April 19, 2023
The Real Effective Exchange Rate (REER) is a crucial tool in economic modeling as it provides an important indication of a country's global competitiveness. Generally it measures a country's currency value compared to a weighted average of its trading partners, with adjustments made for inflation differences. An overvalued REER, i.e., when the currency is too strong compared to the equilibrium level justified by the country's relative productivity, can adversely impact a nation's producers' competitiveness in global markets as it renders exports overly expensive. Conversely, an undervalued currency imposes an extra burden on imports, pushing up import prices and inflation. In a floating exchange rate system and liberalized capital markets, the local currency is expected to depreciate (appreciate) in the case of an overvalued(undervalued) currency to correct for the misalignment and return to the equilibrium path.
In the context of Moldova, consumer prices have have surged to unprecedented levels since early 2022, driven by the country's vulnerable energy position, which led to extreme energy tariff adjustments. Additionally, a severe drought has exacerbated the effect of high global food prices, leading to a surge in food inflation. Meanwhile, the Leu has been appreciating significantly in nominal terms since late 2022, mainly due to temporary high FX inflows related to the war and strong external support from Moldova's Western allies. The combination of high inflation and a strengthening currency has resulted in a drastic real appreciation of the Leu, by 14% since early 2022, and by an astonishing 9% over the last 6 months. Given that there is no discernible evidence of significant productivity gains during this period, it may be concluded that the currency is overvalued and should experience substantial depreciation to maintain its competitiveness.
However, this may be a distorted picture. Our analysis suggests that the Consumer Price Index (CPI)-based REER provides an inflated estimate of the overvaluation as it takes into account the effects of utility tariff adjustments and unprocessed food prices. Since these price changes do not affect producers relative costs in any way, they do not lead to a loss of competitiveness in the international markets. Alternative REER metrics that employ core inflation (excluding regulated and food prices from the calculation of the domestic inflation) or producer prices (a more direct measure of producers actual costs) offer better indicators of the currency's competitiveness. These REER estimates paint a less gloomy picture: the Moldovan leu is about 10% less overvalued than indicated by the standard REER measure.
To provide an even more accurate measure, a comparison of relative unit labor costs (ULC) may be used. ULC directly assesses the relative nominal wages in Moldova, adjusted for relative productivity, providing a clearer insight into the country's competitiveness. Our analysis shows that relative unit labor costs have grown at a moderate pace over the last ten years. This growth rate has allowed for the nominal exchange rate developments to remain largely in line with relative unit labor costs, even with the recent marked nominal appreciation of the Leu. Therefore, the ULC-based REER metric underpins our view that the overvaluation of the Leu is less severe than what the CPI-based measure may suggest.
Our view of less severe pressures on the Leu is also supported by the fact that the National Bank of Moldova (BNM) has managed to raise its foreign reserves to unprecedented levels: international reserves increased by more than 20% during the past half year.
In summary, the Moldovan Leu has experienced a significant real appreciation since early 2022, driven by high inflation and strong FX inflows supporting the nominal exchange rate. While a simple CPI-based REER approach may suggest an extreme overvaluation of the currency, our analysis indicates that alternative REER metrics, based on a limited or different set of prices that better gauge producers' costs, may provide a more accurate evaluation of the currency's stance. Based on these alternative measures, the Leu is still slightly overvalued, but the degree of misalignment is much less concerning.