REVISION OF THE PHILIPPINE EFFECTIVE EXCHANGE RATE INDICES

Transcription

1 12th National Convention on Statistics (NCS) EDSA Shangri-La Hotel, Mandaluyong City October 1-2, 2013 REVISION OF THE PHILIPPINE EFFECTIVE EXCHANGE RATE INDICES by Laura Ignacio, Teresita Bascos-Deveza, Hazel Parcon-Santos, and Maria Fatima C. Paule For additional information, please contact: Author s name Laura Ignacio, Teresita Bascos-Deveza, Hazel Parcon-Santos, Maria Fatima C. Paule Designation Bank Officer V, Deputy Director, Bank Officer V, Bank Officer I Affiliation Bangko Sentral ng Pilipinas Address A. Mabini St. cor. P. Ocampo St., Malate Manila, Philippines 1004 Tel. no [email protected], [email protected] Page 1 of 18

2 REVISIONS IN THE MEASUREMENT OF THE EFFECTIVE EXCHANGE RATE INDICES OF THE PHILIPPINE PESO by Teresita Bascos-Deveza, Laura L. Ignacio, Hazel Parcon-Santos, and Maria Fatima C. Paule ABSTRACT The effective exchange rate (EER) index, as a measurement of the overall value of one country s currency against a basket of other currencies, provides a useful indicator of monetary and financial conditions. The Bangko Sentral ng Pilipinas (BSP) nominal effective exchange rate (NEER) is a weighted average of bilateral exchange rates with currencies of trading partners important to Philippine trade. It measures the movement of the peso against the relevant currencies with indications on import prices and export demand. The real effective exchange rate (REER), by taking into account inflation levels in home and trading countries, reflects not only nominal exchange rates but also inflation differentials with trading partners, and is a measure of international competitiveness. To make the NEER/REER indices more current, revisions to the calculation of the indices were introduced that include: (a) changes in the basket of currencies; (b) change in the weighted average formulation and (c) use of chained indices. The new indices will be the official effective exchange rate indices of the BSP starting The paper discusses the old and new NEER and REER indices including the changes and various issues involved in the revisions. Keywords: nominal effective exchange rate, real effective exchange rate, geometric chained indices 1. Introduction Like other currencies, the bilateral exchange rate of the Philippine peso varies across currencies and over time. For example, more pesos are needed to purchase one US dollar compared to that of one Malaysian ringgit, and in a given period of time, the bilateral exchange rates could change depending on the buying and selling rate of the peso versus the US dollar or the ringgit. Considering a basket of currencies, the weighted average change in the peso s bilateral exchange rate in a given period is known as the nominal effective exchange rate (NEER) index of the peso. The NEER index measures the net appreciation or depreciation of the peso s exchange rate relative to a basket of currencies. If the NEER index increases, then, on average, fewer pesos are needed to purchase a unit of foreign currency while the opposite is true otherwise. Similarly, the average real change on the exchange rate of the peso across a basket of currencies is gauged through the real effective exchange rate (REER) index. The REER is computed as the weighted average change in the inflation- or price-adjusted bilateral exchange rates across a basket of currencies. Unlike the NEER which measures increases or decreases on the value of the peso in terms of its equivalent foreign exchange, the REER index measures the increases or decreases on the amount of goods which the peso could purchase in the international market. An increase in the REER means that the peso could buy more or cheaper (imported) goods and services while foreign currencies could buy fewer or more Page 2 of 18

3 expensive Philippine exports. Conversely, a decrease in the REER index would yield the opposite results. Both the NEER and the REER indices are key indicators for monitoring the possible impact of exchange rate movements on economic growth. Significant increases of these two indices could have a negative impact in the country s current account inasmuch as a high exchange rate could negatively affect Philippine export products but favor imports. Even the Business Process Outsourcing industry which is one of the drivers of economic growth in the country could be affected by exchange rate appreciation. On the other hand, lower indices could favor exports but discourage imports. Such imbalances could therefore affect either import or export industries in the Philippines which could cause a slowdown in economic growth. In view of the importance of monitoring the NEER and REER indices as inputs in crafting monetary policy that is supportive of a balanced and sustainable economic growth, the Bangko Sentral ng Pilipinas conducted an in-depth study on the NEER/REER indices with the objective of making the indices more reflective of current Philippine trade transactions and more accurate in terms of estimation methodology. Section 2 of this paper shows the current methodology used in computing the indices while Section 3 focuses on the revisions made in the methodology such as the currencies included in the basket, the types of indices, the change from arithmetic to geometric mean and from a fixed base year to chained base method. Section 4 presents the new BSP indices and compares them to the current indices. Lastly, Section 5 gives a summary of this paper and discusses future work to be done. On December 14, 2012, the Monetary Board of the Bangko Sentral ng Pilipinas approved these revisions and the new indices are already being computed in parallel with the old series until the end of Starting 2014, the new indices will be the official effective exchange rate indices of the Philippine peso. 2. Current Philippine effective exchange rate indices The BSP currently generates three kinds of indices Major Trading Partners index, Broad Competing index, and Narrow Competing index. The Major Trading Partners index measures the NEER and REER indices of the peso against the currencies of advanced economies: the Euro Area, Japan, the United Kingdom and the United States. 1 The Broad Competing index consists of the currencies of seven newly industrialized and emerging economies in Asia: Hong Kong, Indonesia, Malaysia, Singapore, South Korea, Taiwan and Thailand. The Narrow Competing index includes the currencies of Indonesia, Malaysia and Thailand. Trade weights for all three indices were computed based on the country s share in the total foreign trade (imports and exports) in goods of the Philippines. Weights vary yearly, with the trade shares data of the current year used as the weight for the current year. Initially, the latest available foreign trade data are used as weights in the computation of the indices. However, the indices are revised as soon as the required trade data becomes available. NEER index The NEER index is the weighted average change in the exchange rate of the peso using a basket of currencies. The index is computed relative to a base year, which is The present weighted averaging of the NEER index makes use of an arithmetic mean formulation as follows ( C in the superscript denotes current ): (1) 1 In 2003, the indices were revised with the Euro replacing the Deutsche Mark in the basket of currencies. Page 3 of 18

4 where and with = trade weight of partner country in the th period = total of exports and imports of Philippines with country in the th period total of exports and imports of Philippines in the th period, peso cross rates percentage change = dollar rate of the peso in the th period, = dollar rate of the peso in the base period (1980), = dollar rate of the th trading partner s currency in the base period (1980), and = dollar rate of the th trading partner s currency in the th period. Rearranging, ( ) ( ) ( ) ( ) where (2) is the foreign currency-peso ratio in the th year, and is the foreign currency-peso ratio in the base year Thus, a positive change in the index from the base year indicates an appreciation and a negative change, a depreciation of the peso. The NEER index formula in (2) reduces to a Paasche type exchange rate index. REER index The REER index is the peso s bilateral exchange rate with a trading partner deflated by the respective price index ratio.the REER index formula in (3) below is a Paasche type real exchange rate index. = ( ) ( ) ( ) ( ) = ( ) ( ) ( ) ( ) (3) where Philippine consumer price index at j th period = price index (CPI) of i th trading partner country in the j th period 3. Revisions in the Philippine Effective Exchange Rate Indices 3.1 Issues in the formulation of the indices There are various aspects involved in the formulation of EER indices: (1) currencies included in the index; (2) identifying the types of indices; (3) average formulation; and (4) base periods for the exchange rates and weights, and the alternative of a chained index. 3.2 Currencies based on trade shares Most institutions based their currency selection on total trade shares as follows: 1. The Bank for International Settlements (BIS) broad index includes 52 currencies that account for 93 percent of the total trade. 2 2 Klau and Fung (2006) Page 4 of 18

5 2. The European Central Bank publishes three EER indices EER-12, consisting of 12 industrialized and newly industrialized trading partners of the euro area; EER-21, made up of EER-12 plus China and the other eight non-euro area EU Member States; and EER-41, made up of EER-21 plus 20 other relevant trading partners The US Federal Reserve generates three indices: a broad index with 26 currencies, a major index with seven major currencies and the other important trading partners (OITP) index comprising the residual 19 currencies not included in the major index.the 26 currencies selected for the broad index were of countries whose bilateral shares of US imports and exports exceeded ½ percent of total trade in The seven currencies in the major index the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona are traded widely in liquid financial markets and, therefore, the index is a measure of financial market pressure against the US dollar Australia s trade-weighted index (TWI) includes 21 currencies of trading partners whose trade with Australia covers at least 90 percent of Australia s merchandise and services trade New Zealand s official TWI consists of five currencies US dollar, yen, euro, Australian dollar and UK pound sterling that comprise 60 percent of New Zealand trade. 6 For the revision of the basket of currencies of the BSP s NEER and REER indices, the currencies selected were the major trading partners of the Philippines countries that contributed at least one percent to the average Philippine total trade (exports and imports) in the last five years. The revised basket of currencies includes currencies of 14 countries/regions and covers about 95 percent of Philippine total trade. 7 From the 14 countries included in the basket, two sub-groups were created, one for advance economies and the other for developing and emerging economies as shown below: Table 1. New Basket of Fourteen Currencies of Trading Partners Advanced countries Developing and Emerging Markets USA China Singapore Euro Area Hong Kong South Korea Japan Indonesia Taiwan Australia Malaysia Thailand Saudi Arabia United Arab Emirates 3.3 Types of indices based on economic development of trading partners Based on the new basket of currencies, the following three new types of NEER and REER indices were formulated to match the country s group of trading partners: 3 Buldorini, Makrydakis and Thimann 2002; 4 Loretan (2005) Kite (2007) 7 Based on average trade data. Page 5 of 18

6 Table 2. New NEER and REER Indices New NEER/REER Indices Basket of Currencies TPI (Overall) 14 currencies of the major trading partners TPI-A (Advance) 4 currencies of advanced partner economies TPI-D (Developing) 10 currencies of partners from developing /emerging markets The new indices will enable the BSP to monitor changes in the peso s exchange rates across all major trading partners and also among partners in advance and developing economies. 3.4 Average Formulation: Use of Chained Geometric Paasche Index The common practice of central banks and other financial institutions for averaging is the use of geometric mean. For example, the US Federal Reserve shifted from arithmetic mean to the use of geometric mean in while the Reserve Bank of Australia made the change in The use of geometric rather than arithmetic mean is preferred because of its desirable properties. An important characteristic is the symmetric treatment given to depreciations and appreciations of foreign currencies, that is, neither is given a greater weight. Whereas, the use of arithmetic mean gives more weight to a continuously depreciating foreign currency even if the weight of the currency is small. 10 Revising the current formulation by changing the method of averaging from arithmetic to geometric ( G in the superscript denotes geometric ) yields: ( ) (4) ( ) ( ( ) (5) ( ) ( ) = ( ) ( ) (6) ) 3.5 Base period There are two base periods relevant in the formulation of an EER index: base period for weights and base period (or reference period) for exchange rates. (i) Base period for weights. Most institutions use weights that vary across time. However, their methodologies differ with regard to the frequency of updates. Some institutions use the average of trade data for several years (3-5 years) as a base period to smooth out irregular variations. The BIS and the ECB use three-year average trade weights; the methodology may indicate that the weights are fixed in the sense that the same weights are used for the entire period until the next set of weights (three-year trade data) 8 US Federal Reserve (1978) 9 Reserve Bank of Australia (2002) 10 Alsterlind (2006) Page 6 of 18

7 becomes available. The BSP updates its weights annually. There is, however, a problem of attribution in using varying weights across time a change in the index may be due to changes in exchange rates or in weights. 11 Nevertheless, updating weights periodically would be more effective in reflecting changes occurring in trade. (ii) Base period for exchange rates. By definition, EER indices reflect changes in bilateral exchange rates relative to exchange rates in a given base period or reference period. The norm is for the reference period to reflect both external equilibrium (close to trade balance) and internal equilibrium (with low unemployment, low inflation and solid GDP growth), although fulfilling these criteria is difficult. In some cases, the reference period is chosen because it marks a significant policy event. For the Euro EER, the base period of first quarter of 1999 (1999 Q1 = 100) is based on institutional reasons, the period being the start of Stage Three of the Economic and Monetary Union. 12 The base period of BSP s current EER indices is 1980 not because the year was one of equilibrium but because it was the year the BSP started to publish the indices. While this fact may pose the need to revise the reference period, another option is to use chained indices. Table 3 below shows chained geometric formulations ( CH in the superscript denotes chained ) applied to the nominal and real effective exchange rates, making use of current year s trade shares as weights. Table 3. Comparison of Arithmetic and Chained Geometric Formulations = Arithmetic ( ) ( ) ( ) ( ) ( ) Chained Geometric ( ) (7) ( ) ( ) ( ) (8) Thus, a chained index links exchange rates and weights on a year-to-year basis it makes use of varying weights; exchange rates for a particular period are compared with the exchange rates of the previous period, thus, reference period, in a way, varies from year to year thereby eliminating the concerns raised by base periods. There is no base year in the sense of a benchmark against which the performance of an index is measured, only a chained base year (1980) with a value of 100. Thus, it would be possible to rescale to another year. A resulting characteristic, however, of a chained index is that it builds on information that is accumulated, and tends to retain extreme data such as peaks and troughs. Therefore, it is not advisable to chain highly volatile time series data. Nonetheless, in such a case, a solution is to chain geometric series and not arithmetic series that gives more weight to extreme values Coughlin and Pollard (1996) 12 Buldorini, Makrydakis and Thimann (2002) 13 Gaulier et al. (2008) Page 7 of 18

8 4. BSP s new NEER and REER indices of the Philippine Peso 4.1 TPI, TPI-A and TPI-D Using the basket of currencies of major trading partners as shown in Table 2 and the chained geometric formulas (7) and (8) in Table 3, the new NEER and REER indices of the Philippine peso were computed, namely, trading partners index (TPI), trading partners index-advanced (TPI-A) and trading partners index-developing (TPI-D). Figure 1 (a-c) displays the new indices. 14 Among the three, TPI-D has the highest values, TPI-A the lowest values, and (overall) TPI is in between the two sub-indices. Figure 1. NEER and REER values of Trading Partner Indices a. NEER The NEER (Figure 1a) shows a declining trend for the three indices until 2004 and generally appreciates thereafter indicating that the peso has been gaining in terms of its nominal exchange rate vis-à-vis its trading partners currencies in both advanced and developing countries. b. REER The REER (Figure 1b) of the peso showed a decreasing trend from 1980 to 1987, recovers from 1988 to 1996 (after EDSA Revolution and before Asian financial crisis), declines from and increases thereafter i.e onwards. This means that the peso s real exchange rate have also been appreciating against the currencies of both advanced and developing partner countries. 14 The values of the indices are displayed in Appendix Table A1-1. Page 8 of 18

9 From 2005 onwards, the REER showed a much sharper upward trend than the NEER due to the combined impact of the peso s nominal appreciation and higher inflation of the Philippines relative to those of trading partners. c. Gaps between TPI-D and TPI-A Figure 1c shows the trends of the gaps between the TPI-D and TPI-A (for the NEER and REER values). The generally higher positive gap between the NEERs of the TPI-D and TPI-A from 2007 onwards indicates a bigger nominal appreciation of the peso with respect to emerging and developing market currencies. This is reflected more in the REER, where the bigger gap between the REERs of TPI-D and TPI-A indicates bigger real appreciation of the peso against currencies of developing countries than advanced economies. 4.2 Ceteris Paribus Comparisons To better evaluate the new indices, ceteris paribus comparisons are made with each component: (i) From arithmetic to chained geometric formulation. The charts in Figure 2 compare the current arithmetic formulation with the chained geometric methodology making use of old currency baskets. The chained geometric figures follow closely the current arithmetic formulation, especially the Major index. However there are significant differences between the arithmetic and chained geometric method for the Narrow and Broad indices starting This is because the arithmetic indices (compared to the chained geometric indices) are more affected by extreme or highly volatile currencies/inflation rates. Page 9 of 18

10 Figure 2. Comparison of arithmetic and chained geometric formulations using old currency basket a) Major NEER Major REER b) Broad NEER Broad REER c) Narrow NEER Narrow REER (ii) Inclusion of additional currencies. Figure 3 isolates the impact of the inclusion of additional currencies by comparing present currency baskets with revised currency baskets using the present arithmetic formulation. In Figure 3a, the Major index consisting of currencies of advanced economies is compared with the TPI-A which includes the additional Australian dollar and excludes United Kingdom pound. The charts show the two groups having minimal differences. Figure 3b presents comparison of Broad index countries and TPI-D, which adds China, Saudi Arabia and United Arab Emirates. The results show that the TPI-D indices (NEER and REER) were slightly higher than the Broad index indicating that the peso appreciated more nominally and in real terms albeit small with the addition of the 3 new currencies in the basket. Page 10 of 18

11 Figure 3. Comparison of old and new currency baskets with arithmetic formulation a) Major and TPI-A NEER Major and TPI-A REER b) Broad and TPI-D NEER Broad and TPI-D REER 4.3 Comparison of the old and new indices (i) TPI-A and Major Trading Partners Index. Figure 4 (based on Appendix Table A1-2) shows close NEER figures; the small weight of the additional currency (Australian dollar, 3.6 percent) not affecting the general trends of the Major indices. TPI-A has slightly lower figures for the REER due to the higher inflation rates in the additional country (Australia) relative to the excluded country (United Kingdom), reflecting the increases in the REER compared to the old method. Figure 4. Comparison of existing Major Trading Partners Index and TPI-A Page 11 of 18

12 TPI-D and Broad Competing Index. The TPI-D with a broader basket of currencies and reflecting year-on-year cumulative changes show that the increases in the NEER/REER was lower/more gradual compared to what is being depicted by the Broad index (Figure 5, based on Appendix Table A1-3). Figure 5. Comparison of existing Broad Competing Index and TPI-D In addition, the chained formulation, which links year-to-year data, tends to moderate the impact of extreme data. Indeed, differences between the current Broad index and TPI-D are due to both the inclusion of new currencies and the change to chained geometric formulation. (ii) Comparing level and variability of appreciation. A calculation of the percentage change of the EER indices shows smaller appreciation and lower variability for the new indices for the period end-january 2012 to end-december 2012 compared to the old indices, except for TPI-A NEER. Table 2. Level and Variability of Appreciation of EER indices, January December 2012 Level of Appreciation Variability * *Measured by the coefficient of variation = standard deviation / mean 5. Summary and future research work Major NEER Major REER Broad NEER Broad REER TPI-A NEER TPI-A REER TPI-D NEER TPI-D REER Effective exchange rate indices reflect how the domestic currency performs in relation to currencies of trading countries. Given its importance in policy making, the indices should be clearly defined, and appropriately and effectively incorporate importance of trading partners and movements in their respective currencies. The paper describes revisions to the current indices: the shift to geometric mean would remove the bias created by continually depreciating currencies on the index; clarification of the term trading partners would lead to a more proper and effective interpretation of index; Page 12 of 18

13 inclusion of additional currencies gives appropriate weight to important trading partners that were previously omitted, thus adding more relevant information; and the use of chained indices would do away with the need to change base year of the exchange rate. The changes made the peso s effective exchange rate indices more reflective of the nominal and real appreciation/depreciation of the peso. The method is also more in line with more recent improvements made by other central banks. The new EER indices are being computed in parallel with the present series until the end of Starting 2014 the new indices will henceforth be the official EER indices of the BSP. To keep the various EER indices updated to trends in financial markets and international trade, it is proposed that the basket of currencies be reviewed every five years or as needed. Future work. Nonetheless, there are still issues that may need to be considered in the formulation of EER indices, particularly, with regard to the composition of goods and services, and the calculation of weights: a. Inclusion of impacts of third-market competition. A trend in the calculation of exchange rate indices is the incorporation of the impacts of third market competition in addition to the bilateral trade shares. Third-market competition is described as exports of Country A, for example, competing with exports of Country B, in a third market, Country C. Inclusion of third-market impacts in the computation of EER indices of Country A recognizes the effects of Country B s currency changes. This would, however, require Country A, following the example, to have information on Country B exports to Country C. b. Inclusion of trade in services. For the Philippines, the decision to include trade in services in determining EER weights depends on the importance of trade in services and the availability of data. For 2010, trade in services amounted to about US$ 2 billion, about 1 percent of gross national product. 15 Given that the Philippines is a small, open economy with a sizable share of trade in services, the EER indices may be improved with the inclusion of services in the estimation of country weights. c. New index on remittances. In recognition of the growing importance of overseas Filipinos (OF) remittances as a source of foreign exchange, Dakila and Claveria (2007) constructed an exchange rate index based on OF deployment in place of trade weights. The currencies included in the basket represent the top 10 countries of destination of OFs from The weights were normalized percent share of each country to total deployment of OFs for each year. The constructed index proved to be a significant predictor of OF remittances. It may be useful for the BSP to regularly generate such an index to help explain trends in remittances. 15 BSP Balance of Payments statistics. Page 13 of 18

14 REFERENCES Alsterlind, J Effective exchange rates theory and practice. Economic Review Volume 1.SverigesRiksbank. Buldorini, L., Makrydakis, S. and C. Thimann The effective exchange rates of the Euro. Occasional Paper Series No. 2. European Central Bank. Coughlin, C. and P. Pollard A question of measurement: is the dollar rising or falling? Federal Reserve Bank of St. Louis Review, July/August 1996 Vol. 78, No. 5. Coughlin, C., P. Pollard and J. Betts To Chain or Not to Chain Trade-Weighted Exchange Rate Indexes. Working Paper Federal Reserve Bank of St. Louis. Dakila, Jr. F. and R. Claveria Identifying the determinants of overseas Filipinos remittances: Which exchange rate measure is most relevant? BSP Working Paper SeriesNo (Manila: BangkoSentralngPilipinas). Gaulier, G. J. Martin, I. Méjean, and S. Zignago International Trade Price Indices. CEPII Working Paper No June.CEPII. Klau, M. and S. Fung, 2006, The New BIS Effective Exchange Rate Indices. BIS Quarterly Review, March(Basel: Bank for International Settlements). Kite, H A review of the trade weighted exchange rate index. Reserve Bank of New Zealand Bulletin Vol. 70, No. 2. Loretan, M Indexes of the Foreign Exchange Value of the Dollar. Federal Reserve Bulletin.Winter (Washington, DC: Federal Reserve Board). Reserve Bank of Australia Developments in the Trade-Weighted Index. Reserve Bank of Australia Bulletin October Reserve Bank of New Zealand Revisions to the Reserve Bank of New Zealand Trade- Weighted Exchange Rate Index (TWI). News release. US Federal Reserve Index of the Weighted-Average Exchange Value of the U.S. Dollar: Revision. Federal Reserve Bulletin August Waiquamdee, Atchana, PitiDisyatat and RunchanaPongsaparn (2005). Effective Exchange Rates and Monetary Policy: The Thai Experience, Bank of Thailand Discussion Paper, 04/2005. Page 14 of 18

15 Appendix. Values of Trading Partner Indices and Comparisons Table A1-1. NEER and REER Values of Trading Partner Indices All Major Trading Partners NEER Advanced Major Trading Partners Developing and Emerging Trading Partners All Major Trading Partners REER Advanced Major Trading Partners Developing and Emerging Trading Partners TPI TPI-A TPI-D TPI TPI-A TPI-D Source: Department of Economic Statistics, BSP Notes: TPI: Australia, Euro Area, U.S., Japan, Hong Kong, Taiwan, Thailand, Indonesia, Malaysia, Singapore, South Korea, China, Saudi Arabia, and U.A.E. TPI-A: U.S., Japan, Euro Area, and Australia Page 15 of 18

16 TPI-D: Hong Kong, Taiwan, Thailand, Indonesia, Malaysia, Singapore, South Korea, China, Saudi Arabia, and U.A.E Page 16 of 18

17 Table A1-2. Comparison of existing Major Trading Partners Index and proposed TPI-A NEER REER Majors TPI-A Majors TPI-A Source: Department of Economic Statistics, BSP Notes: Majors: U.S., Japan, Euro Area, and UK TPI-A: U.S., Japan, Euro Area, and Australia Page 17 of 18

18 Table A1-3. Comparison of existing Broad Competing Index and proposed TPI-D NEER REER Broad TPI-D Broad TPI-D Source: Department of Economic Statistics, BSP Notes: Broad: Hong Kong, Taiwan, Thailand, Indonesia, Malaysia, Singapore, South Korea TPI-D: Hong Kong, Taiwan, Thailand, Indonesia, Malaysia, Singapore, South Korea, China, Saudi Arabia, and U.A.E Page 18 of 18