Portugal Real Exchange Rate in the EZ

Flashback

From 1995 to 2001 the large decrease in nominal interest rate (panel 1) fueled an expansion in private expenditure (panel 2) financed with debt (panel 3) while the increase in demand pushed nominal labor compensation to ran a rate of 6 percent per annum, a rate well above labor productivity, and GDP inflation to increase to 4 percent per annum. The result was a large and rapid loss in competitiveness vis-a-vis the eurozone partners (panel 4). During and after the recession of 2002, labor compensation and final prices inflation decelerated, but not sufficiently, and Portugal competitiveness continued to, this time slowly, deteriorate against the other eurozone members (panel 4). (click to enlarge)

Competitiveness

A measure of REER based on ULC vis-a-vis the rest of the eurozone, normalized to 100 in 1995, was at 83.4 in the the fourth quarter 2011 implying a cumulative loss of 16.6 pp. A similar measure based on GDP deflators was at 88.3 implying a cumulative loss of 11.8 pp.

Consequences ?

The observation that the real exchange rates remained misaligned so persistently (the GDP deflator REER moved very little since the starting of the euro) leads to the following question: will the REER have to adjust back to the 1995 level or even overshoot to remedy the accumulated consequences of overvaluation?  One argument for overshooting is that the accumulation of net external debt means that the current account cannot be balanced simply by returning to the initial real exchange rate. Now there is a deficit stemming from the increased debt service (and much lower remittances). Therefore, to restore current account balance, an over-depreciation might be required. However not every model/economist agrees on the necessity of the REER adjustment. Another old dispute.

P.S.
One has to remark that last year current account adjustment has been extraordinary and mainly driven by net exports. An interesting question is to explain how this improvement occurred.