Estimating the fundamental equilibrium exchange rate for the czech economy

When currency turbulences hit the CZK in May 1997, the research presented in this paper had been nearly finished. It tried to contribute to the discussion of sustainability of external development of the Czech economy by comparing signals given by a set of indicators to signals implied by the estimates of fundamental equilibrium exchange rate (FEER) for the CZK.Interestingly, the method of indicators did not give an unambiguous answer. Specifically, when applied to the Czech data, debt as well as solvency indicators did not imply a danger of external crisis. Financial indicators with a shorter-time horizon did send some warning signals. Indicators of competitiveness watched by large international investors considered the CZK to be overvalued since 1995.In order to gain more decisive conclusion concerning the danger of external crisis, the structural approach was employed. The model simulations of the FEER indicated that the CZK became overvalued in 1996 with respect to the central parity of the exchange-rate band. This conclusion was quite robust taking into account behavior of both the real economy as well as decisive external financial flows. The Czech experience with currency turbulences provided an unintentional measure on how good the warning indicators were. The FEER methodology was able to conclude that there was a need for a policy shift in the end of 1996 although it did not give the clear warning that the exchange-rate regime itself was not sustainable.