The Bangko Sentral ng Pilipinas (BSP) releases today three new indices which measure the nominal and real effective exchange rates of the peso relative to the currencies of the following groups of countries: 1) all major trading partners of the Philippines covering merchandise exports and imports; 2) trading partners in advanced countries; and 3) trading partners in developing countries. The methodology used for calculating the new indices was also revised as the BSP shifted from arithmetic to geometric formulation and from base year to chained indices.
The effective exchange rate (EER) index measures the relative value of one country’s currency against a basket of currencies. The nominal effective exchange rate (NEER) is a weighted average of bilateral exchange rates with currencies of trading partners. The real effective exchange rate (REER), which is a weighted average of inflation- or price-adjusted bilateral exchange rates with currencies of trading partners, reflects not only movements in nominal exchange rates but also inflation differentials with trading partners.
The new NEER and REER indices would enable the BSP to gauge more objectively the overall movements in the exchange rate of the peso across currencies, where an increase in the indices means an overall appreciation of the peso against the basket of currencies (thus a loss in the external price competitiveness of the country) while a decrease indicates otherwise.
The Philippines has fourteen major trading partners
The major trading partners of the Philippines are defined as those countries which accounted for at least one percent share of the total merchandise exports and imports of the Philippines for the past five years (2007-2011). Based on this criterion, fourteen major trading partners of the Philippines were identified: United States, Euro Area, Japan, Australia, China, Singapore, South Korea, Hong Kong, Malaysia, Taiwan, Indonesia, Saudi Arabia, United Arab Emirates, and Thailand.
New NEER and REER Indices are more comprehensive measures of the peso’s effective exchange rates
The Trading Partners Index (TPI) measures the average nominal and real effective exchange rates of the peso across the currencies of the 14 major trading partners of the Philippines identified above. If one considers the bilateral exchange rate of the peso with each of the 14 currencies, the peso could appreciate against one currency but depreciate or hold steady with respect to another currency. The TPI is an overall measure of the average value of the peso across all fourteen currencies taken together. It provides an indication of the net direction of the peso’s exchange rate against major trading partners.
The second index is the Trading Partners Index- Advanced Countries (TPI-A). This index measures the effective exchange rates of the peso across currencies of trading partners in advanced countries comprising of the United States, Japan, Euro Area and Australia. The TPI-A provides information on the value of the peso against currencies in highly industrialized economies.
The third index is the Trading Partners-Developing Countries (TPI-D). This index measures the effective exchange rates of the peso across 10 currencies of partner developing economies ─ China, Singapore, South Korea, Hong Kong, Malaysia, Taiwan, Indonesia, Saudi Arabia, United Arab Emirates, and Thailand. The TPI-D measures the value of the peso relative to the currencies of developing countries.
The TPI, TPI-A and TPI-D will replace the present NEER/REER indices that the BSP currently monitors. The indices to be replaced are: 1) Majors index which consists of currencies of advanced countries such as the United States, Japan, Euro Area and the United Kingdom; 2) Broad competing countries index which consists of currencies in the TPI-D basket such as Singapore, South Korea, Hong Kong, Malaysia, Taiwan, Indonesia, and Thailand except China, Saudi Arabia, and United Arab Emirates; and 3) Narrow competing countries index which consists of currencies of three developing countries─Indonesia, Malaysia, and Thailand, all of which are also included in the TPI-D. However the current set of NEER/REER indices does not have a comprehensive index similar to the TPI.
The methodology is revised from arithmetic to geometric average formulation and from base year to chained indices
The current indices are computed using the weighted arithmetic average of changes in bilateral exchange rates relative to a base period, which is December 1980. The weights are the respective trading partner’s merchandise trade share (exports and imports) to total Philippine trade. An inherent weakness of the arithmetic mean is that it gives more weight to depreciating currencies. If the currencies in the basket are generally moving in the same direction, then this is not a problem. But if there is a currency that is depreciating considerably, this would introduce an upward bias to the index, even if the weight of the currency is small. For example, the Indonesian rupiah experienced significant depreciation in 1998 as a result of the Asian financial crisis causing the NEER/REER indices of the peso to go up even if the peso was not appreciating significantly relative to the other currencies in the basket.
The nominal effective exchange rate indices of the TPI, TPI-A, and TPI-D are computed using the chained geometric average of the year-on-year changes in the bilateral exchange rates against the peso for each currency included in the index, with the trade share of the corresponding partner country as weights. The reference year for the indices is 1980. Other central banks using the chained geometric mean in the derivation of the NEER and REER indices include the US Federal Reserve Board, Bank of Japan, Bank of Canada, Bank of England, European Central Bank, Reserve Bank of Australia, and the Reserve Bank of New Zealand.
The peso’s effective exchange rate has been appreciating since 2005
Both the current and new indices showed that the peso had depreciated in 1981-2004 and has been generally appreciating against major trading partners since 2005. Based on the TPI, the effective exchange rate value of the peso reached a low in 2004 at 12.9 percent of its nominal and 60.5 percent of its effective exchange rate value in 1980. In 2012, however, following a generally rising trend, the peso appreciated to 14.9 percent and 84.6 percent of its nominal and real effective exchange rate values, respectively, compared to 1980. The peso’s nominal and real effective exchange rate increased by an annual average of 1.8 percent and 4.3 percent, respectively, in the past eight years. Although the peso’s real appreciation could have an effect on the economy’s competitiveness, this was mitigated by the series of economic, financial, and fiscal reforms which have all served to strengthen the country’s economic fundamentals.
Parallel dissemination of old and new indices will be done until end 2013
The new indices will be computed in parallel with the current series until the end of 2013. Starting 2014, the new indices will henceforth be the official effective exchange rate indices of the BSP.