1. Calculating a Relevant TWI Richard Sullivan Reserve Bank of New Zealand

2. Trade weighted exchange rate What is a TWI/NEER/REER? Why have one? What is it used for? What currencies to use? How to weight? Why not just trade weights? How to calculate NEER How to recalculate, and how often? How to calculate REER

3. What is a TWI? TWI = Trade Weighted Index A multilateral exchange rate which is a weighted average of exchange rates of foreign currencies, with the weight for currency based on its share in trade. It measures the average price of goods relative to the average price of goods of trading partners.

4. What is it for? A tool for measuring: direct influence of exchange rate movements on prices indirect influence of the exchange rate on inflation through influence on external sector competitiveness If the index increases, the purchasing power of that currency is higher (the currency strengthened against the country's trading partners). A lower index means that the currency depreciated (devaluation) so that you need more of that currency to pay for imports. Provides a measure of relative value against a range of currencies you are interested in.

5. NEER Nominal Effective Exchange Rate – a nominal TWI The weighted average value of a country's currency relative to a pool of currencies. The weights are determined by the importance a home country places on the other currencies within the pool – usually based on trade. Usually measured by trade flows (hence TWI).

6. TWI less volatile

7. Pa’anga not as volatile as bilateral rates suggest

8. REER Real Effective Exchange Rate – a real TWI Same as NEER, but adjusted for inflation Better measure of competitiveness over time – takes into account price movements A higher REER indicates lower competitiveness as it costs more to produce similar goods.

9. NEER calculation

10. Important decisions Pick the relevant currencies – Trade flow? – Policy goals will provide guide Determine appropriate weights – Which way to weight? – How often to re-weight?

11. Choosing Appropriate Currencies Trade flows – Just exports? if export competitiveness is the primary goal – Just imports? If imported price inflation is key priority – All trade? Other currency flows – Remittances – Capital/grants Completeness vs ease of calculation

12. Factors to consider when determining weights Equal weighting to exports and imports? Other currency flows Foreign currency regimes – Currency pegs (e.g to USD) – Similar ‘baskets’ (e.g Fiji and Tonga)

13. Third country competition Competition faced by exporters from countries not in ‘basket’ – e.g squash from Mexico to Japan Studies show is good proxy for wider range of currencies within TWI

14. More currencies does not mean better coverage TWI14 index includes the five TWI currencies with the addition of the currencies of: China, Malaysia, Indonesia, Thailand, Taiwan, Korea, Singapore, Hong Kong and Canada.

15. Administrivia Arithmetic vs geometric mean Update frequency Ease of finding data – What data to use

16. Data website IMF data – Currencies – GDP – Inflation http://www.imf.org/external/data.htm WEO database for GDP and inflation IFS if you need currencies

20. NEER Examples

21. Examples NZD TWI – 5 currency basket with 50% GDP weight Tonga NEER – 4 currency basket, all trade weight – 5 currency basket, 25% trade weight – What about the CNY?

22. NZD TWI GDP weight greatly increases importance of USD and euro Better reflects actual currency traded, and third country competition

23. TOP NEER Previous methodology – Trade only weights Subject to large changes in weights No account for 3 rd country competition – Updated every 5 years Weights can become inappropriate

24. TOP NEER Added 3 rd country competition – 25% GDP weights/75% trade weights (50% made USA too dominant as other countries were so small relatively) Update more regularly Stability in weight

26. Calculation of NEER 1.Get trade weights for appropriate year – appropriate year will always be 2 years behind (e.g in January 2009, the data you need are for 2007) – insert total annual import and export data into sheet "data" – Calculate trade weight as % of ‘basket’ currencies 2.Get GDP weights for appropriate year – enter GDP data into sheet "data" – enter average exchange rate for year to make – Convert GDP into USD – Calculate GDP weight as % of ‘basket’ currencies 3.NEER weights will be weighted average of both trade and GDP weight 4.Calculate index – Convert bilateral exchange rates to index with common base – Use new weights to calculate index = 100 for month in which you plan to change – Multiply by factor so that it is splice with previous year (eg if NEER is 51.6, multiply new index by 51.6/100)

27. 1. Calculating trade weight Find import and export data for chosen currencies – In local currency Calculate as percentage of all trade with those chosen countries

28. 2. Calculating GDP weight Find GDP data for chosen currencies – In levels – In common currency Calculate as percentage of total GDP of those chosen countries

29. 3. Calculate NEER weight Average exchange rate for year Sum of selected countries

30. 3. Calculate NEER weight Share of trade/sum of trade Share of GDP/sum of GDP Weighted average of above

31. 4. Calculate index Set bilateral exchange rates to common base index Multiply by NEER weights and aggregate Splice with current series

32. Example Create common base Multiply by weights to get NEER Splice index

33. To include the CNY? Currency flows suggest it is a very important currency to consider – Imports – Grants – Loans Pegged to USD – So no reason to add as new currency Peg is being loosened – Should increase importance of CNY – Consider inclusion as CNY moves become less tied to USD

34. REER

35. Another important decision What deflator to use? Depends on policy goal Core inflation is theoretically best – But different countries measure core inflation differently Headline inflation is most accessible – All countries publish – Best for international comparison due to similarity http://www.rbnz.govt.nz/research/bulletin/2007_2011/jun2007.html http://www.rbnz.govt.nz/research/bulletin/2007_2011/jun2007.html “A review of the trade weighted index”

37. Calculation Calculate bilateral real exchange rates – r = e*P/P´ r = real exchange rate e = nominal exchange rate P = home price level P´= foreign price level Index bilateral rates to common base Multiply by NEER weights and aggregate Splice with current index Reweight at same time as NEER

38. Example NZD/TOP Nominal exchange rate CPI (index not inflation) Nominal exchange rate* Tonga CPI/NZ CPI *1023 (to base at 100 in Dec 06)

39. Nominal vs Real

40. Why the difference? CPI Inflation

41. Calculation Calculate bilateral real exchange rates – r = e*P/P´ r = real exchange rate e = nominal exchange rate P = home price level P´= foreign price level Index bilateral rates to common base Multiply by NEER weights and aggregate Splice with current index Reweight at same time as NEER

42. Questions