As we mentioned it in our previous lecture on Real Exchange Rate (RER), a more interesting measure would be the Real Effective Exchange Rate (REER), which gives a bilateral RERs average between the domestic country and each of its trading partners, weighted by the trade shares of each business partner.
- Computing the Nominal Effective Exchange Rate (NEER)
The first step to compute the REER of a specific home country i (currency) would require to determine the Nominal Effective Exchange Rate (NEER) of that specific country i. For instance, the NEER of the Japanese Yen is a summary measure of the Japanese Yen (JPY) vis-à-vis the currencies of Japan’s most important trading partners.
The NEER of a specific currency i is calculated as the geometric weighted average of a basket of bilateral nominal exchange rates (M. Schmitz et al., 2012):
Where N stands for the number of competitor countries in the reference group of trading partners. According to the FX literature, it is common to use geometric averages rather than arithmetic averages to compute effective exchange rates.
There are several to compute the weight associate with each economy, but we will use the weighting scheme presented in Turner and Van’t dack (1993). Details on the trade-based weighting methodology can be seen on the appendix.
With information and fundamentals becoming more and more transparent for every country, the Bank of International Settlements is now releasing monthly (and daily) data on Effective Exchange Rates (Nominal and Real). There are two monthly indices: the Broad Index comprising 61 economies with data from 1994 and the Narrow Index comprising 26 economies with data from 1964. The reason why the BIS EER (Effective Exchange Rates) has been broadened to 61 economies was to reflect the rising importance of the emerging economies in Asia, Central and Eastern Europe and Latin America. In addition, the BIS adopted a time-varying weights in the EER calculations in order to match the rapidly changing patterns between countries; they assign a three-year average trade weights and then construct and indices. For today EER calculations, the most recent weights are based on trade in the 2011-2013 period, with 2010 as the indices’ base year. The 2011-2013 period will be used until the next set of three-year data (i.e. 2014-2016) becomes fully available. This time-varying weights method gives accurate picture of medium to long-term exchange rate movements by taking into account the importance of all trading partners in different periods of time.
Chart 1 represents the historical monthly BIS CNY NEER index since 1995 (as I wrote in my article on the Chinese Yuan History, the CNY became an international currency in 1995 when it was pegged to the US Dollar at an exchange rate of 8.28 Yuan per US Dollar.
Chart 1. Historical data of BIS CNY NEER (1995 – 2016)
We can see that over the past 20 years, the Chinese Currency has been appreciating against its broad basket of trading partners; the index rose from 75 to 117 (August 2016) and hit a high of 127.4 in July 2015. As you can see, the last ‘sharp’ appreciation of the Chinese Yuan occurred between summer of 2014 and the summer of 2015, which matches the Obama Dollar Rise (The US Dollar appreciated by 25% overall during that period). Therefore, as the Chinese Yuan is loosely pegged to the US Dollar, the Chinese currency followed the Dollar move. The previous appreciation of the Renminbi wasn’t a problem as China was experiencing a double-digit growth and was a huge player in international trade in the 2000s; however, with shrinking global demand (i.e. end of the super-cycle, downward revisions of global growth forecasts) and deteriorating trade conditions, the post-2012 ‘area’ was more concerning for China Officials. As a consequence, the PBoC allosed the Yuan to depreciate by nearly 4% against the USD in August 2015 (two-day depreciation, 11th and 12th). Since then, the NEER CNY index has constantly been decreasing according to BIS calculations.
2. From NEER to REER (Real Effective Exchange Rate)
Now that we know the definition of the NEER, we can proceed to the calculation of the Real Effective Exchange Rate, which serves as an indicator of international price and costs competitiveness. The REER is also computed using a geometric weighted average, however we need to deflate nominal exchange rates using relative price or cost measures:
The BIS uses consumer price indexes (CPI) to deflate each exchange rate, which is the simplest measure of inflation as data are available everywhere. Other inflation measure that could be used are GDP deflator, PCE deflator, PPI…
For this case, we are going to study historical REER data for Japan (details on the history of the Japanese Yen here).
Chart 2. Historical data of BIS JPY REER (1995 – 2016)
Since the Housing (and Equity) bubble burst in the early 90s, Japan plunged into a long deflationary period (some say a depression), and has always tried to rebuild its economy through fiscal and monetary stimulus. Despite the highest debt-to-GDP ratio in the world (230%, more than 10tr USD of public debt), a concerning declining population (see more here), and a massive QQME program launched in April 2013 after Abe regained ‘power’ in December 2012 (three arrows, Abenomics), the Japanese Yen has always been considered a safe-haven currency according to market participants:
- It strengthened for several years after the Japanese Equity market popped (Nikkei 225 index almost reached 40,000 on December 29, 1989 before it collapsed) as you can see in the appendix (Bloomberg Chart, JPYUSD in candlestick, if it goes up, it means the JPY gains strength).
- The JPY strengthen again during the Great Financial Crisis (massive carry unwinds, i.e. AUDJPY); the JPY REER index rose from 80 to 107 in 18 months.
- Eventually, after a sharp depreciation due to the post-Kuroda effect (80tr of JGBs purchase to reach a target inflation of 2%) – the JPY REER went down from 97 to 67 in 2-and-half years – the Yen has been strengthening over the past year as a reflection of an equity sell-off (Nikkei 225 is down 20% since June 2015).
The big question today is: could the Yen still be perceived as a safe-haven currency based on Japanese fundamentals? As I wrote it in many articles, it seems that Japanese Officials are running out of options at the moment. The poor performance of the equity market, a negative yield curve up to 10Y and a ‘strong’ Yen is persistently hurting the Japanese economy (poor exports, sluggish growth, market is still not pricing in inflation…), and today the BoJ doesn’t have many bullets to use. The ones we discussed were helicopter money and Reverse Operation Twist.
To conclude, I believe the EERs released by the BIS are important indexes to watch in addition to the historical spot rates as they reflect a more fair / accurate value of a specific currency. In the next lectures, we will study other approaches to examine if a country’s actual real effective exchange rate is consistent with fundamentals. The BEER (Behavioural Equilibrium Exchange Rate) approach, for instance, uses economic methods to establish a behavioural link between the real rate and relevant economic variables. Another more complex approach is the FEER (Fundamental Equilibrium Exchange Rate), one of the most popular of the underlying balance (UB) models.
M. Klau and S.S. Fund (2006), The new BIS Effective Exchange rate indices (BIS)
M. Schmitz (2012), Revisiting the Effective Exchange Rates of the Euro (ECB)
P. Turner and J. Van’t dack (19930, Measuring international price and cost competitiveness (BIS)
Appendix 1. Weights for NEER (and REER)
Appendix 2. JPYUSD (Candlestick) vs. Japan BIS REER (yellow line) since 1989 (Source : Bloomberg)