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The Penn Effect and Transition: The New EU Member States in International Perspective

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Abstract

We aim to put comparative price developments of transition economies in an international perspective. We argue that estimating simple price-productivity relationships without the inclusion of other explanatory factors connected to reform effort might severely bias estimates for CEEC and CIS economies. Our results imply that, when controlling for reform effort and therefore avoiding this endogeneity problem, the price-productivity elasticity for CEEC and CIS economies was not different from that of non-transition economies during the first 15 years of transition.

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Notes

  1. For evidence on observation (d), based on the 1996 Penn World Tables benchmark study, see Herrendorf and Valentinyi (2012).

  2. For a simple exposition, see, for example, Frensch (2006).

  3. The IMF's International Financial Statistics (IFS) provide trade-weighted real effective exchange rate index series for a number of countries that cannot be compared in levels across countries in an economically meaningful way. Frensch (2006) performs simple OLS regressions of yearly changes of available IFS real effective exchange rate data for the decade between 1990 and 2000 on yearly changes of PWT comparative prices. The estimated slope coefficient of 0.40 is significant at the 1% level, the intercept is insignificant at the 10% level (R2=0.29; sample size=864). Specifying country and/or period fixed effects does not qualitatively alter the results. Increasing the time horizon and thus eliminating nominal disturbances even strengthens the link between the two measures. Also, differentials between rates of change of the two measures are not systematically related to PPP-adjusted income per capita.

  4. According to Frensch and Schmillen (2011), many empirical studies may fail to find a significant influence of a simple BS-driven behaviour on real exchange rate developments because of measurement errors leading to downward-biased estimates. They test the BS hypothesis with trade-based variety measures to differentiate between tradables and non-tradables sector productivities that do not suffer from such errors-in-variables and find stable and very robust BS effects.

  5. We also experimented with PMG estimations. Probably due to the shortness of our panel, results were unstable.

  6. While our sample would ideally have included non-transition middle-income or emerging countries, issues related to the availability of the EBRD Transition Indicators made this infeasible. One should note, however, that, in terms of PPP-adjusted income per capita, there is considerable overlap between OECD and CEEC, CEEC and CIS and, because of Turkey, even between OECD and CIS economies (cf. Figure 2).

  7. Empirically, the price reducing competition effect of trade liberalisation is not equal across sectors: less open economies tend to have higher investment to consumer goods price ratios than more open economies (see, among many others, Jones, 1994).

  8. Note that this would not contradict a potentially dampening role of price liberalisation upon inflation; for more on this, see Barlow (2010).

  9. A ‘potentially important difference is that (compared to the 1993 and prior ICP rounds) stricter quality standards were used in the 2005 price surveys, to assure that the ICP was obtaining prices for internationally comparable commodities. This is important given that one expects that lower quality goods are consumed in poorer countries, creating a risk that (without strict standards in defining the products to be priced) one will underestimate the cost of living in poor countries by confusing quality differences with price differences’ (Ravallion, 2010, p. 2).

  10. With the exception of Choudhri and Khan (2005), testing the Penn effect has in general been confined to developed countries.

  11. Recently, the Penn effect may have been attenuated: the 2005 International Comparison Program (ICP) found substantially higher PPP rates, relative to market exchange rates, in most developing countries. Ravallion (2010) finds that more rapidly growing economies experience steeper increases in their price level index, while this effect has been even stronger for initially poorer countries.

  12. Table 1 time-series results are also robust to all Table 2 specifications.

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Acknowledgements

We are grateful to Roswitha King, Emilia Penkova, Volkhart Vincentz and an anonymous referee as well as conference participants in Regensburg, Vallendar, and Tartu for helpful comments and suggestions. Special thanks are due to Joe Brada for editorial guidance.

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Authors and Affiliations

  1. Institute for East and Southeast European Studies, University of Regensburg, Landshuter Str. 4, Regensburg, 93047, Germany

    Richard Frensch

  2. Institute for Employment Research, Institute for East and Southeast European Studies, Regensburger Str. 104, Nuremberg, 90478, Germany

    Achim Schmillen

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Appendices

Appendix

An extended static BS framework for motivating Penn effects in transition

In the simple set-up of the section ‘The Penn effect for Transition Economies’, the only alternative to a deepening productivity gap to imply a more pronounced BS-type relationship is by a rise in the share of non-traded goods in GDP, which seems heavily at odds with empirical developments. The argument in Frensch (2000 and 2006), on which we build here, however, allows us to separate tradability from reallocation in terms of changes in income shares spent on services and industrial goods. For further analysis, we return to the arbitrage view of the BS set-up, extending the framework to incorporate the effects of transition, defined as institutional reform-driven resource reallocation, corporate restructuring, and liberalisation (Blanchard, 1997). Then,

following the notation in section ‘The Penn effect for Transition Economies’ omitting time. Rather than differentiating only between tradables and non-tradables, we assume two sectors, industry (I) and services (S), with products entering price levels with potentially different weights such that,

We make a few simplifying assumptions to modify the set-up of the section ‘The Penn Effect for Transition Economies’:

(ASS. 1) While all services are non-tradable, only some part of industrial goods, τ j , is tradable due to the existence of barriers to trade, that is,

(ASS. 2) Prices are proportional to unit labour costs,

where h=S; I, T; I, NT, w is the wage rate and A is labour productivity, which is the same in all of industry.

(ASS. 3) Exposure to international trade increases the intensity of competition, that is,

(ASS. 4) PPP, as usual, does not hold for non-tradables; for tradables, PPP is restricted by quality differentials according to

where country 2 product quality of tradables, κ21I, T, is defined relative to country 1.

From (A.1) and (A.6),

where (A.2) implies that

and from (A.3)

From (A.8) and (A.9),

Substituting from (A.9),

and from (A.3),

Substituting for prices according to (A4) and collecting terms yields

Then, Equation A.7 implies,

After total differentiation and again collecting terms, we decompose the rate of change of the real exchange rate of country 2 relative to country 1 into four separate effects (where a Δ of a logarithmic value indicates a growth rate),

Separating tradability from income shares spent on services and industrial goods allows us to show that, in addition to the productivity gap effect, reallocation from industry towards services in country 2, relative to country 1 (Δφ2<0), also implies a real exchange rate appreciation assuming that productivity in industry is higher than in services. Also, quality improvements drive up the real exchange rate. A unilateral reduction in country 2 versus country 1 foreign barriers to trade in industrial products (Δτ2>0 and Δτ1=0) implies a real depreciation for country 2. Symmetric reduction in barriers to trade (Δτ1=Δτ2>0) implies a depreciation for country 2 as long as the share of this country's services sector in total production is smaller than in country 1. While this depreciation effect is rooted in the pro-competition effect of trade liberalisation, trade liberalisation, along with all other reform measures described in section ‘Estimation and results’, influences and even dominates restructuring efforts and sectoral reallocation, specifically pronounced during transition.

Appendix B

Data

Table B1

Table B1 Countries covered
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Table B2

Table B2 Variables used in regressions (1)–(8) in Tables 1 and 2
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Frensch, R., Schmillen, A. The Penn Effect and Transition: The New EU Member States in International Perspective. Comp Econ Stud 55, 99–119 (2013). https://doi.org/10.1057/ces.2012.35

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