REER and FEER

admin — Thu, 25 Jun 2009 21:34:32 +0000

In line with the external balance approach, the Real Effective Exchange Rate (REER) is the trade-weighted exchange rate (NEER) adjusted for inﬂation. As with PPP, the purpose of using REER is to try to gauge an exchange rate’s over- or undervaluation relative to a given norm. As with PPP, using REER is far from an exact science and in fact PPP and REER run into similar problems. For instance, a major problem with PPP is which base year to choose. REER has the same problem and for similar reasons. Using a particular base year with which to begin one’s analysis can signiﬁcantly distort the results. On the face of it, it would seem logical to start both PPP and REER analyses in the 1971–1973 period when the Bretton Woods exchange rate system broke up, yet this was a highly inﬂationary and therefore distorting period as far as such analyses are concerned.
The transmission mechanism is again the current account balance. Signiﬁcant REER over-valuation relative to a given norm of 100 tends to produce a widening current account deﬁcit or “external imbalance” in the jargon of economists. In order to restore balance or equilibrium, there has logically to be a REER depreciation. This can be achieved either by a depreciation of the trade-weighted exchange rate — that is to say by a depreciation of the nominal exchange rate — or by a sharp decline in inﬂation.
So far, this seems relatively logical and deceptively predictable. However, signiﬁcant REER overvaluations can last for substantial periods of time. In some cases it can take several years before an adjustment process takes place to eliminate such overvaluation. A good example again is that of the Russian rouble, whose REER value was overvalued by around 60% for three years — depending on the base year used — before it ﬁnally succumbed to gravity. The REER values of both the Mexican peso and the Venezuelan bolivar have indicated signiﬁcant overvaluation for several years now, and in the case of the Mexican peso to a greater degree than before the 1994–1995 “Tequila” crisis. The lesson of REER is that it can be a useful tool for diagnosing over- or undervaluation and a consequent need for an adjustment to restore equilibrium — but what it cannot do is tell you when that will happen.
Another way to estimate a real exchange rate’s equilibrium is FEER, or Fundamental Equilibrium Exchange Rate, pioneered by the writer and economic scholar John Williamson in 1985. Recognizing the imperfections of the PPP concept, FEER reﬂects the exchange rate value that is the result of a current account surplus or deﬁcit that is in turn appropriate to the long-term structural capital inﬂow or outﬂow in the economy, assuming that the country does not have barriers to free trade and is also trying to pursue internal balance. Assessing the appropriate level of long-term structural capital inﬂow or outﬂow requires a considerable degree of value judgement. Even if it did not, it assumes that such capital inﬂows or outﬂows should persist simply because they have occurred in the past. Given this construction, it is not surprising that estimates of an exchange rate’s FEER value vary widely. This is not to say that it is not a useful model. Indeed, models based on the FEER concept have been widely used within the private sector for some time. However, it is to say that using such a type of exchange rate model puts a considerable degree of emphasis on the value judgement of the analyst concerned, thereby undermining the point of using a model in the ﬁrst place. Looking at exchange rate models in general that use some variation of the external balance approach, we see that considerable “misalignments” in the external balance — and therefore presumably in the exchange rate — can persist over signiﬁcant periods of time. The fact that this can happen suggests equally that for substantial periods of time the importance of the external balance to the exchange rate can be more than offset by capital ﬂows. Eventually, it appears that the misalignment in the external balance reaches a level which produces a loss of market conﬁdence and capital outﬂows. As capital outﬂows occur, this by necessity must reduce the current account deﬁcit. The problem of course is that this level, this trigger point which causes a loss of market conﬁdence, is not static but changes. Thus, as with all exchange rate models, those which focus on the external balance should be used for long-term exchange rate considerations rather than for the short term.

Financial issues » Exchange Rate

REER and FEER