Monday, June 20, 2011

Effective Exchange Rates: A New Measurement

One of the problems with measuring the “correct” value of exchange rates is that we’re talking about a relative price against a whole bunch of other relative prices. For example, though the most often quoted exchange rate (and the one with the highest turnover) the world over is against the USD, this is really a remnant from the Bretton Woods era and is more customary rather than economic – Malaysia’s direct trade with the US is somewhat less than 12%.

One way around this is to calculate “effective” exchange rates, which is a weighted average exchange rate typically using the value of trade as a weighting scheme. For the MYR, the current weights would be about 14% for the SGD and CNY, 13% for the JPY, 12% for the USD and about 11% for the EUR. Those five currencies alone denominate two-thirds of Malaysia’s trade, even if invoicing and settlement are primarily in USD.

However, this approach has a problem when you’re comparing exchange rates. There’s an underlying assumption that goods traded between each country are “independent” or unique, i.e. that they are produced fully in each of the trading countries. In practice of course, this is not true – many goods are inputs into other goods. For example, PCBs from Singapore, memory chips from Korea, processors from Malaysia and the Philippines, designs from the US, all go into laptops assembled in China. Something like two-thirds of Malaysia’s imports are intermediate goods, goods that are used as inputs into final products or into other intermediate goods.

But this reality of a global rather than local supply chain makes judgements on over or undervaluation highly problematical, as adjustments of exchange rates alone will not have the full effect on trade predicted by basic economic theory i.e. looking at the wrong measurement will yield the wrong policy prescription. The US Congress will not solve America’s trade deficit by exchange rate adjustment alone, as its looking at China’s low cost production base in isolation and not as the final assembly point of a trail of industrial and raw material inputs from across the whole East Asian region and beyond.

A new proposal hopes to solve this measurement conundrum by explicitly factoring in global supply chains:

Asia’s supply chain: Implications for rebalancing

Persistent global imbalances are raising concerns about the sustainability of the global recovery and economic growth in general. This column argues that a proper appreciation of the influence of exchange rates and demand on global imbalances requires taking into account an important feature of Asia’s trade – cross-border supply chains or “vertical integration”…

…Thorbecke (2010) proposed the concept of an “integrated effective exchange rate” to explicitly capture this supply-chain effect on cost competitiveness. In our work (Unteroberdoerster 2011), we implement this by combining the conventional real effective exchange rate with a measure that captures the supply-chain features. Specifically, we use the bilateral real exchange rates between the country’s supplier economies and its final destination markets; the weights equal the supplying economies’ share in the country’s imported value added. To illustrate this, suppose Thailand exports to only one destination (US), but imports components from Japan and China. The integrated effective exchange rate would use the Thai-US exchange rate on the export side and a weighted average of the Japanese and Chinese exchange rates and the US.

This example shows that the main difference with respect to the conventional effective exchange rate is that integrated effective exchange rate also accounts for the supplier economies’ exchange-rate movements vis-à-vis those export markets.

This difference means that movements in the conventional real effective exchange rate can differ markedly from those of the integrated effective exchange rate...

…Accounting for the internationalisation of supply chains also affects the way we measure global demand imbalances. For example, when we redistribute the imported inputs embedded in China’s exports to the US to Asian economies supplying these inputs and calculate trade flows based on value added, we find that China’s share in Asia’s trade surplus to the US shrinks, from about 62% to 54% on average for 2005-2008, whereas that of most other Asian economies increases.

All this implies that because of the high degree of production sharing in Asia, a durable reduction in imbalances would require adjustment across all major Asian economies and currencies. It would be misleading to focus on bilateral imbalances and exchange rates.

I sincerely doubt this will really catch on, even if this approach does solve a major shortcoming of current valuation methods. The biggest issue is simply data – you need to know input-output parameters of each economy and trade partner. While data on this is (usually) available, the depth and scope of the data means that tabulating it is no simple matter, and its also not very high frequency. Malaysia’s input-output tables for example will only be updated this year (IIRC), after a gap of 5 years. While this type of data has historically been pretty stable, there’s been massive movement in trade patterns in the last ten years due to the emergence of China, and I wouldn’t lay odds against IO tables changing radically as a result. You’ll also have to deal with substantial data lag, which makes policy-making a little dicey.

So I’d file this as one more measure that has some promise, but also one that won’t become an integral part of the macro-analyst’s toolkit anytime soon.

Technical Notes:

Mohommad, Adil; Olaf Unteroberdoerster, and Jade Vichyanond, "Asia’s supply chain: Implications for rebalancing", VoxEU Article, June 2011 (accessed June 20 2011)

Unteroberdoerster, Olaf, Adil Mohommad, and Jade Vichyanond,“Implications of Asia’s Regional Supply Chain for Rebalancing Growth” Chapter 3, Regional Economic Outlook: Asia and Pacific, International Monetary Fund, April 2011

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