European emerging countries face a phenomenon known on financial markets as the Balassa-Samuelson effect. The model, named after two famous economists (Balassa and Samuelson), is highly valued by researchers and financial markets analysts because it provides relevant explanations about the influence that labor productivity growth has on inflation and real appreciation of the exchange rate. First of all, all partners in the financial markets are aware of inflation risk associated with their portfolios. A deep understanding of macroeconomic and financial phenomena it is essential for the investors that want to buy securities from emerging markets. Inflation and exchange rates are important variables that reflect synthetic developments in the real economy and financial markets. Any investor will retain in his portfolio only those securities that offer a return that is not affected by the purchasing power decrease. Given all these conditions, we ask ourselves if it can be developed a behavioral model that can offer information to specialists or non-specialists in order to decide about making an investment. The topic is important, especially, for the European emerging countries (Poland, Romania, Czech Republic, and Hungary) as they depend on investments from abroad. The selection of these countries is made due to the fact that they allow a floating exchange rate, a essential condition in explaining productivity influence on inflation evolution. Also, these countries aim to join the euro area.

Why inflation is an important indicator in making an investment decision?

A specialist in finance and accounting is aware of the consequences of a rising inflation. The financial statements of multinational companies are affected by the currency risk. Also, at a microeconomic level, a company profit is influenced by the loss of purchasing power. In a long term, the negative consequences can influence the development of a business plan.
The relationship between productivity, inflation and exchange rate
In emerging markets the labor productivity in the tradable sector (associated with the industry) is bigger than the productivity level from the non-tradable sector (services). What is the most important effect? Logically, the employees with a basic activity in the industrial sector will gain bigger salaries and wages. Their remuneration is argued by the fact that the gross value added reported to the number of employees is smaller for the firms with an activity in the services sector. Contemporary needs for social services imply more expenses in a growing public sector. Even if the public sector doesn’t produce a higher gross value added we cannot deny its importance. As such, all the employees from education, health or public administration will ask for bigger wages. Also, the private firms form services sector will raise their costs in order to cover their supplementary expenses generated by bigger wages. The main consequence is a raising inflation in the services sector compared with the industrial one.
Poland, Romania, Czech Republic and Hungary are member countries of European Union that do not impose restriction on international trade and capital flows to the other members. Over 70% of their imports and export are made with the euro area. As such, an analyze it is relevant by comparison with the Eurozone. Given the above, a rising inflation rate in industry than services in Poland, Romania, Czech Republic and Hungary to the Eurozone implies an exchange rate appreciation in real terms.

What was the influence of current economic conditions?

In the last six years, the unions lost their influence in governmental decision regarding employees’ wages in the public services sector. The decrease was offset by the increase of the pressure from population. The private firms were affected by a declining demand for services. In this difficult context, aggressive tax policy led to closure of many companies. Only hope for the European emerging countries in order to improve the balance of payments situation was the stimulation of industrial production. In countries like Poland, Romania or Hungary automotive engineering industry led to exports increase. Also, it is known that many of these economies depend on foreign investments. In this regard, government authorities are making efforts to attract multinational companies that can assure increased productivity and jobs for population.  Even if the governmental authorities were enthusiastic about their `achievements`, the central banks were concerned about rising inflation pressures determined by a higher productivity in industrial sector than in services. Also, the decline in credit activity determined a decrease in the reference interest rate in order to stimulate the local demand. A smaller interest rate stimulates the demand for local products and services and leads to a rising inflation.

The labor productivity and nominal convergence criteria

European Union emerging markets as Poland, Romania, Czech Republic and Hungary aim to adopt the euro. In this direction, their scope is to assure exchange rate stability and a small value of inflation rate. Also, all this countries seek a higher productivity that can assure a stable situation of their current accounts. As we illustrated before, a higher productivity led to an increasing inflation and an exchange rate appreciation in real terms. In these circumstances, it is difficult for central banks to maintain price stability and, in the same time, to assure a framework for a sustainable economic growth.

Final remarks

Rising living standards in the European emerging markets is an important objective for each government. This purpose is very difficult to achieve because of the difficult economic and financial conditions specific to the recent financial crisis. However, social pressures have forced governments in countries with emerging economies to provide incentives to increase productivity. This has resulted in a relatively higher inflation and led to currency appreciation. Also, it was threatened nominal convergence criteria concerning the exchange rate and inflation. Negative effects were found in the purchasing power of the population that was already unhappy with government austerity measures. Central bank attempts to revive the credit by reducing interest rates have created upward pressure on inflation. Finally, we propose a rethinking of the implications it has the increased productivity on inflation and exchange rate due the current economic conditions.