Information about Asia and the Pacific Asia y el Pacífico

Appendix I Real Exchange Rate Movements and External Competitiveness

Ichiro Otani, and Chi Pham
Published Date:
May 1996
  • ShareShare
Information about Asia and the Pacific Asia y el Pacífico
Show Summary Details

Movements in the real exchange rate are summarized in Charts 6 and 7, which show the path of the real effective exchange rate (that is, the trade-weighted exchange rate adjusted for relative consumer price inflation) for the July 1980-December 1994 period.41

The Real Effective Exchange Rate and Internal Terms of Trade

The real effective exchange rate for state trade transactions appreciated tremendously in real terms between 1981 and 1987, as the fixed nominal rate (which was changed only three times between 1980 and 1987) was not adjusted in line with underlying inflation: this would help explain the weak export performance of many goods during this period, particularly between 1985 and 1987. However, the real effective exchange rate for various nonstate transactions42 depreciated gradually on a trend basis, despite short periods of strong appreciation during inflationary episodes, as nominal rates were adjusted with greater frequency. The real effective exchange rate in the parallel exchange market depreciated through the end of 1984 and then began to appreciate. From the unification of exchange rates in the beginning of 1988 through the end of 1994, the kip depreciated by about 90 percent in nominal terms against the U.S. dollar. The growth of consumer prices over the same period, however, was much higher, and the real effective exchange rate appreciated by about 60 percent.

While an effective exchange rate deflated by a consumer price index (CPI) can indicate trends in relative costs of living, it is not an ideal measure of price competitiveness. A more relevant indicator may be the internal terms of trade, which directly measure the price of nontradable goods relative to tradable goods.43 An increase in the internal terms of trade would create a greater incentive for factors of production to move into nontradable goods sectors rather than export- and import-substituting sectors; at the same time, it would induce a shift in consumption from nontradable goods toward imported and exportable goods. Thus, the internal terms of trade can be a useful indicator of the potential impact of relative price changes on the current account balance.

An internal terms of trade series for the Lao P.D.R. was estimated for 1988–94 by dividing the components of the CPI into nontraded and traded goods, as suggested by Wickham (1993);44 the ratio of the two resulting indices is shown in Chart 7 as the internal terms of trade. As measured by this index, the relative price of nontradables also increased between 1988 and 1994, but by 20 percent, as opposed to the 60 percent appreciation of the real effective exchange rate. The internal terms of trade and the real effective exchange rate have also differed with regard to the timing and magnitude of changes in their trends. For instance, during 1989–91, the former increased only moderately, while the latter appreciated strongly.45 The internal terms of trade then began to appreciate strongly in 1992 and in the first half of 1993, while the real effective exchange rate remained broadly constant. During June-December 1993, however, both indices appreciated quite sharply before falling back in 1994.

Chart 6.Real Effective Exchange Rates

(December 1979 = 100)

Sources: Lao authorities; and IMF, International Financial Statistics and staff estimates.

1Rate for state commercial transactions.

2Average of rate for private remittances and rate for import cooperatives.

Chart 7.Indicators of Real Exchange Rates

(1988 = 100)

Sources: Lao authorities; and IMF staff estimates.

Other Factors Affecting Competitiveness

Despite the overall appreciation in both indicators for the period shown (1988–94), which would have implied declining competitiveness in tradable goods sectors, output growth was strong and export performance quite robust; the share of tradables in total production rose, and the share of exports in world markets increased substantially. This development suggests that other factors, including rapid trade and payments liberalization and technological progress, overshadowed the effects of the real exchange rate appreciation during 1990–94.

First, the unification of the Lao P.D.R.'s exchange rates in 1988 at the level of the parallel rate probably produced an excessive devaluation of the kip relative to its long-run real equilibrium level because the parallel rate was very depreciated in relative purchasing power terms. Indeed, Chart 6 suggests that the “average” exchange rate (defined before 1988 as the average of the various existing rates) depreciated substantially in 1988 in comparison with previous years; this was particularly true for the large portion of trade transacted through state trading organizations.

The initial undervaluation of the currency implied a need for subsequent real appreciation to bring the real rate closer to long-run equilibrium levels. In goods markets, this appreciation coincided with high rates of investment and growth in tradables production, which set the stage for strong export growth in the next decade. Thus, if the initial incentive to produce tradables was very high, an increase in the internal terms of trade would not cause a loss in the competitiveness of tradables vis-à-vis nontradables; rather, it would reflect movement toward a more equilibrated level. Tradables production would still expand and remain profitable, despite the appreciation of the internal terms of trade.

Dividing GDP at factor cost between tradables and nontradables gives an estimate of the supply response to movements in the internal terms of trade. The ratio of nontradable to tradable production fell almost continually, by 13 percent, between 1988 and 1994 despite the appreciation in the internal terms of trade (Table 12 and Chart 8). Considering that production in both tradables and nontradables also grew strongly in absolute terms, it is clear that the appreciation of the internal terms of trade neither hampered total output growth nor unduly directed resources toward nontradables. In fact, the current account balance in relation to GDP declined over the period 1988–94 (Table 13).

Table 12.Tradables and Nontradables Production and Real Exchange Rates(1988 = 100)
198819891990199119921993Est. 1994
Tradables and nontradables production
(percentage change)-5.2219.2310.731.108.865.579.71
(percentage change)0.3010.904.445.415.506.167.09
Ratio of nontradables to tradables100.0093.0187.7391.4788.6589.1487.01
(percentage change)5.83-6.99-5.674.26-3.090.55-2.39
Real exchange rates
Internal terms of trade100.00104.99105.96110.44119.32127.31123.38
(percentage change)4.990.934.238.046.70-3.09
Real effective exchange rate100.00118.09129.54142.51145.38147.19155.4
(percentage change)18.099.7010.
Sources: Lao authorities; and IMF staff estimates.
Sources: Lao authorities; and IMF staff estimates.

Second, the appreciation reflected the strong growth of domestic investment demand and the increased availability of foreign financing. The rapid decline of loans and aid from the nonconvertible area in the late 1980s gave rise to an increase in demand for investment financing from other sources: at the same time, an increased willingness to invest in the Lao economy is shown by the considerable growth of concessional loans, grant aid, and foreign direct investment flows from the convertible area during this period (Table 13).46

Table 13.Balance of Payments1
19881989199019911992Est. 1993Est. 1994
Exports (f.o.b.)57.863.378.796.6132.6232.3277.7
Convertible area36.847.258.194.2130.2228.5273.9
Nonconvertible area21.
Imports (c.i.f.)162.4210.7201.6215.0265.6410.7528.0
Convertible area90.4135.7130.7210.4265.6410.7528.0
Nonconvertible area72.
Trade balance-104.6-147.4-122.9-118.4-132.9-178.4-250.3
Services (net)0.44.510.8-5.320.539.734.8
Private transfers6.78.310.910.48.69.510.5
Current account (excluding official transfers)-97.5-134.6-101.2-113.2-103.8-129.2-205.0
Official transfers13.814.722.663.962.9103.5130.6
Capital account (net)77.4111.259.776.245.939.668.4
Medium- and long-term loans22.348.545.136.663.148.778.4
Convertible area16.338.343.738.965.952.582.2
Nonconvertible area6.010.21.4-2.3-2.8-3.8-3.8
Bilateral trade agreements51.450.437.62.5
Direct foreign investment2.
Deposit money banks-27.2-28.1-3.634.9-14.9-35.813.3
Other capital inflows10.014.39.0
Errors and omissions228.936.5-25.4-15.8-25.8-42.0-68.9
Overall balance-1.8-4.4-
Change in net reserves3 (- increase)1.84.418.2-32.2-4.9-13.96.1
Net IMF credit (+ net purchase)-3.47.511.
Memorandum items:
Gross official reserves40.71.72.328.941.163.365.2
(In months of imports)
Net official reserves5-1.8-6.2-24.37.913.127.016.0
Current account/GDP
(In percent, excluding official transfers)-16.8-18.5-11.7-11.0-8.8-9.4-12.7
Debt-service ratio615.515.910.311.
Medium- and long-term debt7187.5237.5308.6337.8411.9466.7560.8
(In percent of GDP)31.932.735.732.834.734.234.7
Sources: Lao authorities; and IMF staff estimates.

Nonconvertible currency values are converted into dollars at an exchange rate of Rub 2.2 = US$1.

Includes short-term private capital flows and unrecorded imports.

Excludes valuation changes.

Before 1991, official reserves were held for the Government by the state-owned commercial bank, Banque pour le Commerce Exterieur.

Includes valuation changes.

As a ratio of exports of goods and nonfactor services.

Includes IMF; excludes debt to the nonconvertible area of Rub 796 million at end-1993.

Sources: Lao authorities; and IMF staff estimates.

Nonconvertible currency values are converted into dollars at an exchange rate of Rub 2.2 = US$1.

Includes short-term private capital flows and unrecorded imports.

Excludes valuation changes.

Before 1991, official reserves were held for the Government by the state-owned commercial bank, Banque pour le Commerce Exterieur.

Includes valuation changes.

As a ratio of exports of goods and nonfactor services.

Includes IMF; excludes debt to the nonconvertible area of Rub 796 million at end-1993.

Indeed, strong efforts to increase domestic investment accompanied the large number of major structural reforms that were introduced in 1989–91. Government spending on infrastructure, although lower than in 1988–89, had a larger impact on the economy during 1990–94, as it was almost totally carried out with technical and financial assistance from the convertible area. At the same time, increased confidence in the economy entailed large inflows of private transfers, particularly in the construction sector, as well as foreign direct investment. These factors exerted further pressure on the relative price of nontradables.

Chart 8.Tradable and Nontradable Goods Production and Real Exchange Rates

(1988 = 100)

Sources: Lao authorities; and IMF staff estimates.

Finally, changes in the CPI were probably a poor predictor of actual changes in unit manufacturing costs in the Lao P.D.R. during 1988–94 because price and trade liberalization reduced the costs of imported inputs and eliminated monopoly rents, and widespread privatization enhanced productivity in the industrial sector. In addition, technological change may have favored the production of tradables rather than nontradables, as the former benefited from foreign direct investment, competition, and economies of scale.47

Moreover, civil service wages were constrained by the Government's wage restraint policy, while the strong privatization program and the restrictive credit policy held down wage pressures in the state enterprise sector. As in other transition economies, real wage changes are likely to have diverged from actual changes in living standards because the price adjustments were occurring in an environment of shortages.48

In the Lao P.D.R., the small depreciation of the parallel market exchange rate and the strong increase in foreign investment indicate clearly that recent changes in unit manufacturing costs were not as large as those indicated by the CPI. (Alternatively, those movements indicate that the level of manufacturing costs in 1988, the base year, was artificially low.)49

Nonprice incentives may have also significantly favored producing tradables over nontradables during 1988–94. For example, foreign direct investment regulations were liberalized, quantitative trade restrictions were greatly eased, and access to foreign currency and banking services were substantially improved. These changes are likely to have significantly countered the possible adverse impact of the appreciation of the internal terms of trade on incentives to the traded goods sector.

That real exchange rate appreciation did not adversely affect the competitiveness of the traded goods sector is also supported by data on the market penetration of Lao exports. In volume terms, exports more than tripled between 1988 and 1993, when partner countries' demand for imports grew by only one half. Thus, Lao exports' market share more than doubled between 1988 and 1993, suggesting that the competitiveness of the Lao export sector did not deteriorate during this period.


The real effective exchange rate is constructed as a weighted average of the nominal exchange rate, adjusted for differentials in overall price levels. For the Lao P.D.R., trade weights are derived from 1993 exports to, and imports from, the country's eight largest trading partners (except Australia, owing to the lack of monthly consumer price index (CPI) data). Nonconvertible trade is excluded from the calculation; thus, the real effective exchange rate series does not account for movements in implicit exchange rates vis-à-vis the nonconvertible area.

Because it is the only index available on a frequent and regular basis, the Lao CPI is used to calculate price differentials. The use of the CPI may lead to distortions if it is not measured properly. In particular, the Lao P.D.R.'s statistical base is weak, and the CPI is limited geographically and in terms of products; moreover, the transition to a market economy entailed continuing large changes in consumer items and product quality that are not likely to have been captured properly by the available CPI, with a probable overstatement of implied inflation. In addition, even when prices are measured correctly, shifts in relative prices and output proportions consequent to liberalization create serious index number problems; distortions of over 10 percentage points for inflation measures are not unlikely. See Osband (1991).


Defined as an average of the various rates applying to private current transactions.


For the purpose of this analysis, nontradable goods are defined as the sum of the value-added products, in real GDP at factor costs, of “livestock and fishery,” “construction,” “transport, storage, and communication,” “trade and banking,” “ownership of dwelling,” and “public services,” while tradable goods are defined as the sum of “agricultural crops and forestry,” “mining and quarrying,” “manufacturing,” “electricity, gas, and water,” and services of “nonprofit institutions, hotels, and others.” Although these definitions are not perfect, they should be good first approximations for the period under review.


In practice, these two indices are derived by dividing the CPI basket into those goods that are traded and not traded at prevailing prices. However, whether a particular good or service is traded depends in large part on its price. Thus, goods must be classified as tradable or nontradable with reference to a specific set of prices.


The slow growth in the internal terms of trade during 1989–91 is partly explained by the suppression of administered price increases, which affected nontradables. However, this does not explain why the internal terms of trade appreciated less over the longer period 1988–94 because administered prices later caught up with market prices.


The increased availability of domestic financial instruments, together with declining levels of inflation and rising rates of return, probably induced portfolio adjustment and brought assets back into the country. This movement would also have contributed to real exchange rate appreciation.


For a small developing country such as the Lao P.D.R., output growth is likely to be concentrated in tradable production, owing to the small size of the domestic market.


See, for example, the discussion of real wages in Poland in Ebrill and others (1994).


The Lao P.D.R.'s macroeconomic performance in the past few years has been very similar to the transition economies' of Central and Eastern Europe (in particular, the Baltic states, which have also achieved nominal exchange rate stability over a lengthy period). In the Baltic states, initial overdepreciation and rapid productivity growth led to high rates of real exchange rate appreciation without adversely affecting export competitiveness. See Saavalainen (1995).

    Other Resources Citing This Publication