EQUILIBRIUM EXCHANGE RATE AND THE CONVERGENCE TO THE EUROPEAN MONETARY UNION

The estimation of the equilibrium exchange rate is a highly important subject in the assessment of a country's potential of fulfilling both nominal and real convergence criteria. A systematic undervaluation of the currency leads to inflation and thus compromises the Maastricht criteria regarding inflation. On the other hand, a systematic overvaluation reduces exports and increases imports, damaging the current account balance and delaying real convergence. Especially in the view of the accession to the Monetary Union, it is crucial for the exchange rate to trend around its equilibrium value. If the central parity established before entering the Exchange Rate Mechanism II won't be consistent with the equilibrium exchange rate, then it will be unsustainable and the Central Bank won't be able to defend it. The recent nominal and real appreciation of the Romanian currency can be viewed as a movement towards equilibrium of an initially undervalued RON or a serious department from exchange rate fundamentals. In order to determine the sources of real and nominal appreciation of the Romanian Leu we follow the Behavioural Equilibrium Exchange Rate (BEER) approach. We test for cointegration between the real exchange rate and a number of fundamental variables (the degree of openness, the ratio of net foreign assets to GDP, the productivity differential and real interest rate differential) employing the Johansen cointegration test. Using the estimated cointegration vectors we compute the short term and total misalignment of the exchange rate from its equilibrium. We thus determine the periods of undervaluation and overvalualion of the domestic currency concluding about the trend of the equilibrium exchange rate.