Real effective exchange rates (REER) should incorporate Global Value Chains

Nice article by Nikhil Patel and Shang Jin Wei:

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. They can do so thanks to technological improvements, lower trade barriers, and the closer integration of emerging markets into the global economy. Ignoring this reality can lead to substantial mismeasurement of the REER, resulting in questionable policy inferences.

To see how the standard approach could be wrong, 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 improvementin China’s competitiveness. This example shows that the standard REER calculation is getting not only the magnitude wrong, but also the direction of change.

Hmmm…

They also explain how adjusting for GVCs lead to Chinese Renminbi showing appreciation trend compared to the oft cited depreciation trend…

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