Over the last few years, we always hear from traders and manufacturers of different countries who are complaining that their home currency is overvalued relative to other major foreign currency. Yet, there is no easy consensus view regarding the valuation of a country’s currency. The Real Effective Exchange Rate (REER) is one of the popular measures that is used by economists and policy makers in assessing the real value of a country’s currency against the basket of the trading partners of the country. It is also used to see how it performs itself with respect to the past.
What is REER?
Effective Exchange Rate (EER) is an important competitiveness indicator. It is the weighted average of a country’s currency in relation to a basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the Index. Adjusting for inflation for every currency, the calculated is then known as the Real Effective Exchange Rate (REER).
To illustrate, let’s assume China has only two trading partners: the US and Japan. The country imports $40 billion of goods from the US and $60 billion of goods from Japan, respectively; and it exports $80 billion and $20 billion of goods to these partners, respectively. As such, the total trade of the two countries is $200 billion, and the trade weight is 0.6 ($120billion/$200 billion) for the US and 0.4 ($80billion/$200 billion) for Japan.
Now, let’s assume the bilateral exchange rate change for China RMB during the year is 10% vs. the US dollar and 20% vs. the Japanese Yen, while the CPI of China, US and Japan is 105, 102 and 100 respectively. Therefore, the real exchange rate change for China RMB during the year is 7.4% vs. the US dollar and 16% vs. the Japanese Yen.
Overall, the change of RMB REER index in this example shows that the RMB actually appreciates 10.84% (7.4%*0.6 + 16%*0.4) during the year if taking the trade weight in consideration. In other words, a move of a currency with a larger trade weight would have a much critical impact than those with a lower trade weight.
Limitations of REER
An increase in REER means that local currency is appreciated against foreign currency which in turn exports become expensive and imports become cheaper. However, REER has its limitation too as the amount of trade can be affected by many other factors (i.e. other than exchange rate change) such as product price changes and tariff impact. Besides, a conventional REER does not account for supply chain bias, e.g., China is importing some materials or components from Japan for end-products manufacturing, and therefore a depreciation of Japanese Yen may not be a bad thing for Chinese exporters. Likewise, the convention REER also ignore cross-sector differences as each sector could face a totally different currency exposure than on the country level.