (real exchange rate), β2 (domestic demand), β3 (FDI stock).
  - Integration gain condition: βα33 > , i.e., FDI improves net exports (notation preserved).
- Calibrated elasticities (Table 1):
  - Export Function (7)
    - Real exchange rate elasticity of exports α1 = 3.15
    - Foreign demand elasticity of exports α2 = 1.00*
    - FDI (stock) elasticity of exports α3 = 0.70
  - Import Function (8)
    - Real exchange rate elasticity of imports β1 = -0.62
    - Domestic demand elasticity of imports β2 = 1.00*
    - FDI (stock) elasticity of imports β3 = 0.24
  - Notes:
    - α2 and β2 values denoted with an asterisk were imposed during estimations.
    - The integration gain is statistically significant: a one-percentage point increase in FDI increases net exports by almost 0.5 percent (implied by calibrated parameters and model structure).
- Net external debt targets (binding in 2022) (Table 2):
  - Czech Republic, Hungary, Slovenia: Exports-to-GDP Ratio (in percent) Higher than 40 → External Debt Target 65
  - Poland, Greece, Portugal, Spain: Exports-to-GDP Ratio (in percent) Higher than 30, but lower than 40 → External Debt Target 53
- Data and simulation details:
  - Main data sources: NIGEM (February 2004), IMF Balance of Payments Statistics Yearbook, 2002, IFS, Rider (1994).
  - Key NIGEM variables: effective foreign import demand S, effective world real interest rate r, import prices Pm, export prices Px, US dollar exchange rate E, real domestic output Y, real exports X, real imports M, domestic CPI P, stock of FDI (percent of GDP) F.
  - Initial external debt D0 from NIGEM, IFS, Rider (1994); net external debt target D* for T = 2022 based on IMF (2002).
- Simulation technique and uncertainty:
  - Solved equations 7–10 with WinSolve 2.0 using the Newton procedure for 1995Q1:2010Q4.
  - Input variables observed 1995Q1–2003Q4, forecasted 2004Q1–2010Q4 from NIGEM.
  - Only the sustainable real exchange rate simulated; other macro variables treated exogenous.
  - Uncertainty addressed via:
    - In-sample confidence intervals from estimation errors of trade equations.
    - Off-sample confidence intervals based on historical standard errors of exogenous variables and uncertainty about external debt target D*.
    - Sensitivity tests and comparison with other medium-term studies; confidence bands similar in order to other studies and misalignment estimates similar in sign and magnitude to Égert and Lommatzsch (2003).
  - Acknowledged high model uncertainty and absence of a definitive true model in the literature.

### II. Forerunners and latecomers: stylized facts and lessons
- Latecomer context and sample:
  - Latecomer EU accession countries (joined May 2004): Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia.
  - Focus sample for empirical work: Czech Republic, Hungary, Poland, Slovenia (consistent data and NIGEM country models available).
- Stylized facts for latecomers (1992–2003 unless noted):
  - Real exchange rates in the new accession countries appreciated on average by 3.3 percent annually; one-half of which was realized in 1998–2002.
  - Balassa–Samuelson effect does not fully explain the gradual and long-lasting real appreciation; simple versions imply implausible productivity gains in nontradable sectors.
  - External-wealth accumulation hypothesis does not explain observed patterns: transition economies (except Slovenia) have negative and increasing net foreign assets while running persistent trade deficits together with real appreciation.
  - Massive inflows of FDI likely affected investors’ perceptions of long-term sustainable external balances; FDI identified as main culprit explaining real exchange rate appreciation.
- Forerunners (Greece, Portugal, Spain) prior to euro adoption:
  - Forerunners exhibited similar patterns: real exchange rates appreciated on average by 0.5 percent annually during the ten years prior to joining EMU; net external liabilities increased (partly reflecting FDI inflows); current account deficits widened.
  - Forerunners’ road to the euro was long: Greece 20 years, Portugal and Spain 13 years.

### B. The Concept of Sustainable Exchange Rates and empirical ambiguities
- Two uses of SRER concept:
  - Measure misalignment of historic real exchange rate series.
  - Forward-looking measure of real exchange rate stability in the run-up to euro adoption.
- Methods and ambiguities:
  - Two main approaches: single-equation cointegration-based estimates and normative-target based models.
  - Single-equation (cointegration) approach: assumes observable return to equilibrium; may be less suitable for short, monotonic transition-country series.
    - Mixed findings across studies (undervaluation, near-equilibrium, overvaluation, mixed results).
  - Normative-target based estimates: less dependent on horizon; sensitive to choice of target variables (e.g., current account target, external debt target).
    - Different assumptions can produce widely different valuations (examples cited in source).
- Author stance:
  - Doubtful about policy relevance of single-equation approach for transition countries.
  - Normative-target methods better suited for assessing long-lasting disequilibrium and sensitivity to chosen targets.

### B. Forerunners: test-driving the model (validation)
- Purpose: validate SRER framework against forerunners (Greece, Portugal, Spain) who experienced ERM membership and euro adoption in 1996–1999/2001.
- Main findings:
  - Forerunners started ERM membership with fundamentally correct parities vis-à-vis the euro; after two years in the ERM their parities appeared sustainable.
  - The peseta slightly undervalued; the drachma and escudo within SRER corridors; drachma broadly in line with model-predicted equilibrium.
  - For Portugal and Spain, the euro appeared some 10–20 percent too strong in real terms, reducing competitiveness.
  - Post-adoption real appreciation vis-à-vis the SRER seemed relatively persistent with no signs of abating.
- Interpretation:
  - Forerunners entered ERM and the eurozone at appropriate times and with appropriate parities according to the SRER model.
  - Forerunner lessons for latecomers depend on initial misalignment and volatility of macroeconomic forecasts.

### Misalignment: empirical findings for accession currencies (end-2003)
- General:
  - Three out of four accession currencies (Czech koruna, Hungarian forint, Polish zloty; not the Slovenian tolar) were significantly above their fundamental-based equilibrium exchange rates in 2003.
  - On average, fundamentals explained about 60 percent of the real appreciation during the last decade.
  - Unexplained appreciation possible contributors: excessively optimistic expectations about speed of convergence; temporary privatization inflows; psychological effect of EU enlargement; medium-term volatility of nominal exchange rates.
- Country-specific misalignments and confidence bands (end-2003):
  - Czech koruna: overvaluation increased to about 15 percent at end-2003; simulated confidence band ±5 percent.
  - Hungarian forint: massive appreciation equivalent to almost 50-percent misalignment at mid-2003, partly corrected in late 2003; confidence band ±11 percent.
  - Polish zloty: misalignment of some 15–25 percent in 2002; depreciated in 2003 reducing misalignment to below 20 percent at end-2003; confidence band ±4 percent.
  - Slovenian tolar: after prior real undervaluation, in line with fundamentals at end-2003; confidence band ±3 percent. Slovenia did not rely on exchange-rate stabilization and did not fully liberalize its financial account.
- Fixing euro conversion rates at early-2004 exchange rates and without major policy adjustments would have posed a major problem for the forint, zloty, and koruna (in that order), but not for the tolar.

### Sustainability: SRER simulations and ERM2 consistency (2004–2010)
- Main result:
  - Under NIGEM macroeconomic projections, nominal convergence required by the Maastricht criteria and ERM2 may prevent the forint, koruna, and zloty—at their end-2003 levels—from converging toward their equilibrium real exchange rates.
- Stability corridor definitions used:
  - Narrow stability corridor: 3.75 percent around the central estimate (reflecting inflation 1.5 percent and exchange rate 2.25 percent criteria).
  - Wide stability corridor: 16.5 percent around the central estimate.
  - ERM2 permits nominal exchange rate fluctuations within a ±15 percent band.
- Projected SRER paths 2004–2010:
  - SRERs appreciating in all four countries.
  - Koruna and forint appear farthest from the implied ERM2 corridor and remain well outside the narrow 3 3/4-percent stability corridor throughout 2010.
  - Only in the late 2000s would the mid-point of the estimated koruna SRER approach the wider, 16 1/2-percent stability corridor.
  - The mid-point of the forint SRER would be some 30 percent above the upper band of the wider corridor.
  - Zloty: only currency where calculations suggest end-period convergence of the SRER and stability corridors (ERM2 entry consistent with the pre-announced date).
  - Tolar: nominal convergence appears sustainable with respect to the external balance but may need a revaluation of up to 20 percent toward the end of the period.
- Country summaries on sustainability 2004–2010:
  - Czech koruna: nominal convergence criteria too restrictive; koruna at end-2003 exchange rate will remain overvalued.
  - Hungarian forint: nominal convergence and external balance incompatible at the end-2003 exchange rate.
  - Polish zloty: similar path to koruna but faster; short-term nominal convergence criteria too restrictive, toward end of decade corridors begin to overlap.
  - Slovenian tolar: nominal convergence appears sustainable, though revaluation up to 20 percent might be needed toward end of period.

### Policy implications and recommendations
- For accession countries contemplating ERM2 participation and euro adoption:
  - Consider delaying ERM2 entry until macroeconomic policies are sufficiently strengthened.
  - If opting for a peg or stepping toward the euro, adopt tighter fiscal policies relative to those under a float, or achieve much faster GDP and export growth to avoid growing external disequilibria and real exchange rate misalignment.
- Additional policy points:
  - Fixing a currency irrevocably at an improper parity to the euro would require subsequent costly adjustments (domestic price or wage adjustment).
  - Locking currencies into an exchange rate regime with the euro too early removes monetary and exchange-rate shock absorption.
  - To achieve convergence in the model, one of two is required:
    - substantial improvement in growth and export performance relative to the model; or
    - tightening of macroeconomic policies—fiscal deficits and external debt—relative to NIGEM projections under flexible exchange rates.
  - The “pragmatist” approach (“wait for the right time and do what you can”) may not be viable given slow adjustment of exchange rates and large initial disequilibria.
  - Post-adoption risks:
    - A slowdown in FDI inflows could decelerate real convergence substantially.
    - New accession countries may not be able to accumulate foreign liabilities like forerunners because of already high external debt.
    - As fiscal deficits in the Czech Republic, Hungary, and Poland swell, governments may compete with the private sector for external financing.

### Conclusions — summary findings
- The paper develops a theoretical model of real exchange rate determination with strong neoclassical effects and simulates it for three forerunners and four new accession countries using NIGEM time series.
- Misalignment findings:
  - Three of the four new accession countries (Czech Republic, Hungary, Poland) would likely experience difficulties in ERM2 if joining too early.
  - All currencies but the Slovenian tolar were overvalued in 2003.
- SRER simulations through 2010 indicate currencies fixed at end-2004 exchange rates would likely not stay within stability corridors, conditional on NIGEM projections.
- Primary impact of external disequilibrium in the model: accumulation of debt and erosion of external competitiveness.
- Policy warning: pursuing convergence criteria too soon may harm competitiveness of Czech, Hungarian, and Polish economies; Slovenian currency may require revaluation prior to euro adoption.
- Historical contrast: forerunner countries (Greece, Portugal, Spain) showed no real exchange rate misalignment at their euro adoption time and followed more stable medium-term paths than expected for new accession countries.
- Final judgment: an early "race to the euro" may be a costly competition.

*Source: IMF working paper chapter "1.     A Review of Equilibrium Exchange Rate Methodology" (extracted content from _wp0527).*

### 1.     A Review of Equilibrium Exchange Rate Methodology ................................................ 27

### 1.     A Review of Equilibrium Exchange Rate Methodology ................................................ 27

### III. Introduction and objectives
- Purpose: quantify transition costs of euro adoption for new EU accession countries by estimating Sustainable Real Exchange Rates (SRERs) using economic fundamentals.
- Key variables used in SRER estimation: net external debt, net foreign direct investment (FDI), domestic and external demand variables.
- Two uses of SRER estimates:
  - Gap between observed real exchange rate and SRER signals currency misalignment, unsustainable macroeconomic policies, or both.
  - An unstable medium-term SRER projection signals a period of real exchange rate volatility requiring exchange rate adjustment or macroeconomic policy adjustment under a fixed regime.
- Principal conclusion preview:
  - A move toward the euro will require either tighter fiscal policies than under the float or much faster GDP and export growth.
  - Continuation of current policies under a peg would result in growing external disequilibria and real exchange rate misalignment.
- Model uncertainty is emphasized: "model-specific results" and "the existing literature does not offer a consensual model of equilibrium exchange rate determination."

### Methodology and model innovations
- Theoretical underpinning:
  - A simple dynamic IS-LM framework is used to motivate real exchange rate developments in countries with large FDI inflows.
- Empirical approach:
  - The theoretical model is simplified for empirical estimation and simulation.
  - Simulations of 2004–09 equilibrium real exchange rate developments are conditional on projections from the National Institute Global Econometric Model (NIGEM).
- Distinguishing features relative to prior literature:
  - Estimates of medium-term misalignment are not mean-reverting; the model allows real exchange rates to depart from equilibrium values during the five-year simulation period.
  - Robustness of the second-generation SRER model is tested on several forerunners (current eurozone member countries).

### Key empirical findings (in-sample and simulations)
- For countries that adopted the euro in the late 1990s/early 2000s (Greece, Portugal, Spain):
  - In-sample simulations indicate no problems with currency misalignment.
  - The medium-term path of their real exchange rates was "fairly stable in the 2000s."
- For selected new accession countries (Czech Republic, Hungary, Poland, Slovenia):
  - All currencies but the Slovenian tolar were "overvalued significantly in 2003" according to the model.
  - Under current policies, simulations suggest currencies would be unlikely to stay within the ERM2 stability corridors during 2004–10, even though they would be converging to their fundamental equilibria.
  - Implication: entering ERM2 too soon after EU entry could be problematic.
- General implication:
  - An early "race to the euro" is likely to do more harm than good unless macroeconomic policies are strengthened.

### Policy implications and recommendations
- For accession countries contemplating ERM2 participation and euro adoption:
  - Consider delaying ERM2 entry until macroeconomic policies are sufficiently strengthened.
  - If opting for a peg or stepping toward the euro, adopt tighter fiscal policies relative to those under a float, or achieve much faster GDP and export growth to avoid growing external disequilibria and real exchange rate misalignment.
- Under a fixed exchange rate regime:
  - Policymakers must be prepared to adjust macroeconomic policies rather than the exchange rate to address SRER-driven imbalances.

### Scope, limitations, and robustness
- Limitations:
  - Results are model-specific and subject to high model uncertainty.
  - The approach differs from cointegration-based models and produces non-mean-reverting medium-term misalignment estimates.
- Robustness checks:
  - The second-generation SRER model is assessed using forerunner countries (eurozone members) to test in-sample performance.

*Source: IMF working paper chapter "1.     A Review of Equilibrium Exchange Rate Methodology" (extracted content).*

### Section V suggests some policy implications of our findings, and the final section concludes.

### _wp0527 - Section V suggests some policy implications of our findings, and the final section concludes.

### II. FORERUNNERS AND LATECOMERS: ARE THERE LESSONS TO BE LEARNED?
- Context and question
  - Latecomer EU accession countries (joined May 2004): Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia.
  - Focus sample: Czech Republic, Hungary, Poland, Slovenia (consistent data and NIGEM country models available).
  - Central question: Is the volatile process of real exchange rate appreciation in transition countries over (making EMU entry trivial), or will it continue for a few more years, creating potentially costly adjustment?

- Stylized facts for latecomers (1992–2003 unless otherwise noted)
  - Real exchange rates in the new accession countries appreciated on average by 3.3 percent annually; one-half of which was realized in 1998–2002.
  - Balassa–Samuelson effect does not fully explain the gradual and long-lasting real appreciation; simple versions imply implausible productivity gains in nontradable sectors.
  - External-wealth accumulation hypothesis does not explain observed patterns: transition economies (except Slovenia) have negative and increasing net foreign assets while running persistent trade deficits together with real appreciation.
  - Massive inflows of foreign direct investment (FDI) likely affected investors’ perceptions of long-term sustainable external balances; FDI is identified as the main culprit explaining the real exchange rate appreciation, consistent with empirical work (Lansbury et al., 1996; Benáček et al., 2003).

- Forerunners (Greece, Portugal, Spain) prior to euro adoption
  - Forerunners exhibited similar patterns: real exchange rates appreciated on average by 0.5 percent annually during the ten years prior to joining EMU; net external liabilities increased (partly reflecting FDI inflows); current account deficits widened.
  - Forerunners’ road to the euro was long: Greece 20 years, Portugal and Spain 13 years.

### A. Exchange Rate Developments in the Transition Countries
- Key observations
  - Substantial real appreciation in latecomers; average annual appreciation 3.3 percent (1992–2003), half in 1998–2002.
  - Balassa–Samuelson insufficient to account for appreciation.
  - Transition economies accumulated external liabilities while experiencing real appreciation and trade deficits (slippage from external-wealth predictions).
  - FDI inflows plausibly drive expectations of future net export gains, consistent with observed appreciation.

- Policy-relevant implications highlighted
  - Fixing a currency irrevocably at an improper parity to the euro would require subsequent costly adjustments (domestic price or wage adjustment).
  - Locking currencies into an exchange rate regime with the euro too early removes monetary and exchange-rate shock absorption.

### B. The Concept of Sustainable Exchange Rates and Accession Countries
- Two uses of the sustainable real exchange rate concept
  - Measure misalignment of historic real exchange rate series.
  - Forward-looking measure of real exchange rate stability in the run-up to euro adoption.

- Methods and empirical ambiguities
  - Two main approaches: single-equation cointegration-based estimates and normative-target based models.
  - Single-equation (cointegration) approach: assumes observable return to equilibrium; may be reasonable for long 30-year industrial-country series but less so for short, monotonic transition-country series.
    - Mixed results across studies: findings include currencies significantly undervalued (Halpern and Wyplosz, 1997; De Broeck and Sløk, 2001), near-equilibrium (Frait and Komárek, 2001), overvalued or broadly in line (Égert, 2002a and 2002b), and mixed (Rahn, 2003).
    - Driver and Westaway (2003) explain ambiguity by differing time horizons across methods: long-term studies find undervaluation; medium-term studies find overvaluation.
  - Normative-target based estimates: less dependent on horizon; sensitive to choice of target variables (e.g., current account target, external debt target).
    - Examples: Spatafora and Stavrev (2003) on Russia (ruble either fairly valued or undervalued by up to 40 percent depending on assumptions); Coudert and Couharde (2002) find Czech, Estonian, Hungarian, Polish, Slovenian currencies close to equilibrium in 2001; Šmídková et al. (2002) with fixed external debt target of 60 percent of GDP find all except Slovenian tolar overvalued in 2000–2001 by 5–10 percent.

- Author stance
  - Doubtful about policy relevance of single-equation approach for transition countries.
  - Normative-target methods better suited for assessing long-lasting disequilibrium and measuring sensitivity to chosen targets.

### III. A MODEL OF FDI-DRIVEN REAL EXCHANGE RATES
- Model setup (small open economy with FDI effects)
  - Core equations (log variables): LM, IS, production function, capital accumulation, debt accumulation, uncovered interest parity; notation from the source preserved.
  - FDI (f) contributes to capital stock and increases output beyond capital accumulation due to productivity spillovers.
  - Capital accumulation declines with existing capital stock, real interest rate, and total debt (crowding out).
  - Debt accumulation influenced by FDI inflows and fiscal deficits; debt predetermined by initial level d.
  - Uncovered interest parity links real exchange rate dynamics: *rrc−= &.

- Qualitative dynamics and comparative statics
  - Equilibrium is a “saddle point”; unique convergent path in (k, c) space.
  - Permanent increase in FDI:
    - Stationary lines shift down; equilibrium: domestic currency appreciates and capital stock increases.
    - Real appreciation is instantaneous with some overshooting; capital stock jumps up.
    - First-round output and net-export effect ambiguous: output may decline initially if competitiveness loss large and capital increase small; thereafter higher capital boosts output.
  - Increase in initial total debt:
    - Appreciates the currency, lowers equilibrium capital stock via FDI outflow; steady-state output declines (crowding out future investment and appreciation raising interest rates).
  - Permanent increase in foreign demand (y*):
    - Both real exchange rate and capital stock schedules shift down by equal amount; steady-state capital stock unchanged; domestic currency appreciated; foreign demand raises output but competitiveness loss offsets it exactly.

- Key model insights
  - FDI delivers additional growth effect and can dominate net-foreign-asset forces in exchange rate determination.
  - Real appreciation associated with FDI may offset some integration gains.
  - FDI-dependent economies are vulnerable to changes in indebtedness.

### IV. EMPIRICAL EVIDENCE
- Scope and approach
  - Focused empirical SRER (Sustainable Real Exchange Rate) estimates for three forerunners: Greece, Portugal, Spain; and four latecomers with floating exchange rates: Czech Republic, Hungary, Poland, Slovenia.
  - Approach: normative-target SRER framework with trade equations linking exports/imports to fundamentals (real exchange rate, terms of trade, domestic/foreign activity), explicitly incorporating FDI-driven integration gains.
  - Underlying macro projections (domestic and external) taken from NIGEM; SRER solved for the path that makes asset-stock external balance consistent with country-specific sustainable external debt targets.

A. The SRER Model
- Core empirical structure
  - Export function (equation 7) includes real exchange rate, foreign demand, and FDI stock: parameters α1, α2, α3.
  - Import function (equation 8) includes real exchange rate, domestic demand, and FDI stock: parameters β1, β2, β3.
  - Integration gain condition: βα33 > , i.e., FDI improves net exports.
  - External debt sustainability approximated by initial stock and country-specific net external debt target for end of simulation period T (2022): D* defined by [T D D0, δ = ] format from source (notation preserved).

- Calibration and parameter values (Table 1: calibrated elasticities)
  - Export Function (7)
    - Real exchange rate elasticity of exports α1 = 3.15
    - Foreign demand elasticity of exports α2 = 1.00*
    - FDI (stock) elasticity of exports α3 = 0.70
  - Import Function (8)
    - Real exchange rate elasticity of imports β1 = -0.62
    - Domestic demand elasticity of imports β2 = 1.00*
    - FDI (stock) elasticity of imports β3 = 0.24
  - Notes:
    - α2 and β2 values denoted with an asterisk were imposed during estimations.
    - The integration gain is statistically significant: a one-percentage point increase in FDI increases net exports by almost 0.5 percent (implied by calibrated parameters and model structure).
    - FDI elasticities for accession countries are somewhat higher than estimates for several developed economies.

- Net external debt targets (Table 2)
  - Country groups and targets (binding in 2022)
    - The Czech Republic, Hungary, Slovenia: Exports-to-GDP Ratio (in percent) Higher than 40 → External Debt Target 65
    - Poland, Greece, Portugal, Spain: Exports-to-GDP Ratio (in percent) Higher than 30, but lower than 40 → External Debt Target 53
  - The model uses country-specific sustainable debt targets rather than a uniform rule-of-thumb.

- Data and simulation details (Table 3 definitions)
  - Main data sources: NIGEM (February 2004), IMF Balance of Payments Statistics Yearbook, 2002, IFS, Rider (1994).
  - Key variables from NIGEM: effective foreign import demand S, effective world real interest rate r, import prices Pm, export prices Px, US dollar exchange rate E, real domestic output Y, real exports X (base index), real imports M (base index), domestic CPI P, stock of FDI (percent of GDP) F.
  - Initial level of external debt D0 from NIGEM, IFS, Rider (1994).
  - Net external debt target D* for T = 2022 based on IMF (2002).

- Simulation technique and uncertainty
  - Solved equations 7–10 with WinSolve 2.0 using the Newton procedure for 1995Q1:2010Q4.
  - Input variables observed in-sample (1995Q1–2003Q4), forecasted out-of-sample (2004Q1–2010Q4) from NIGEM.
  - Only the sustainable real exchange rate is simulated; other macro variables treated exogenous.
  - Uncertainty addressed via:
    - Confidence intervals: in-sample CIs from estimation errors of trade equations; off-sample CIs based on historical standard errors of exogenous variables and uncertainty about external debt target D*.
    - Sensitivity tests and comparison with other medium-term studies; found confidence bands similar in order to other studies and misalignment estimates similar in sign and magnitude to Égert and Lommatzsch (2003).
  - Acknowledged model uncertainty remains and literature offers no definitive true model.

B. Forerunners: Test-Driving the Model
- Purpose: validate SRER framework against forerunners (Greece, Portugal, Spain) who experienced ERM membership and euro adoption in 1996–1999/2001.
- Main findings
  - All forerunners started ERM membership with fundamentally correct parities vis-à-vis the euro; prior to euro adoption after two years in the ERM their parities appeared sustainable.
  - Specifically:
    - The peseta was slightly undervalued.
    - The drachma and escudo were within their SRER corridors.
    - The drachma remained broadly in line with the equilibrium rate predicted by the model.
    - For Portugal and Spain, the euro appeared some 10–20 percent too strong in real terms, reducing their competitiveness.
  - Post-adoption real appreciation vis-à-vis the SRER seemed relatively persistent with no signs of abating.
- Interpretation
  - Forerunners entered ERM and the eurozone at appropriate times and with appropriate parities according to the SRER model.
  - Implication for latecomers depends on:
    - Initial real exchange rate misalignment.
    - Volatility of latecomers’ macroeconomic forecasts relative to forerunner historic volatility.
  - Forerunners’ historic real exchange rate volatility measured as 0.1 percent (context cut off in the source excerpt).

*Source: _wp0527 - Section V suggests some policy implications of our findings, and the final section concludes.*

### 3.3 percent in the latecomer countries, mostly as a result of tightly managed nominal exchange

### _wp0527 - 3.3 percent in the latecomer countries, mostly as a result of tightly managed nominal exchange rates in the run-up to euro adoption.

### Misalignment: empirical findings for accession currencies
- Three out of the four accession currencies (Czech koruna, Hungarian forint, Polish zloty; not the Slovenian tolar) were significantly above their fundamental-based equilibrium exchange rates in 2003 (Figure 5).
- Fixing euro conversion rates at early-2004 exchange rates and without major policy adjustments would have posed a major problem for the forint, zloty, and koruna (in that order), but not for the tolar.
- On average, fundamentals explained about 60 percent of the real appreciation during the last decade.
- Possible contributors to the unexplained appreciation include:
  - excessively optimistic expectations about the speed of real and nominal convergence;
  - a temporary impact of privatization inflows;
  - the psychological effect of EU enlargement;
  - medium-term volatility of nominal exchange rates.
- Country-specific misalignments and confidence bands (end-2003 and recent dynamics):
  - Czech koruna: overvaluation increased to about 15 percent at end-2003; simulated confidence band ±5 percent.
  - Hungarian forint: massive appreciation equivalent to almost 50-percent misalignment at mid-2003, partly corrected in late 2003; confidence band ±11 percent.
  - Polish zloty: misalignment of some 15–25 percent in 2002; depreciated in 2003 reducing misalignment to below 20 percent at end-2003; confidence band ±4 percent.
  - Slovenian tolar: after prior real undervaluation, in line with fundamentals at end-2003; confidence band ±3 percent. Slovenia did not rely on exchange-rate stabilization and did not fully liberalize its financial account.

### Sustainability: SRER simulations and ERM2 consistency (2004–2010)
- Main result: under NIGEM macroeconomic projections, nominal convergence required by the Maastricht criteria and ERM2 may prevent the forint, koruna, and zloty—at their end-2003 levels—from converging toward their equilibrium real exchange rates.
- Formal comparison: estimated SRER confidence bands versus “stability corridors” reflecting convergence criteria for inflation and exchange rate stability.
- Stability corridor definitions used:
  - Narrow stability corridor: 3.75 percent around the central estimate (reflecting inflation 1.5 percent and exchange rate 2.25 percent criteria).
  - Wide stability corridor: 16.5 percent around the central estimate.
  - ERM2 permits nominal exchange rate fluctuations within a ±15 percent band.
- Projected SRER paths 2004–2010:
  - SRERs appreciating in all four countries.
  - Koruna and forint appear farthest from the implied ERM2 corridor and remain well outside the narrow 3 3/4-percent stability corridor throughout 2010.
  - Only in the late 2000s would the mid-point of the estimated koruna SRER approach the wider, 16 1/2-percent stability corridor.
  - The mid-point of the forint SRER would be some 30 percent above the upper band of the wider corridor.
  - Zloty: only currency where calculations suggest end-period convergence of the SRER and stability corridors (ERM2 entry consistent with the pre-announced date).
  - Tolar: nominal convergence appears sustainable with respect to the external balance but may need a revaluation of up to 20 percent toward the end of the period.
- Country summaries on sustainability 2004–2010:
  - Czech koruna: nominal convergence criteria too restrictive; koruna at end-2003 exchange rate will remain overvalued.
  - Hungarian forint: nominal convergence and external balance incompatible at the end-2003 exchange rate.
  - Polish zloty: similar path to koruna but faster; short-term nominal convergence criteria too restrictive, toward end of decade corridors begin to overlap.
  - Slovenian tolar: nominal convergence appears sustainable, though revaluation up to 20 percent might be needed toward end of period.

### Policy implications
- Early adoption of the euro by the latecomer countries is unlikely to be as smooth as forerunners given current macroeconomic policies.
- At end-2003, real exchange rates were not close to fundamental-based values; early fixing vis-à-vis the euro would have resulted in overvalued currencies in all countries but Slovenia.
- Meeting convergence tests for exchange rate and price stability would be costly because equilibrium real exchange rates converge only gradually toward the narrow band.
- To achieve convergence in the model, one of two is required:
  - substantial improvement in growth and export performance relative to the model; or
  - tightening of macroeconomic policies—fiscal deficits and external debt—relative to NIGEM projections under flexible exchange rates.
- The “pragmatist” approach (“wait for the right time and do what you can”) may not be viable given slow adjustment of exchange rates and large initial disequilibria.
- Post-adoption risks:
  - A slowdown in FDI inflows (as observed forerunners) could decelerate real convergence substantially.
  - New accession countries may not be able to accumulate foreign liabilities like forerunners because of already high external debt.
  - As fiscal deficits in the Czech Republic, Hungary, and Poland swell, governments may compete with the private sector for external financing.

### Conclusions
- The paper develops a theoretical model of real exchange rate determination with strong neoclassical effects and simulates it for three forerunners and four new accession countries using NIGEM time series.
- Misalignment findings:
  - Three of the four new accession countries (Czech Republic, Hungary, Poland) would likely experience difficulties in ERM2 if joining too early.
  - All currencies but the Slovenian tolar were overvalued in 2003.
- SRER simulations through 2010 indicate currencies fixed at end-2004 exchange rates would likely not stay within stability corridors, conditional on NIGEM projections.
- Primary impact of external disequilibrium in the model: accumulation of debt and erosion of external competitiveness.
- Policy warning: pursuing convergence criteria too soon may harm competitiveness of Czech, Hungarian, and Polish economies; Slovenian currency may require revaluation prior to euro adoption.
- Historical contrast: forerunner countries (Greece, Portugal, Spain) showed no real exchange rate misalignment at their euro adoption time and followed more stable medium-term paths than expected for new accession countries.
- Early “race to the euro” may be a costly competition.

### Theoretical model: structure and dynamics (summary)
- Model elements: money- and goods-equilibrium schedules, classical production function, uncovered interest parity, capital accumulation schedule, debt accumulation schedule.
- Key variables and notation:
  - m: money supply; p: price level; y and y*: domestic and world output; R and R*: domestic and world nominal interest rate; k: stock of capital; c: real exchange rate; g: fiscal impulse; f: foreign direct investment; d: real stock of total debt; t: time. Stars denote world variables; lower-case variables are in logarithms.
- Dynamics and solution properties:
  - State variables: c (driving/jump variable) and k (predetermined).
  - Determinant of Jacobi matrix negative under stated parameter conditions; system is a saddle point, motivating a rational-expectations equilibrium.
  - Slopes: 0 = dc/dk& and 0 = dk/dc& relationships derived; 0 = k& is flatter than 0 = c& under assumptions.
  - Schedule shifts due to FDI, debt, and foreign demand shocks are characterized by sign statements (e.g., ∂c&/∂f < 0, ∂c&/∂d > 0).
- Conceptual implication: SRER path and exchange-rate dynamics respond to FDI, debt accumulation, and external demand shocks; slow adjustment and potential long-lasting misalignment arise because mean reversion is not imposed.

*Source: Authors' calculations and analysis as presented in the supplied content.*

### REFERENCES

### _wp0527 - REFERENCES

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*Source: _wp0527 - REFERENCES (PDF).*

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