Growth, Nontradables, and Price Convergence in the Baltics

IMF Working Papers, April 1, 1995

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The recent real exchange rate appreciation observed in the three Baltic countries can be viewed primarily as a consequence of the undervalued real exchange rates of the new currencies.
Continued real appreciation is to be expected as part of the transition process toward higher income levels.
Differential productivity growth rates between the tradable and nontradable sectors contribute to the tendency for real appreciation.
In the absence of an appreciation of the nominal exchange rate, real appreciation will occur through inflation rates that are higher than in industrial countries.
Provided that current prudent economic policies are continued, such higher inflation will not threaten macroeconomic objectives and may indicate that the transition process is progressing as expected.

Cause: Initial undervaluation of the new currencies has produced observed real exchange rate appreciation.
Transition dynamics: As income levels rise, sectoral productivity differentials (tradables vs. nontradables) drive further real appreciation.
Price path: Without nominal exchange rate appreciation, inflation in the Baltics is expected to exceed inflation in industrial countries, producing real appreciation via higher domestic inflation.

Maintain current prudent economic policies to ensure that higher inflation associated with real appreciation does not threaten macroeconomic stability.
Interpret higher inflation (relative to industrial countries) during the transition as a potentially benign sign of convergence toward higher income levels, rather than as an immediate macroeconomic failure.

Growth, Nontradables, and Price Convergence in the Baltics (IMF Working Paper, April 1, 1995).