Real Effective Exchage Rates Reviewed

(from my colleague Ilan Solot)

Now that the dust is settling on the small CNY depreciation, let’s revisit the recent trends in real effective exchange rates (inflation and trade weighted).

The Chinese yuan comes in as the currency that experienced the greatest real currency appreciation while the Colombian peso experienced the greatest currency depreciation. Over a 6- and 12-month period, the yuan’s REER appreciated about 1.3% and 13%, while the peso’s depreciated about 10% and 24%, respectively. In the specific case of these two countries, the impact is partially mitigated by the fact that China is a commodity importer and Colombia a commodity exporter, so terms of trade has to be taken into account. Nevertheless, it still goes to show how small the recent nominal CNY depreciation was in comparison with the recent REER moves. 

Brazil and Mexico also come out as having seen a relatively large real depreciation of their currencies. Meanwhile, many major EMs, such as India, Chile, Poland, Mexico and South Africa, saw a relatively small fluctuation in their real exchange rate over the last 12-months. That said, all countries in the sample, except for China, saw some real depreciation of their currencies over the last 6-months. 

The large moves in nominal currency crosses explain most of these differences. Below is a table showing the top three trade partners for selected countries, using total bi-lateral trade for 2014, as compiled by Bloomberg.  For example, here we see that part of the reason for China’s REER appreciation is that the CNY has appreciated against two of its three top trading partners. But also note that China’s total trade with the US is about the same as that of Japan and South Korea combined, so that has helped prevent further strengthening. 

  Meanwhile, the poor nominal performance of the Brazilian real against its main trading partners was more than enough to offset the country’s relatively high inflation rate (averaging around 7.5% over the 12 months). In Turkey, however, the higher inflation (average of 8.2% over the 12 months), was enough to prevent a larger REER depreciation of the lira. In addition, having Russia as the country's second largest trading partner also played a role and balancing out the move from the nominal side.

Extending the same analysis to selected G10 countries, we see two clusters in the 12-month time frame: The US, Switzerland and the UK experiencing real exchange rate appreciation, while Japan, Norway and Germany on the other side of the scale. Of course, much of this just reflects nominal currency trends, since inflation amongst G10 countries is relatively more uniform than that in EM. While Germany and Japan saw their currencies weaken substantially against its top trading partners, the opposite happened in the US and UK.

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