# A review of the trade weighted exchange rate index

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4 Box 2 A basic summary of how a multilateral effective exchange rate is calculated: Calculating the weight on country A in New Zealand s exchange rate index. The IMF produces separate formulas for the construction of weights in the commodity, manufacturing, and tourism sectors. The commodity weights are designed so that they incorporate the global importance of the foreign country (country A) in the trade of each commodity and the internal importance of each commodity to New Zealand. The manufacturing and tourism weights account for different goods (services) markets separately; the basic steps involved are described below: 1. Weights for the three types of competition, for each country, for each product, are calculated. (a) The Import competition weight assigned to country A is equal to the share of total imports into New Zealand that come from country A. (b) The Bilateral export competition weight assigned to country A is calculated using the share of New Zealand exports that go to country A and the proportion of country A s domestic market that is supplied by domestic producers (the degrees of openness of country A for the good). If country A is a relatively closed economy, then country A will have a higher weight, as it is more important as a direct bilateral competitor. (c) Weights that take account of third-market competition are calculated by multiplying country A s share in total supply of goods to a third market by the relative importance of the market as a destination for New Zealand exports. 2. Aggregation The import competition, bilateral export competition and third-market competition weights are then aggregated according to their relative importance to New Zealand. A huge amount of trade flow data is required to determine these weights and they tend not to vary too much over time. More parsimonious methods: The 50:50 trade to GDP methodology The 50:50 trade-to-gdp weighted TWI that was adopted in 1999 was designed to be a simpler proxy for the more complicated multilateral index. The intuition behind the use of GDP in the currency weight is that large countries are more likely to have a presence within other countries domestic economies, and hence act as a competitor to our export markets. For example, it is more likely that we are going to compete in country A with a third country that is relatively large than one that is relatively small. Thus, by incorporating GDP into currency weights, we can, to some degree, capture the importance of third-country competition. Similarly, it is more likely that larger countries will have a bigger influence on the world price of a commodity than smaller countries. Thus GDP can also be used as a proxy for the importance of a country in the pricing of trade commodities. This is a straightforward proxy for a complicated process. Although there are conceptually superior ways to account for the competition effects, by using GDP we are applying an easily calculated index that is simple and transparent. In the past, the 50:50 weighted TWI has been found to track closely to the multilateral TWI and the 50:50 weights have therefore been considered an approximation to the more complicated IMF multilateral trade weights. 6 It may be possible to construct exchange rate indices that better capture the influence of trading partner economies on the world price of New Zealand s commodity exports than the more parsimonious IMF multilateral index. Such indices could include weights based on global trade in particular New Zealand commodities, or country production and consumption of particular commodity exports. However, there are a number of limitations associated with calculating such indices. In order to comprehensively account for trade 6 Hargreaves and White (1999). Reserve Bank of New Zealand: Bulletin, Vol., No. 2 23

7 Figure 1 The current official 5 currency TWI and the analytical 5- currency TWI, back cast using 50:50 GDP-to-trade methodology 5 currency TWI (back cast) Official 5 currency TWI Weights set in December 2006 (based on data from the year to 2005) are given in table 1 below. It is important to note that these weights have varied over time, with changes being particularly marked for developing economies and those countries with which trade flows have increased notably over the past decade for example, the weight of China has increased to 8.1 percent from 2.2 percent in 19. In the following, we present each index, and identify any divergence between the different measures. An expanded (14 currency) calculated using the same 50:50 methodology used in the current TWI Figure 2 shows an expanded index that includes the five currencies in the current TWI with the addition of the currencies of China, Malaysia, Indonesia, Thailand, Taiwan, Korea, Singapore, Hong Kong and Canada. These are Figure 2 The extended 14 currency TWI and 5 currency TWI (analytical series) ( January 19=) Asian Crises 2001 IT bubble (US recession) USD exchange rate 14 currency TWI 5 currency TWI 130 Despite the variation in currency weights, we find that the resulting exchange rate indices move very closely over time Table 1 (a) Weights for the 14 and 5 currency TWI (analytical series) Economy GDP weight 5-currency Trade weight Final weight Weight GDP weight 14-currency Trade weight Final weight Australia USA Japan Euro UK Korea China Malaysia Hong Kong Indonesia Thailand Singapore Canada Taiwan Reserve Bank of New Zealand: Bulletin, Vol., No. 2

8 (b) Weights for the PPP-based 14 and 5 currency TWI (analytical series) Economy GDP weight (PPP) 5-currency Final weight (PPP) GDP weight (PPP) 14-currency Final weight (PPP) Australia USA Japan Euro UK Korea China Malaysia Hong Kong Indonesia Thailand Singapore Canada Taiwan the currencies of New Zealand s top 14 trading areas and together they make up approximately percent of our trade; each of these countries individually has a trade share greater than 1 percent. As shown by figure 2, the 14 currency index has tended to be slightly stronger over recent history than the five currency index. Aside from episodes around the Asian crisis and 2001 dot-com bubble, much of the relative movement in the extended TWI reflect movements in the US dollar. The influence of the US dollar on the extended index tends to be greater than in the five currency index, given the inclusion of a number of Asian currencies, such as the Chinese yuan, that have been largely fixed against the US dollar over recent history. depreciating most sharply against the NZD (together these economies had just over 7 percent weight in the index). Again, in the years following the 2001 dot com bubble, the NZD appreciated to a greater extent relative to the Asian currencies than the US dollar. However, more recently, the 14 currency index appears to have been supported by the marked appreciation of the NZD relative to the US dollar. Of course, the influence of the US dollar on the extended index may decrease over time as the Asian currencies move further away from a US dollar peg. Indices may also diverge in future if changes in the relative GDPs across the countries were to lead to significant changes in the weights. The influence of movements in the US dollar on the extended 14 currency index can clearly be seen in the years before the 1997 Asian crises. Over this time, the 14 currency index appreciated more sharply relative to the five currency index, in line with an appreciation of the NZD vis-à-vis the US dollar. However, following the peak of the Asian crises, the 14 currency index held up relative to both the five currency index and the US dollar cross rate a reflection of the depreciation of the Asian currencies over this time, with the currencies of Indonesia, Thailand, Malaysia and Korea Reserve Bank of New Zealand: Bulletin, Vol., No. 2 27

9 Indices calculated using PPP-based GDP weights Figure 3 (a) compares the newly-calculated 14 currency index with an alternative 14 currency index in which PPPbased GDP has been used to form the country weights (as discussed in section 3). Figure 3 (b) is a recalculation of the five currency TWI using PPP-based GDP. The effect of PPP-GDP weighting is a relatively higher GDP weight on currencies where purchasing power in the domestic sector is high (relatively poor countries tend to have a higher PPP-based GDP than GDP converted to US dollars at current exchange rates). In the case of the 14 currency index, the final weight increases most significantly for China (see table 1 (b)). The weight on the US and Japan in the indices also decreases when PPP GDP is used. This is a result of the relatively lower purchasing power residents have in the domestic sector. Given the marked difference in weights when PPP-based GDP is used in the 14-currency index, the similarities in the resulting exchange rate indexes may be somewhat surprising (figure 3 (a)). The PPP based GDP series has tended to move with the US dollar to a slightly greater extent in recent years, despite the reduced weight on the US dollar when PPPbased GDP is used. This effect is likely to reflect the higher weight placed on relatively poor currencies that have tended to be tied to the US dollar over this time. Certainly, there is potential for a more significant divergence in these indices in future, in particular, if we see the Chinese yuan move more freely against the US dollar. For the five currency index, the use of PPP-based GDP has little impact on the final TWI weights; thus, as we may expect, the exchange rate indices calculated using these differing methodologies move very closely over time (figure 3 (b)). The slight divergence between the indices represents the reduced weight on the US in the PPP index. Figure 3 Comparison of the TWIs with indices based on PPP-based GDP (a) The 14 currency TWI and 14 currency TWI (based on PPP GDP rates) ( January 19=) 14 currency TWI (PPP based GDP) 14 currency TWI (b) The 5 currency TWI (analytical series) and 5 currency TWI (based on PPP GDP rates) ( January 19=) 5 currency TWI 5 currency TWI (PPP based GDP) A real TWI construct The indices constructed above are nominal exchange rate measures. Although such measures are often used as indicators of external competitiveness, a conceptually superior assessment of competitiveness should be done in terms of a real exchange rate index (where individual currencies in the TWI are scaled by the ratio of domestic production costs between New Zealand and the country or region in question). If New Zealand s production costs are rising more rapidly than in its trading partners, for example, this would be reflected in a real exchange rate appreciation (loss of competitiveness) for any given nominal exchange rate. 28 Reserve Bank of New Zealand: Bulletin, Vol., No. 2

10 When inflation is low and stable among the countries included in the TWI, there should be little difference between movements in the nominal and in the real measures, and, over the short term at least, nominal exchange rate movements can be a useful proxy for real exchange rate movements. However, over the longer haul, and especially in the context of an expanded TWI, which includes countries with divergent inflation rates, it becomes imperative to look at the real exchange rate measures. Figure 4 Real TWI constructs (a) 14 currency TWI, real and nominal series ( January 1999=) 14 currency TWI In this section, we calculate real counterparts to both the five and 14 currency indices. We use individual country Consumers Price (CPI) inflation in order to construct real exchange rates. Using consumer prices is not ideal, as theoretically the price deflator used to construct the real index should provide some indication of the relative costs faced by producers across the different countries. Box 3 explains why we use the CPI rather than more theoretically robust price measures. Real 14 currency TWI (b) 5 currency TWI, real and nominal series (analytical series) ( January 1999=) Real 5 currency TWI Figure 4 (b) illustrates the nominal and real indices for the five currency exchange rate; in real terms, the NZD has appreciated to a slightly greater extent over the past decade, because inflation has been a little higher in New Zealand relative to the weighted average of the five trading partners captured in the five currency exchange rate. This may not be a surprise, given the deflationary pressures in Japan over currency TWI this time. The divergence between the real and nominal 14 currency indices (figure 4 (a)) is even smaller than for the five currency index, possibly reflecting the higher weight on Asian economies with inflation rates that tend to move the average trading partner inflation experience closer to New Zealand s inflation experience. We might expect the real and nominal 14 currency indices to diverge more over time, given rates of inflation can be more variable in emerging markets. Reserve Bank of New Zealand: Bulletin, Vol., No. 2 29

11 Box 3 Constructing real exchange rate measures When constructing real exchange rate measures, you need some measure of relative prices. The relative price measure used will depend on both theoretical and practical considerations. Theoretically, it would be ideal to use price indices that measure either the price of goods produced and exported by each country or a measure of costs faced by producers. Producer Price Indices (PPIs) or Export Price Indices (EPIs) are examples of indices that measure prices of traded goods, while Unit Labour Cost (ULC) indices measure part of the production costs faced by producers. However, in practice, it may not be appropriate to use these price measures. In addition to theoretical considerations, the price measure should be: -timely; - similarly constructed across countries; - available for a wide range of countries over a long time span; -representative of price conditions in each of the countries; and - reasonably free from measurement error. Unfortunately the PPI, EPI and ULC all fail at least one of these conditions. For example, none of these price measures is constructed similarly across a wide range of countries and, in many cases, they are not available over a long time-span. The CPI is not an ideal measure of relative prices in a theoretical sense, but in practical terms performs very well. Of all the price measures available, it is the one that best meets all the practical considerations. Most importantly, it is easily available for all the countries in the 14 currency index. Because all the other price measures perform poorly against the practical considerations, we use the CPI in our real exchange rate calculations. In the future, it may possible to use a more theoretically appropriate price measure as countries produce more robust and comparable price statistics. 6 Concluding comments In this article we have reviewed the current methodology used to produce the official TWI. We noted that a summary exchange rate measure designed to capture external sector competitiveness is the most appropriate for monetary policy purposes. After reviewing the methodological options, we found the current methodology remains a suitable proxy for the effect of third country competition. However, the importance of an index that captures a broader range of currencies than the five currency TWI has also led the Bank to begin calculating and publishing an expanded 14 currency TWI along with the present index. CPI-based real measures of the TWI corresponding to these two indices will also be regularly published on the Bank s website. 12 The article showed that the 14 currency and five currency TWIs have not been substantially different in history, but this could change in the future given a world of increased exchange rate flexibility, especially in Asia. Figure 5 shows 12 Full technical details on the construction of the indices will also be provided. Figure 5 Relative movement in TWI14 and TWI5 in recent months ( February 2007=) J anuary the divergence in the 14 and five currency TWIs over the course of the past five months. Whilst the series move very closely together, the 14 currency index has tended to exhibit a slightly larger cycle as the NZD has moved to a greater extent against Asian currencies (largely tied to the US dollar) over this time. TWI5 TWI14 Asia ex-j apan weighted exchange rate February March April May Reserve Bank of New Zealand: Bulletin, Vol., No. 2

12 Whether the 14 currency index will provide a materially better fix on New Zealand s international competitiveness and on the exchange rate output linkage in practice will be an empirical matter. This should become clear when the various indices are tested over time (eg in export equations and in other modelling situations). References Bayoumi, T, J Lee and S Jayanthi, (2005), New rates from new weights, IMF Working Paper. Leahy, Michael (1998), New summary measures of the foreign exchange value of the dollar, Federal Reserve Bulletin. Lynch, B and S Whitaker, The new sterling ERI Bank of England Winter 2004 Quarterly Bulletin. White, Bruce (1997), The trade weighted index (TWI) measure of the effective exchange rate, Reserve Bank of New Zealand Bulletin (2). Becker, C and M Davies (2002), Developments in the Trade- Weighted, Reserve Bank of Australia Bulletin. Hargreaves, D and B White (1999), Measures of New Zealand s effective exchange rate, Reserve Bank of New Zealand Bulletin 63 (3). Reserve Bank of New Zealand: Bulletin, Vol., No. 2 31

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