NOK in the long run

Photo: Magne Østnor, FX analyst DNB Markets

(10.10.2013) The purchasing power parity points to a constant real currency exchange rate for Norway, while higher growth in Norway than among its trading partners, improvement of the terms of trade and increasingly higher net foreign assets indicate that the long-term real exchange rate for NOK has appreciated in recent decades. This means that the NOK is less overvalued than purchasing power parity calculations indicate. This is supported by our own calculations.

By Magne Østnor, FX analyst, DNB Markets

A number of empirical studies have found evidence showing that in the long run the purchasing power parity holds for Norwegian krone. Deviations from the purchasing power parity can, however, be both sizeable and long-lasting and do not necessary indicate anything about the movement of the exchange rate in the immediate future.

In the period from 1970 to the present, it may look like the real exchange rate has fluctuated around a constant level. In actual fact, however, Norway has seen a number of different monetary policy regimes in this period. The real exchange rate is often more stable during fixed exchange rate regimes than it is during floating-rate regimes, because of the importance of the nominal exchange rate on movements in the real exchange rate. It can thus be argued that a shorter time interval should be used to calculate the equilibrium level of the real exchange rate.

Normal measures of a country’s productivity or “richness” are labor productivity, growth relative to the trading partners, terms of trade (the difference between the movements of export and import prices) or net foreign assets. After a difficult period starting at the end of the 1980s, with a banking crisis, high unemployment and low growth, Norway experienced strong growth in the 1990s, especially as a result of increased activity in the petroleum sector.

Since then, however, growth in Norway has not been particularly strong compared with its trading partners. If the shift of relative growth in the 1990s is deemed to be permanent, this should result in a stronger real exchange rate for the last 15 years than in the preceding period. As opposed to the growth rate, the terms of trade have continued to increase in Norway’s favor ever since the mid-1990s. This is a result of constantly rising prices for Norwegian export goods and strong competition for many of the goods that Norway imports. In parallel with the improvement of the terms of trade, income from the petroleum sector has increased and has helped build up substantial foreign assets.

A number of factors thus indicate that the long-term real exchange rate for Norwegian krone is not constant, but rather that it has been trending stronger for the last few decades. Compared with simple purchasing power parity calculations based on a constant long-term exchange rate, this means that the exchange rate for Norwegian kroner is not as overvalued as might be assumed.

Empirical studies show that deviations from the long-term level for the real exchange rate for Norwegian kroner are reduced more quickly than is the case for other currencies. This is a common pattern in countries with high, volatile inflation. While the typical half-life for deviations from the real equilibrium currency exchange rate for industrialized counties is from three to five years, the equivalent half-life for NOK is about six quarters. This may be due to a more open economy, a stable exchange rate regime, and the Norwegian wage bargaining model.

When the real exchange rate deviates from the long-term level, changes in both the nominal rate of exchange and in relative prices cause the real exchange rate to converge towards the long-term level. The contribution from changes of the nominal exchange rate, however, is greater than the contribution from relative prices. It is thus reasonable to expect the movement of the nominal rate of exchange going forward to be similar to that of the real exchange rate. Additional shocks could however preserve, increase or reduce the deviations of the real rate of exchange from the long-term level.

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