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1 Occsionl Pper series No 134 / JUNE 2012 REVISITING THE EFFECTIVE EXCHANGE RATES OF THE EURO by Mrtin Schmitz, Mrten De Clercq, Michel Fidor, Berndette Luro nd Cristin Pinheiro

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3 OCCASIONAL PAPER SERIES NO 134 / JuNE 2012 REVISITING THE EFFECTIVE EXCHANGE RATES OF THE EuRO In 2012 ll publictions feture motif tken from the 50 bnknote. by Mrtin Schmitz, Mrten De Clercq, Michel Fidor, Berndette Luro nd Cristin Pinheiro 1 NOTE: This Occsionl Pper should not be reported s representing the views of the Europen Centrl Bnk (). The views expressed re those of the uthors nd do not necessrily reflect those of the. This pper cn be downloded without chrge from or from the Socil Science Reserch Network electronic librry t 1 The uthors would like to thnk F. Gross, P. Krdeloglou, H.-J. Klöckers, S. Mkrydkis, L. Nordquist, R. Oliveir-Sores, A. vn Riet, A. Schubert nd C. Willeke for their comments. Any errors or omissions re exclusively the responsibility of the uthors.

4 Europen Centrl Bnk, 2012 Address Kiserstrsse Frnkfurt m Min, Germny Postl ddress Postfch Frnkfurt m Min, Germny Telephone Internet Fx All rights reserved. Any reproduction, publiction nd reprint in the form of different publiction, whether printed or produced electroniclly, in whole or in prt, is permitted only with the explicit written uthoristion of the or the uthors. Informtion on ll of the ppers published in the Occsionl Pper Series cn be found on the s website, scientific/ops/dte/html/index.en.html. Unless otherwise indicted, hrd copies cn be obtined or subscribed to free of chrge, stock permitting, by contcting info@ecb.europ.eu ISSN (print) ISSN (online)

5 CONTENTS ABSTRACT 4 CONTENTS NON-TECHNICAL SuMMARY 5 1 INTRODuCTION 7 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO Trde bsis Trding prtners Clculting the nominl effective exchnge rtes of the euro The rel effective exchnge rte nd its defltors Bse period nd frequency Aggregtion of Pre-1999 legcy currency dt to proxy the euro exchnge rte Adjustments in the effective exchnge rtes of the euro due to euro re enlrgements EFFECTIVE EXCHANGE RATES OF THE EuRO AND HARMONISED COMPETITIVENESS INDICATORS OVER TIME Nominl effective exchnge rtes of the euro Rel effective exchnge rtes of the euro Hrmonised competitiveness indictors of euro re countries CONCLuSION 3 1 REFERENCES 3 2 APPENDIX 3 4 3

6 ABSTRACT This pper describes in detil the methodology currently used by the Europen Centrl Bnk () to determine the nominl nd rel effective exchnge rte indices of the euro. Building on the work of Buldorini et l. (2002), it shows how the s techniques for clculting effective exchnge rtes hve been updted over time nd explins the relted theoreticl foundtions. In prticulr, the pper discusses the use nd development of trde weights bsed on trde in mnufctured goods (tking ccount of third mrket effects), the trding prtners selected, nd the choice of defltors for constructing the rel effective exchnge rte indices. In ddition, it presents evidence on exchnge rte nd competitiveness developments for both the euro re s whole nd individul Member Sttes. While the growing importnce of Chin is reflected in the updted trde weights of euro effective exchnge rtes, it ppers tht the incresing integrtion of the euro re with other Europen economies ccounts for the lrgest vrition in trde weights. The US dollr, n nchor currency for number of lrge emerging mrkets, continues to ply n importnt role for the effective exchnge rte of the euro nd euro re competitiveness. Overll, euro re competitiveness hs improved slightly since the introduction of the single currency, despite significnt heterogeneity within the euro re. JEL codes: F10, F30, F31, F40 Keywords: competitiveness, effective exchnge rte (EER), hrmonised competitiveness indictor (HCI), nominl effective exchnge rte (NEER), rel effective exchnge rte (REER), trde weights 4

7 NON-TECHNICAL SuMMARY In preprtion for the strt of Stge Three of the Economic nd Monetry Union (EMU), the Europen Centrl Bnk nd the ntionl centrl bnks (NCBs) of prticipting countries begn work on the construction of set of effective exchnge rte (EER) indictors for the euro bsed on commonly greed methodologicl frmework. The generl methodologicl principles of the euro EER indices were greed upon in Februry 1999, with the implementtion of this commonly greed frmework being undertken by the. The Eurosystem s pproch to clculting the EERs of the euro is described by Buldorini et l. (2002) nd brodly follows the methodology of the Bnk for Interntionl Settlements (BIS). The weights ssigned to trding prtners re derived from their shre in interntionl trde in mnufctured goods, nd combine informtion on both exports nd imports. The import weights re the simple shres of ech prtner country in totl euro re imports. As for the export weights, these re determined in such wy tht they cpture both the importnce of specific euro re export mrkets nd the competition fced by euro re exporters in foreign mrkets from domestic producers nd exporters from third countries. The nominl EERs of the euro re geometric weighted verges of the bilterl exchnge rtes of the euro ginst the currencies of the euro re s min trding prtners. Hence, they provide summry mesure of the euro s vlue vis-à-vis these currencies. The rel EERs of the euro obtined by deflting the nominl EERs by different price or cost indices re commonly used indictors of interntionl price nd cost competitiveness. Depending on dt vilbility, rel EERs re clculted on monthly or qurterly bsis. Historicl dt required for the compiltion of the indices for the yers before 1999 re computed using theoreticl euro exchnge rtes: clculted on the bsis of the exchnge rtes of the legcy currencies of individul euro re countries. Since 1999, number of enhncements hve been introduced to the methodology for clculting the EERs. When the trde weights were updted for the first time in 2004, the list of countries included in the lrgest group of trding prtners ws expnded to encompss ll Europen Union (EU) Member Sttes nd ccession countries. In ddition, new group of trding prtners ws creted, composed of the 12 countries lredy in the nrrow group of trding prtners plus the ten tht joined the EU in 2004 nd Chin (given its emergence s one of the euro re s lrgest trding prtners). Production of EERs bsed on the nrrow group ws not discontinued, s these time series strt erlier thn those bsed on the lrger groups. This is due to the fct tht, for certin countries, dt for erlier periods re not vilble. In 2006, methodologicl simplifiction ws introduced, whereby the trde weights for the smller groups of trding prtners re obtined by proportionlly rescling the weights of the lrgest group of trding prtners. The trde weights re now revised nd updted every three yers. The second nd third revisions took plce in December 2009 nd Jnury 2012, respectively. Following n updte, the EERs nd hrmonised competitiveness indictors (HCIs) re reclculted by chin-linking the indices bsed on the trde weights for consecutive three-yer periods (currently , , , nd ). The trde weights re lso reclculted following ech enlrgement of the euro re. In 2006, the strted publishing HCIs deflted by consumer prices for ech individul euro re country. Since 2008, the hs lso published HCIs bsed on gross domestic product (GDP) defltors nd unit lbour costs for the totl economy. The HCIs provide meningful nd comprble mesures of the price nd cost competitiveness of euro re countries tht re consistent with the rel effective exchnge rtes of the euro. The HCIs re in fct constructed using the sme methodology s tht for the rel euro EERs. NON-TECHNICAL SuMMARY 5

8 The min objective of this pper is to provide comprehensive ccount of the methodologicl frmework dopted by the Eurosystem to clculte its set of effective exchnge rtes nd hrmonised competitiveness indictors. 1 Accordingly, the pper contins previously unpublished technicl informtion on the construction of nominl nd rel euro EERs s well s the HCIs for euro re countries. It lrgely builds on the work of Buldorini et l. (2002) nd highlights the modifictions in methodology tht hve been introduced over the lst decde. The pper lso presents evidence on developments in the effective exchnge rtes of the euro nd the competitiveness of the euro re s whole s well s of individul Member Sttes. In ddition, while the growing importnce of Chin is reflected in the updted trde weights of euro EERs, it ppers tht the incresing integrtion of the euro re with other Europen economies ccounts for the lrgest vrition in trde weights. The United Sttes (US) dollr, which serves s n nchor currency for number of lrge emerging mrkets, continues to ply n importnt role for the effective exchnge rtes of the euro nd euro re competitiveness. Overll, since the introduction of the single currency, the competitiveness of the euro re hs improved slightly reltive to its min trding prtners, but there remins significnt degree of heterogeneity cross euro re countries. The HCIs re therefore useful complement to the EERs in the nlysis of euro re competitiveness. 1 The effective exchnge rtes of the euro nd the HCIs for euro re countries cn be obtined from the s Sttisticl Dt Wrehouse ( Up-to-dte informtion is lso vilble vi the following links: en.html nd en.html. 6

9 1 INTRODuCTION In times of globl economic integrtion, countries re incresingly influenced by movements in their exchnge rtes vis-à-vis the currencies of mny prtner countries. This is prticulrly true for the euro re, with this being the most open of the world s lrgest economies. 2 In order to obtin useful ggregte mesure of exchnge rte fluctutions, n effective exchnge rte combines vrious bilterl rtes into single indictor. There re two distinct indictors to mesure these fluctutions: the nominl effective exchnge rte (NEER) nd the rel effective exchnge rte (REER). While the euro NEER is the weighted verge of bilterl nominl exchnge rtes ginst the currencies of selected trding prtners, the REER indices re derived by djusting the nominl indices for reltive price nd cost developments between given economy nd its trding prtners. To construct these indices in meningful wy, one needs to decide on the composition of the index nd the reltive weights of the vrious prtner currencies. The weighting method for euro EERs reflects the importnce of different countries in euro re trde in mnufctured goods, hence ccounting for trde integrtion with these countries. The trde weights combine informtion on both exports nd imports. While import weights re ech trding prtner s simple shre of totl euro re imports, export weights re double-weighted to ccount for third mrket effects. Specificlly, they cpture the effect of competition fced by euro re exporters in foreign mrkets from both domestic producers nd exporters from third countries. The NEER of the euro is summry mesure of the euro s vlue vis-à-vis the currencies of the euro re s most importnt trding prtners. Menwhile, the REER usully serves s mesure of interntionl price nd cost competitiveness: it cptures brod mcroeconomic developments in the exchnge rte nd prices or costs. While it neither includes ny firm-level dt nor explicitly revels fctors relting to non-price competitiveness (such s product qulity nd reputtion), it does, nevertheless, provide comprehensive ssessment of the interntionl pressures on domestic firms over the medium term in respect of costs or prices. The high relevnce of the rel effective exchnge rte s mesure of competitiveness is lso reflected by its inclusion in the scorebord of the EU Mcroeconomic Imblnce Procedure tht ws dopted in December 2011 (see Europen Commission, 2012). This pper lrgely builds on the work of Buldorini et l. (2002), which provides detiled description of the frmework for clculting effective exchnge rtes dopted by the nd NCBs fter the foundtion of the euro re. Buldorini et l. note tht the s methodology for constructing EERs combines the frmework used by the Bnk for Interntionl Settlements (s per Turner nd Vn t dck, 1993), with euro re-specific components. We present n updted version of this methodology. In prticulr, we highlight the modifictions tht hve been introduced since the publiction of the pper by Buldorini et l. (2002), i.e. s regrds the prtner countries included in the EER indices, the pproch used to clculte trde weights nd the choice of defltors for the REERs. Hence, similr to Buldorini et l., this pper ims t providing comprehensive reference guide for reserchers nd users of the s euro EERs. Moreover, it presents n overview of existing stte-of-the-rt methodologies for clculting effective exchnge rtes. To this end, we explin the methodologicl choices mde by the Eurosystem, highlight the positive nd negtive spects of these choices, present potentil venues for future enhncement of the indices nd provide comprison with the methodologies of other interntionl institutions (see Tble A in the Appendix). 2 This is conventionlly mesured, for exmple, by the rtio of combined exports nd imports to GDP. 1 INTRODuCTION 7

10 There re two min peculirities with regrd to the clcultion of EERs for the euro re: first, in order to obtin long time series, the ntionl exchnge rtes of the originl 11 euro re legcy currencies need to be ggregted for the period before 1 Jnury 1999, the dte on which the single currency ws introduced s n ccounting currency. Second, s the composition of the euro re chnges over time, with the entry of ech new Member Stte, the EERs need to be flexible to tke these chnges into ccount. 3 The methodology for constructing the euro REERs is lso used to clculte hrmonised competitiveness indictors for individul euro re Member Sttes. While intr-euro re trde flows re not considered in the clcultion of trde weights for euro EERs, they re used for the HCIs, which re constructed from the perspective of individul Member Sttes. Hence, ll other euro re countries re considered s trding prtners. The HCIs re highly relevnt, s they show competitiveness developments for ech individul euro re Member Stte. Hence, the HCIs illustrte how domestic fctors, notbly price nd wge developments, ffect the interntionl competitiveness of euro re countries, lso vis-à-vis fellow Member Sttes. The reminder of the pper is orgnised s follows. Section 2 explins in detil the methodology for clculting the euro EERs: first, it presents the trde bsis of the necessry weighting scheme, trding prtners, theories nd formule, regulr updtes nd ptterns of trde weights over time. Second, it describes the theory nd defltors for the REERs nd then explins the ggregtion of the euro s legcy currencies for the period before 1999 s well s the djustments of the EERs following euro re enlrgements. Section 3 discusses the evolution of the EERs of the euro since its introduction nd presents evidence on developments in the competitiveness of the euro re s whole nd of individul Member Sttes bsed on REER indices nd HCIs respectively. Lstly, Section 4 provides some conclusions. 3 Greece joined the euro re in 2001, Sloveni in 2007, Cyprus nd Mlt in 2008, Slovki in 2009 nd Estoni in

11 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO This section describes the methodology behind the effective exchnge rtes of the euro. Tking economic theory nd dt constrints into ccount, it presents the options vilble for constructing the nominl nd rel effective exchnge rtes of the euro nd the choices eventully mde. In prticulr, it discusses the weighting method (bsed on the theoreticl foundtions outlined by Armington, 1969) nd set of defltors used to compile the REERs. Hrmonised competitiveness indictors for individul euro re Member Sttes re lso constructed using the sme methodology. 2.1 TRADE BASIS It is common prctice to use bilterl trde s the bsis for determining the weight of the different bilterl exchnge rtes included in the clcultion of n effective exchnge rte; the ide being to ssign greter weight to those countries ccounting for higher proportion of n economy s foreign trde. Trde flows cn be brodly clssified into three min ctegories: mnufctured goods, commodities nd services. As outlined by Buldorini et l. (2002), the EERs of the euro re bsed on mnufctured goods trde weights, with such trde being defined s per Sections 5 to 8 of the Stndrd Interntionl Trde Clssifiction (SITC). 4 Choosing mnufctured goods trde to clculte the weights is consistent with the prctice of mny interntionl orgnistions nd centrl bnks, most notbly the BIS. 5 This type of trde ccounted for bout 61% of totl euro re exports nd 49% of totl euro re imports of goods nd services in 2009, nd is generlly deemed most responsive to developments in competitiveness. In ddition, high qulity dt re vilble for brod set of countries. 6 Thus, the s weighting scheme does not reflect ptterns of trde in griculturl products, rw mterils, energy products or services. Commodities re not included, s these re considered to be homogeneous goods whose prices re determined in globl mrkets without being influenced by the competitiveness of individul countries. Indeed, including trde in griculturl or mining products my distort the competitiveness nlysis, s such goods re often hevily regulted or subsidised. From conceptul point of view, it would be desirble to include services trde in the weighting scheme, s mny different types of services re subject to competition in globl mrkets. This would be prticulrly importnt if ptterns in services trde flows were to differ significntly from those observed for mnufctured goods. However, despite improvements in the coverge of bilterl services trde flows over the lst decde, there re still considerble dt gps compred with dt on trde in mnufctured goods. Nevertheless, services trde weights re used by number of institutions (gin, see Tble A in the Appendix). For exmple, the Bnk of Englnd uses bilterl services trde dt from the Office for Ntionl Sttistics of the United Kingdom (UK; Lynch nd Whitker, 2004) nd the Interntionl Monetry Fund (IMF) includes trde in services by using the sme weights s for mnufctured goods, while tourism flows re used for those countries where these re sizeble (Byoumi et l., 2005); the Hong Kong Monetry Authority clcultes REER bsed solely on services trde vis-à-vis smll group of prtner countries (H nd Fn, 2003). As regrds the euro, Di Muro et l. (2008) hve constructed n experimentl effective exchnge rte bsed on bilterl services trde with regrd to 24 prtner countries. They conclude tht simple services trde weights (i.e. ones without third mrket effects) re typiclly higher thn mnufcturing-relted weights for trde between the euro re nd dvnced countries such s the United Kingdom nd the United Sttes, 4 These ctegories comprise chemicls nd relted products, mnufctured goods, mchinery nd trnsport equipment, nd miscellneous mnufctured rticles. 5 See Tble A in the Appendix for detiled comprison of the methods used by different orgnistions to clculte effective exchnge rtes. 6 The dt sources for bilterl trde in mnufctured goods re Eurostt, the OECD, nd the United Ntions. 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO 9

12 while reltively smller for trde between the euro re nd emerging economies. Given the incresing vilbility of dt for both bilterl trde in services nd relted price indices, n extension of the trde bsis to include services my become fesible in the future. 2.2 TRADING PARTNERS The EERs of the euro re currently clculted ginst two min groups of trding prtners, i.e. the EER-20 group nd the brod EER-40 group: 7 EER-20: this group is composed of the noneuro re EU Member Sttes (Bulgri, Czech Republic, Denmrk, Ltvi, Lithuni, Hungry, Polnd, Romni, Sweden nd the United Kingdom), plus Austrli, Cnd, Chin, Hong Kong, Jpn, Norwy, Singpore, South Kore, Switzerlnd nd the United Sttes. EER-40: in ddition to the trding prtners in the EER-20, the EER-40 includes Algeri, Argentin, Brzil, Chile, Croti, Icelnd, Indi, Indonesi, Isrel, Mlysi, Mexico, Morocco, New Zelnd, the Philippines, Russi, South Afric, Tiwn, Thilnd, Turkey nd Venezuel. 8 The selection of countries is bsed on their importnce s trding prtners of the euro re nd on dt vilbility, prticulrly in respect of the high qulity dt on price nd cost indictors required for clculting the REER CALCuLATING THE NOMINAL EFFECTIVE EXCHANGE RATES OF THE EuRO THEORY AND FORMuLAE The nominl effective exchnge rte (NEER) of the euro is clculted s the geometric weighted verge of bsket of bilterl nominl exchnge rtes: N w = e t i NEER t ( (1) i=1 i,euro ( where N stnds for the number of competitor countries in the reference group of trding t prtners, e i,euro is n index of the verge exchnge rte of the currency of prtner country i vis-à-vis the euro in period t (expressed in terms of foreign currency per euro), nd w i is the trde weight ssigned to the currency of trding prtner i. It is common prctice to use geometric verges rther thn rithmetic verges for clculting effective exchnge rtes. Exchnge rte indices bsed on geometric verging hve the convenient feture tht the logrithm of the index is equl to the rithmetic verge of the logrithms of the underlying bilterl rtes. As Brodsky (1982) notes, percentge chnge in the geometriclly verged effective exchnge rte between two periods is independent of the bse period. However, when n rithmetic verge is pplied, it is ffected by ll movements since the bse period. Moreover, for geometriclly verged EERs, proportionlly equivlent currency pprecitions nd deprecitions hve the sme effect (with opposing signs) on the overll index, wheres there is n upwrd bis in rithmeticlly verged indices In ddition, the publishes indices vis-à-vis nrrow group of 12 prtner countries (the EER-12, comprising Austrli, Cnd, Denmrk, Hong Kong, Jpn, Norwy, Singpore, South Kore, Sweden, Switzerlnd, the United Kingdom nd the United Sttes). This is becuse, for some of the countries included in the EER-20 (nd thus the EER-40), the historicl dt do not llow for the production of n EER over long period, strting from the 1980s. 8 The composition of the two groups chnges in the cse of n enlrgement of the euro re, s the joining Member Sttes re removed from the group of trding prtners. 9 For the ske of brevity, ll trding prtners re herefter referred to s countries irrespective of their legl sttus s territoril entity. To be included in the nrrow group of countries, Buldorini et l. (2002) mention the following selection criteri: (i) significnt trde links with the euro re; (ii) the vilbility of exchnge rte dt on dily bsis; nd (iii) the vilbility of dt relted to sufficiently brod rnge of price nd cost indices on monthly or qurterly bsis with ll dt to be reltively timely nd relible. For inclusion in the brod group, one or more of the following fetures re necessry: (i) n individul shre of totl euro re mnufcturing trde lrger thn 1%; (ii) EU ccession country sttus; (iii) significnt trde links with individul euro re countries; nd (iv) timely nd relible vilbility of monthly CPI dt. 10 For exmple, under geometric EER, ceteris pribus pprecition of 5% (x 1 =x 0 *1.05) in the currency of trding prtner would produce symmetric effect of deprecition of 4.76% (x 1 =x 0 /1.05). 10

13 WEIGHTING METHOD The pproch used for clculting the effective exchnge rtes of the euro follows the BIS methodology presented in Turner nd Vn t dck (1993). Under this method, import weights re ech trding prtner s simple shre of totl euro re imports. Export weights, on the other hnd, re double-weighted to ccount for third mrket effects. Consequently, they cpture the effect of competition fced by euro re exporters in foreign mrkets from both domestic producers nd exporters from third countries. The overll weight of ech prtner country i in the brod group of trding prtners is obtined s the weighted verge of the export nd import weights, tht is: m im x w w i = x +m + x +m, i=1,2,..., N (2) where w im nd w ix re prtner country i s import nd export weights, respectively, nd m nd x re totl imports nd totl exports by the euro re, respectively. The import weight of competitor country i is clculted s its simple shre of totl euro re imports: w i m m / N i m i i =1 =, i= 1,2,..., N w i x (3) where m i denotes gross import flows into the euro re from country i during the reference period. Hence, this mesure cptures the reltive importnce of ech of the prtner countries in totl euro re imports. It lso implies tht, the higher the shre of country i in totl euro re imports, the greter the weight of its exchnge rte in the bsket of currencies included in the EER of the euro. In order to cpture the effect of competition fced by euro re exporters from domestic producers in the economies of the trding prtners, the domestic supply of mnufctured goods in these countries is included in the clcultion of export weights. The export weights lso tke into ccount ech trding prtner s bilterl exports to different foreign mrkets. In this wy, the trde weights lso reflect the competition fced by euro re exporters in ech given foreign mrket from exporters of the countries included in the group of trding prtners. For this purpose, distinction is mde between N, the trding prtners, nd, R, the group of countries referred to s the rest of the world (whereby H = N + R, with H being the totl number of export mrkets). It is ssumed tht the euro re nd the N competitor countries re the only suppliers of mnufctured goods in the R countries. Hence, the clcultions neither include exports from the rest of the world to the N trding prtners, nor the rest of the world s domestic mnufcturing output. The shre of ech mrket in totl euro re exports is clculted s xj=, j=1, 2,..., H x / H j x j j =1 (4) where x j denotes the gross export flows in the reference period from the euro re to mrket j. The subsequent djustment of export shres to cpture third mrket effects yields the double export weights of ech prtner country i, i.e. w x H i j =1 = ( S x ), i= 1,2,..., N i, j j (5) S i,j is the shre of country i s supply in mrket j, which is obtined s: S i, j = S i,j / N S i =1 i, j (6) where S i,j (for i j, i=1, 2,, N, nd j=1, 2,..., H) denotes the gross export flows from country i to mrket j, nd S i,i (for i=1,2,, N) represents the gross mnufcturing output of country i tht is sold in its domestic mrket. S i,i serves s proxy for the gross vlue of the domesticlly produced supply of mnufctured goods. For ech country, it is obtined by dding mnufctured goods imports to the vlue dded of the mnufcturing sector nd then subtrcting mnufctured goods exports. Imports of mnufctured goods re used s proxy for both domestic non-mnufctured inputs nd imported inputs. According to Turner nd Vn t dck (1993), this method cn be used to obtin n estimte of the 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO 11

14 gross vlue of the mnufctured goods produced nd sold domesticlly which is comprble with interntionl trde dt tht re lso expressed in similr (gross vlue) terms. 11 In n lterntive, but equivlent wy to eqution (5), one cn decompose the double export weights (s per Turner nd Vn t dck, 1993) to disentngle direct export competition nd third mrket competition: w x i = H 1 k =1, k i xi H x j j =1 x k H x j j =1 Si, i + N S j, i j =1, j i Si, i ( ) S i, k N S i, k i =1, i k S + ( ) k, k +, i = 1,2,, N (7) where x denotes the euro re s exports to i H mrket i, x is the sum of euro re exports j j =1 to ll mrkets H. S i, i represents the domestic N production of country i, while ( Sj, i ) denotes j =1, j i gross export flows from ll N competitor countries to mrket i. The first term of eqution (7) mesures the direct competition fced by the euro re in economy i from domestic mnufcturers. Hence, the weight is greter if i is n importnt export mrket for the euro re nd if i s shre of domesticlly produced nd sold goods in totl domestic supply is lrge (i.e. i is reltively less open to foreign mnufctured goods). The second term of eqution (7) shows the third mrket effect, i.e. the competition fced by euro re exporters in ll H foreign mrkets (excluding i s domestic mrket) from exporters of economy i: one considers the shre of euro H re exports k/ x j to ech mrket k, nd the j =1 exports S i,k of economy i to mrket k, divided N by S k,k + S i, k which includes the domestic i =1, i k x ( ) supply in economy k (except for rest of the world countries, whose domestic supply is not N tken into ccount) nd the exports ( S i, k) of i =1, i k ll N competitor economies to mrket k. Hence, the weight of i s currency in the euro re s EER is greter if i is n importnt exporter to foreign mrket which is key destintion for euro re exports. The trde weights for the nrrower reference groups (i.e. the EER-12 nd EER-20) re clculted by rescling the overll trde weights obtined under eqution (2) for the EER-40 group, s per eqution (8) below. This represents chnge in methodology compred with tht outlined in Buldorini et l. (2002), where set of weights is clculted seprtely for ech trding prtner group ccording to slightly different formule. Using the new method implies tht the trde weights of the smller trding prtner groups cn be obtined by proportionlly rescling the corresponding country trde weights in such wy tht they dd up to 100. For exmple, in the cse of N, brod group of 40 prtner countries nd, M, nrrow group of 20 countries (i.e. M < N), the overll trde weight of country i in the nrrow group (w i(nrrow) ) is clculted from the weights of the brod group (w i(brod) ) using the following formul: w i(nrrow) = w i(brod) M w i(brod) i=1 (8) Effective exchnge rtes clculted in this wy hve the useful feture tht vrious combintions of sub-indices re consistent with the overll EER index for the brodest group of countries. Using the rescling pproch enbles ll vilble informtion on trde nd domestic supply conditions in the lrgest group of countries to be tken into ccount, nd thus limits the potentil for bis to just the rest of 11 The dt on the gross vlue dded of the mnufcturing sector re retrieved from vrious sources (minly from the United Ntions Ntionl Accounts dtbse). 12

15 the world countries. In fct, by employing the former method of clculting seprte weights for ech smller group of trding prtners, one excludes informtion on sizeble number of countries, thereby introducing (potentilly significnt) distortions in the clcultions. 12 DOuBLE EXPORT WEIGHTS IN PRACTICE How re double export weights obtined in prctice? All of the elements involved in the relted clcultions for the EER-40 group cn be observed in Tble 1. Pnel 1.1 of Tble 1 reports the simple percentge shre of euro re mnufctured goods exports destined for ech of the 40 prtner countries plus the ggregte for the rest of the world. For exmple, 1.28% of such euro re exports go to Austrli, 1.17% to Cnd, 2.11% to Denmrk, etc. The supply structure mtrix of the competitor countries in the brod group is presented in the second pnel of Tble 1. Ech element in this pnel (S i,j ) excluding those on the min digonl represents the percentge of mnufctured goods produced in one of the N competitor countries (cross the rows) tht is exported brod to one of the H foreign mrkets (cross the columns). The elements on the min digonl of the supply structure mtrix (S i,i ) stnd for the percentge of totl mnufctured goods tht is ccounted for by domestic production in ech of the competitor countries. Tking the first column of Pnel 1.2 s n exmple, it cn be seen tht, in Austrli, 68.57% of the totl supply of mnufctured goods is due to domestic production, while 0.41% is ccounted for by imports from Cnd, 0.18% by imports from Denmrk, nd so forth, with ll these percentges totlling to 100%. To obtin the double export weights shown in the third pnel of Tble 1 ech row of the supply structure mtrix (Pnel 1.2) is multiplied by the simple euro re export shres (Pnel 1.1), s defined in eqution (5). For exmple, the double export weight of 1.48% ssigned to Austrli in the brod EER index of the euro is obtined s follows: (1.28% 68.57%) + (1.17% 0.08%) (14.34% 0.76%). The double export weight ssigned to Austrli mesures the competition fced by euro re exporters from Austrlin producers in both the Austrlin mrket s well s in ll of the other mrkets. Only 0.88 percentge points (1.28% 68.57%) of Austrli s double export weight (1.48%) is due to competition encountered by euro re exporters in the Austrlin mrket, while the reminder stems from third mrket competition. updating OF TRADE WEIGHTS The trde weights for the effective exchnge rtes of the euro re time-vrying s they re clculted over non-overlpping three-yer periods. An dvntge of using three-yer verges, s opposed to trde weights tht re updted more frequently, is the smoothing out of potentilly lrge short-term fluctutions in trde flows. Moreover, more frequent updting lso entils dditionl dt revisions, which could complicte the nlysis of competitiveness developments. Using time-vrying weights hs the dvntge of giving n ccurte picture of both current trde ptterns, s well s those for pst periods. As noted by Klu nd Fung (2006), this ensures tht the EERs ccurtely reflect medium to long-term exchnge rte movements by tking ccount of the vrying importnce of different trding prtners t different points in time. 13 In 1999, the first set of trde weights employed to clculte the euro EERs ws bsed on trde dt for the three-yer period These were kept constnt until 2004, when the weights for the period were reclculted on the bsis of dt revisions for tht period, nd new trde weights were determined for the three yers from 1999 to Buldorini et l. (2002) describe this problem in footnote Using moving verges of trde weights (e.g. over three-yer period) is nother pproch tht would smooth out short-term fluctutions. This method, however, would be subject to nnul updtes nd revisions. 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO 13

16 Tble 1 Trde weight clcultions for the EER-40 group (percentges) Austrli Cnd Denmrk Hong Kong Jpn Norwy Singpore South Kore Sweden 1.1 Euro re exports Euro re exports Supply structure mtrix Austrli Cnd Denmrk Hong Kong Jpn Norwy Singpore South Kore Sweden Switzerlnd United Kingdom United Sttes Bulgri Czech Republic Hungry Ltvi Lithuni Polnd Romni Chin Algeri Argentin Brzil Chile Croti Icelnd Indi Indonesi Isrel Mlysi Mexico Morocco New Zelnd Philippines Russi South Afric Tiwn Thilnd Turkey Venezuel Totl Double export weights Export weights Import weights Import weights Overll weights Overll weights

17 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO Switzerlnd United Kingdom United Sttes Bulgri Czech Republic Hungry Ltvi Lithuni Polnd Romni Chin Algeri

18 Tble 1 Trde weight clcultions for the EER-40 group (cont d) (percentges) Argentin Brzil Chile Croti Icelnd Indi Indonesi Isrel Mlysi 1.1 Euro re exports Euro re exports Supply structure mtrix Austrli Cnd Denmrk Hong Kong Jpn Norwy Singpore South Kore Sweden Switzerlnd United Kingdom United Sttes Bulgri Czech Republic Hungry Ltvi Lithuni Polnd Romni Chin Algeri Argentin Brzil Chile Croti Icelnd Indi Indonesi Isrel Mlysi Mexico Morocco New Zelnd Philippines Russi South Afric Tiwn Thilnd Turkey Venezuel Totl Double export weights Export weights Import weights Import weights Overll weights Overll weights Source:. Note: Countries re ordered lphbeticlly, ccording to their introduction to the vrious groups. Hence, those countries included in the EER-12 bsket re presented first followed by those dded to form the EER-20 bsket nd ll other remining countries. 16

19 2 METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO Mexico Morocco New Zelnd Philippines Russi South Afric Tiwn Thilnd Turkey Venezuel Other Countries Totl

20 In 2007, the Eurosystem decided to updte the trde weights more frequently. As result, since 2009, trde weights hve been updted every three yers (i.e. insted of every five yers) for more timely reflection of recent developments in the pttern of interntionl trde. The weighting scheme for , s clculted in 2004 nd s djusted fter euro re enlrgements, ws mintined under the second updte of In ddition, new trde weights were clculted on the bsis of revised mnufcturing trde dt for the three-yer periods , nd Besides these two updtes, the trde weights hve been reclculted following ech enlrgement of the euro re. In the third nd most recent updte crried out in Jnury 2012, ll existing periods were updted with revised mnufcturing trde dt; moreover, trde weights for the period were lso included. As result, five sets of weights re currently vilble, bsed on trde dt for the periods , , , nd For the EERs of the euro, fixed chin-linking on three yerly bsis is used. This mens tht the indices re chin-linked t the end of ech period. A disdvntge of chin-linking is tht chnges in trde weights hve permnent effect on EERs, even when exchnge rtes nd weights revert to initil levels (Klu nd Fung, 2006). 14 Menwhile, centrl rgument in fvour of more frequent updtes concerns the development of emerging mrket economies (most notbly Chin) s importnt globl trding prtners over the lst decde. Consequently, less frequent updtes of trde weights my result in bised effective exchnge rte. 15 Di Muro et l. (2008) hve constructed n effective exchnge rte of the euro using qurterly time-vrying weights for the euro re s 24 most importnt trding prtners nd find tht the impct of more frequent updtes is reltively limited there is devition of bout 4%, t most, compred to the officil euro EER. Moreover, t higher updting frequencies, third mrket effects cnnot be clculted due to dt vilbility constrints. PATTERNS OF TRADE WEIGHTS In recent yers, the geogrphicl composition of euro re trde hs undergone significnt chnge, which is lso reflected in the trde weights of the EERs of the euro. In prticulr, the growing importnce of emerging economies nd the stedily intensifying integrtion of economies in Europe re incresingly shping the trde linkges of the euro re. Tble 2 presents the verge trde weights of ech country included in the brod EER-40 group for ll vilble periods. Advnced economies continue to ccount for sizeble shre of totl euro re trde, lthough the importnce of the lrgest dvnced economies in the EER-40 of the euro hs been declining over time. Between 1995 nd 2009, the two individul countries with the gretest weights were, on verge, the United Sttes nd the United Kingdom, which together ccounted for lmost one-third of the EER-40 bsket. With Jpn, they lso were mong the euro re s three lrgest single trding prtners in the erly period , with combined weight of, on verge, round 45% of the EER-40 bsket. However, their combined shre in this bsket declined to round 30% in the period The decrese in the shre of the lrgest dvnced economies in the EER-40 bsket is not due to decline in trde with the euro re, but reflects insted the growing importnce of other regions in the globl economy, in prticulr, the emerging mrket economies. As consequence, the combined weight of trding prtners from emerging Asi in the EER-40 incresed from below 19% in the period to bove 27% in the period This expnsion results lmost exclusively from substntil increse 14 See Ellis (2001) for more detils on the chin-linking of effective exchnge rtes. 15 The Bnk of Englnd uses time-vrying smple of trding prtners (Lynch nd Whitker, 2004): country is included if its verge trde weight over the previous three yers is higher thn specified threshold vlue (1% for nrrow group nd 0.5% for broder group of trding prtners). 18

21 Tble 2 Trde weights of countries in the EER-40 group (percentges) Country Period Averge Chnge vs United Sttes United Kingdom Chin Jpn Switzerlnd Sweden Polnd Czech Republic South Kore Turkey Russi Denmrk Hungry Tiwn Indi Hong Kong Cnd Singpore Brzil Mexico Mlysi Norwy Romni Thilnd South Afric Isrel Austrli Indonesi Morocco Croti Philippines Bulgri Argentin Chile Algeri Lithuni Venezuel Ltvi New Zelnd Icelnd Totl Source:. Note: trde weights for the EER-20 nd EER-12 cn be obtined by proportionlly rescling the corresponding countries' trde weights in such wy tht they dd up to METHODOLOGY FOR CALCuLATING THE EFFECTIVE EXCHANGE RATES OF THE EuRO of bout 10 percentge points in the weight of Chin this becme the euro re s lrgest single trding prtner in the period By contrst, the combined weight of the remining BRICs, i.e. Brzil, Indi nd Russi, incresed only mrginlly by 1.7 percentge points, nd the shre of emerging Asin economies other thn Chin hs remined brodly unchnged over time. These trends re ll visible in Chrt 1, which presents developments in the trde weights of mjor regions in the globl economy, s well s those of the euro re s lrgest single trding prtners. Historiclly, in terms of combined weight, the lrgest group of trding prtners in the EER-40 bsket is tht of other Europen countries : the weight of this group incresed stedily from 19