The Real Effective Exchange Rate
As noted in earlier posts, the REER is the trade-weighted exchange rate (NEER) adjusted for inflation. It is viewed as a good indicator of medium- to long-term currency valuation. If we look at the Russian and Turkish crises, we see beforehand that the Russian rouble and Turkish lira were around 50–60% overvalued on a REER basis. This provides extremely useful information in that it actually suggests that the rouble and the lira will have to experience significant real exchange rate depreciations to restore equilibrium. That’s the good news. The bad news is that it does not tell you when that significant real — and therefore nominal — depreciation will take place. In both cases, the rouble and the lira were overvalued for two to three years before the inevitable happened.
However, there are important clues as to when that REER appreciation may be about to end. Such REER appreciation usually causes significant trade and current account balance deterioration. The fact that this does not have an immediate reaction in the exchange rate confirms not only the existence of the J-curve but also the presence of significant capital inflows. Such inflows can offset a widening trade deficit for a period of time, but eventually are not able to. When they reverse, or rather when they just stop, the exchange rate comes under ever increasing pressure until such time as it collapses to restore equilibrium. This process can also work equally well with real depreciations. From the end of 1995 to mid-1998 the Japanese yen experienced an increasing REER depreciation. Capital outflows offset an increasingly improving current account balance until such time as they could no longer do so, whereupon the Japanese yen rallied significantly, resulting in one of the most dramatic collapses in the dollar–yen exchange rate — or any exchange rate — in history. REER valuation and the external balance are both cause and effect. It takes a REER depreciation of a currency to narrow significantly a large external imbalance. That said, an excessive REER appreciation can cause that imbalance in the first place.