The Effective Exchange Rates of Rufiyaa THE EFFECTIVE EXCHANGE RATES OF RUFIYAA by: Azeema Adam* Introduction Eff ective exchange rates are important currency1 or to test the Balassa-Samuelson indicators for macroeconomic analysis of a eff ect.2 Th e NEER can be used to estimate country. Th ese rates show the relative strength the eff ect of NER changes on domestic prices, of a country’s currency relative to a basket of which is known as the exchange rate pass- currencies of its major trading partners. Th e through. nominal eff ective exchange rates (NEER) measures the weighted averages of bilateral Th is article3 summarizes the conceptual nominal exchange rates (NER). Th e real and methodological aspects of constructing eff ective exchange rates (REER) are expressed eff ective exchange rates and presents as NEER adjusted for price diff erentials or alternative indices of both NEER and REER infl ation between the home country and its for the Maldives. Th e developments and major trading partners. trends in these indices from January 1990 to March 2012 are also briefl y discussed. Real eff ective exchanges rates are most commonly used as an indicator of price or cost competitiveness. In this regard, a depreciation of the REER indicates an Methodology increase in competitiveness of the home country relative to its trading partner, and Th ere are several measures of NEER and conversely, an appreciation is regarded as a REER and various ways in which to construct loss in competitiveness for home country producers of goods and services. However, * Th e author is from the Monetary Policy and Research Division of given that competitiveness encompasses the Maldives Monetary Authority. diff erent dimensions of productivity and 1 To fi nd the degree of exchange rate misalignment, the medium market performance in interaction with one to long-run equilibrium REER (ERER) has to be computed. Th e diff erence between the REER and its ERER is the exchange rate other, REER may not always be an appropriate misalignment. measure of competitiveness. REER measures 2 Th e Balassa-Samuelson eff ect refers to the increase in can also be used to evaluate the degree of productivity in the tradable sector relative to non-tradable sector, leading to a rise in the relative price of non-tradables and pushing exchange rate misalignment of the domestic up the real exchange rate of the country (Appleyard, Field, & Cobb, 2010). 3 Th is article draws on a more in-depth research paper of this author on the construction of eff ective exchange rates for the Maldives, prepared as part of her Doctoral thesis and will soon be available in MMA Working Paper Series. 36 Quarterly Economic Bulletin, September 2012 The Effective Exchange Rates of Rufiyaa them. Th e construction of these indices be- partners of the home country and ಡ౟ౚ ୢୡ౟ gins with a measurement of the NER and the is the bilateral RER with ith country. Th e real exchange rates (RER). Th e NER is nor- mally quoted in domestic currency terms, as ಡ౟ౚ can be expressed as: ୢୡ౟ the units of home currency per unit of foreign currency. Th e RER is the nominal exchange ܲீ௙ (3) כ ௗ௖ܴܧௗ௖ ൌܴܰܧܴܤ of the home country adjusted for the price ܲீௗ level between the home country and the for- eign country. Defi ned this way, an increase in where ܤܴܧܴௗ௖ is the bilateral RER between the NER/RER refl ects a depreciation of the the domestic currency and a foreign currency; home currency and a decrease is appreciation of the home currency in nominal terms. ܲீ௙ is the general price index of the foreign Th e methodology used for constructing the country; and ܲீௗ is the general price index of eff ective exchange rates for the Maldives is the domestic country. drawn from Hinkle & Nsengiyumva, (1999), because their methodology has shown to be As regards the averaging process that is used appropriate for developing countries with to calculate the weighted average exchange data limitations, as is the case for the Mal- rate indices, geometric averaging is used due dives. Th e following equations are used to cal- to its many advantages. culate the NEER and REER for the Maldives. In many developing countries, the offi cial ex- NEER is expressed as: change rate may not be the only exchange rate used in the country. In countries where there ୫ ಡ౟ౚ (1) are parallel markets for foreign exchange, the ൌෑ ୢୡ ୢୡ౟ ୧ୀଵ offi cial and unoffi cial rates might diverge sig- nifi cantly. Th is would alter the outcomes for RER calculations, depending on the NER where ܰܧܴௗ௖ is the index of units of used. If a country does not have a signifi - domestic currency per one unit of foreign cant parallel market, the use of the offi cial exchange rate is suitable. Otherwise, the ex- currency and ɘ୧ୢ is the trade weight change rate prevailing in the parallel market assigned to the ith country (where i = 1.....m). may be the representative exchange rate of Th e REER can be expressed as: the country, and using the offi cial exchange rate to calculate RER would not produce reli- ୫ able estimates (Edwards, 1988). However, the ಡ౟ౚ (2) problem with parallel market exchange rates ൌෑ ୢୡ ୢୡ౟ ୧ୀଵ is that they are not always available, especially in a consistent manner. In the Maldives, parallel markets have oc- where ୢୡ is the REER for domestic casionally emerged in the past, typically fol- currency; m is the number of trading lowing periods of foreign exchange shortages. Research Articles 37 The Effective Exchange Rates of Rufiyaa However, no data exists on the parallel market In the Maldives there is a signifi cant diff er- exchange rates or the volume of transactions ence in the importance of trading partners for using parallel market rates. Th erefore, the of- imports, exports and tourism. In this respect, fi cial NER is used. eff ective exchange rates are constructed based on imports weights, exports weights, tourism Based on the trade patterns of the Maldives, weights and aggregate trade weights, separate- trade weights based on exports of goods, im- ly. Th e aggregate trade weights are simply the ports of goods and tourism infl ows are com- relative shares of imports, exports and tour- puted for the country. For each of these cate- ism in the total trade in goods and services. gories, separate weights are calculated for each Th e following equations are used to compute trading partner, allowing them to be used to the four sets of trade weights. construct eff ective exchange rates based on each type of trade. In addition, aggregations Import weights: of these weights are computed to derive over- all trade weights. Constant or fi xed weights ݉௜ (4) ݓெ ൌ are the simplest to both derive and use in the ௜ ܯ construction of eff ective exchange rates. Fixed Export weights: weights assume that the relative shares of trad- ing partners remain constant over the period. ଡ଼ ୧ (5) ୧ ൌ However, this assumption rarely holds, espe- cially over long periods, during which time Tourism weights: the shares of a country’s trading partners may change substantially. Th erefore, weighting ୘ ୧ (6) ୧ ൌ schemes that allow trade weights to change from period to period are used in this paper, Aggregate trade weights: as they produce a more representative index of eff ective exchange rates (Richter & Svavars- ୘୛ ൌ ୫ ൅ son, 2006). ୧ ൅൅ ୧ (7) ୶ ൅ ୲ In the Maldives, the importance of the main ൅൅ ୧ ൅൅ ୧ trading partners has shifted signifi cantly over the years, which makes moving weights more ெ ௑ ் ்ௐ suitable. Th erefore, time-varying weights by where ݓ௜ ǡݓ௜ ǡݓ௜ ݓ௜ denote the trade assigning three-year averages for each three- weights for the ith country based on imports, year period and chaining the indices as sug- exports, tourism receipts and aggregate trade gested by Ellis (2001) are used to construct in goods and services, respectively. Th e vari- a consistent time-series index of eff ective exchange rates. Th e justifi cation for using ables ݉௜ܽ݊݀ݔ௜represent the value of imports three-year average weights instead of the more th -common annual weights is to smooth out the and exports of the i country and ݐ௜ repre potentially abnormal movements in year-to- sents the tourist arrivals from the ith country. year variations in trade. Th e variables M and X are the total value of imports and exports of the Maldives, T is the 38 Quarterly Economic Bulletin, September 2012 The Effective Exchange Rates of Rufiyaa total number of tourists from all the countries Table 1: Countries Included in Trade Weights, by and TR is the total tourism receipts.4 Category Aggregate Imports Exports Tourism Trade Th e trade shares are calculated for the major (M) (X) (T) Weights trading partners in each category using (TW) Equations 4 to 7 for 17 countries. Th ese Austria x x countries account for about 80% of trade in China x x x goods and services for the Maldives. For each France x x x x Germany x x x x year, the trade weights are calculated as the India x x x average of that year and the preceding two Italy x x x years. For example, the trade weights used to Japan x x x calculate the eff ective exchange rates for 2011 Malaysia x x is the three-year average of the period 2009- Russia x x 2011. For any current year, the past three-year Singapore x x x average is used. Th e use of diff erent weights South Korea x x for diff erent periods requires the indices to be Sri Lanka x x x chain-linked to make a consistent time series.