Getting Exchange Rates Right - real effective exchange rate (REER)

https://www.project-syndicate.org/commentary/real-effective-exchange-rate-global-value-chains-by-nikhil-patel-2-and-shang-jin-wei-2019-04?utm_source=Project+Syndicate+Newsletter&utm_campaign=67b864029b-sunday_newsletter_21_4_2019&utm_medium=email&utm_term=0_73bad5b7d8-67b864029b-93854061&mc_cid=67b864029b&mc_eid=be3809ebbc

The real effective exchange rate (REER) may sound arcane to non-economists, but it is one of the most important international financial indices. The REER is a summary index that tracks the difference in the prices of goods produced by a country and its trading partners. Other things being equal, an increase in a country’s REER indicates a loss of trade competitiveness. And rising current-account imbalances are often associated with deviations in the REER from equilibrium values.

...central banks and international financial institutions devote considerable resources to calculating and analyzing it. But their methods have become outdated as global value chains (GVCs) become increasingly widespread. We therefore recently proposed a new REER calculation with Zhi Wang that addresses the current shortcomings.

Standard calculations of the REER by most central banks and statistical agencies assume that countries export only final goods. But GVCs spread the different stages of production among different countries....

...consider a hypothetical value chain for the production of smartphones...Suppose Japan manufactures the components and ships them to China, where the phones are assembled and exported globally as finished products. Traditional REER models would assume that Japan exports final goods to China, and that the two countries are competitors. A depreciation of the Japanese yen, therefore, would help Japan’s competitiveness and hurt that of China.

In this case, however, a weaker yen would lower the price of Japanese components, which may lead to lower prices and increased demand for Chinese phones – leading to an improvement in China’s competitiveness. This example shows that the standard REER calculation is getting not only the magnitude wrong, but also the direction of change.

... a large part of Chinese exports represents value added embedded in parts and components from other countries besides China – including a significant share coming from the US itself.

...our analysis shows that China’s real exchange rate against the US dollar displays a pronounced and consistent appreciation trend. By contrast, the standard calculation shows a real depreciation of the renminbi in the period leading up to China’s abandonment of its exchange-rate peg in 2005, and then an exchange-rate appreciation that is smaller than the traditionally measured one.