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1 econstor Make Your Publications Visible. A Service of Wirtscaft Centre zbwleibniz-informationszentrum Economics Barnett, Russell; Carbonneau, Karyne; Poulin-Bellisle, Guillaume Working Paper A new measure of te Canadian effective excange rate Bank of Canada Staff Discussion Paper, No Provided in Cooperation wit: Bank of Canada, Ottawa Suggested Citation: Barnett, Russell; Carbonneau, Karyne; Poulin-Bellisle, Guillaume (2016) : A new measure of te Canadian effective excange rate, Bank of Canada Staff Discussion Paper, No , Bank of Canada, Ottawa Tis Version is available at: ttp://dl.andle.net/10419/ Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenscaftlicen Zwecken und zum Privatgebrauc gespeicert und kopiert werden. Sie dürfen die Dokumente nict für öffentlice oder kommerzielle Zwecke vervielfältigen, öffentlic ausstellen, öffentlic zugänglic macen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt aben sollten, gelten abweicend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewärten Nutzungsrecte. Terms of use: Documents in EconStor may be saved and copied for your personal and scolarly purposes. You are not to copy documents for public or commercial purposes, to exibit te documents publicly, to make tem publicly available on te internet, or to distribute or oterwise use te documents in public. If te documents ave been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise furter usage rigts as specified in te indicated licence.

2 Staff Discussion Paper/Document d analyse du personnel A New Measure of te Canadian Effective Excange Rate by Russell Barnett, Karyne Carbonneau and Guillaume Poulin-Bellisle Bank of Canada staff discussion papers are completed staff researc studies on a wide variety of subjects relevant to central bank policy, produced independently from te Bank s Governing Council. Tis researc may support or callenge prevailing policy ortodoxy. Terefore, te views expressed in tis paper are solely tose of te autors and may differ from official Bank of Canada views. No responsibility for tem sould be attributed to te Bank.

3 Bank of Canada Staff Discussion Paper January 2016 A New Measure of te Canadian Effective Excange Rate by Russell Barnett, Karyne Carbonneau and Guillaume Poulin-Bellisle Canadian Economic Analysis Department Bank of Canada Ottawa, Ontario, Canada K1A 0G9 rbarnett@bankofcanada.ca kcarbonneau@bankofcanada.ca ISSN Bank of Canada

4 Acknowledgements Te autors are grateful to Eric Santor, Rys Mendes, Harriet Jackson, Brigitte Desroces, Nikita Perevalov and Nicolas Labelle St-Pierre for comments and elpful suggestions. All remaining errors are our own. ii

5 Abstract Canada s international competitiveness as received increasing attention in recent years as exports ave fallen sort of expectations and Canada as lost market sare. Tis paper asks weter te Bank of Canada s current effective excange rate measure, te CERI, is still an accurate measure of Canada s international competitiveness. Overall, wile te CERI represented an improvement over previous measures wen it was introduced, we find tat it as several drawbacks tat make it less well suited to address current competitiveness issues. To address tese deficiencies, we develop a new Canadian effective excange rate (CEER) index using a metodology based on current international best practices. Te new index includes a broader set of countries and uses annually updated competition-based weigts. Tese weigts account for bot Canada s bilateral trade wit anoter country and te competition Canada faces from tat country on a product-by-product basis in tird markets. We find tat te CEER as depreciated less tan te CERI in recent years, reflecting te greater importance of tird-market competition from emerging-market economies in te CEER. Tis could elp explain wy Canada s sare of te U.S. import market as continued to decline despite te recent large depreciation of te Canadian dollar against te currencies of a number of advanced economies. JEL classification: F1, F31 Bank classification: Excange rates; International topics Résumé La compétitivité du Canada sur les marcés internationaux est de plus en plus débattue depuis quelques années dans un contexte où l évolution des exportations canadiennes ne répond pas aux attentes et où le pays perd des parts de marcé. Ce document d analyse cerce à déterminer si l indice de taux de cange effectif du dollar canadien (TCEC) qu utilise la Banque du Canada est encore une mesure fidèle de la compétitivité des entreprises canadiennes à l étranger. Dans l ensemble, l indice TCEC représentait un progrès par rapport aux mesures qui étaient alors employées lorsqu il a été adopté, mais il apparaît aujourd ui rendre moins bien compte de la compétitivité du Canada, du fait de plusieurs failles. Pour corriger ces défauts, nous avons mis au point un nouvel indice de taux de cange effectif du dollar canadien (TEC) en nous fondant sur une métodologie inspirée des pratiques internationales contemporaines. Ce nouvel indice englobe un plus grand nombre de pays et s appuie sur des pondérations mises à jour annuellement. Ces pondérations rendent compte du commerce bilatéral du Canada ainsi que de la concurrence produit par produit sur les marcés tiers. Le taux de cange s est moins iii

6 déprécié selon l indice TEC que selon l indice TCEC au cours des dernières années. Ce constat reflète l importance grandissante de la concurrence des pays émergents sur les marcés tiers dans le TEC. En soi, ce pénomène pourrait aider à comprendre pourquoi la forte dépréciation du dollar canadien observée récemment face aux monnaies de plusieurs pays avancés n a pas empêcé le Canada de continuer à perdre des parts de marcé aux États-Unis. Classification JEL : F1, F31 Classification de la Banque : Taux de cange; Questions internationales iv

7 1. Introduction A number of central banks, including te Bank of Canada, routinely publis effective excange rates for teir respective economies. Effective excange rates attempt to encapsulate movements in a country s bilateral excange rates wit its important trading partners into a single index. Suc indexes may be built for a variety of reasons, altoug tey are typically intended to capture ow an economy s excange rate affects its competitiveness in global trade markets. Since 2006, te Bank of Canada as publised te Canadian-dollar effective excange rate index (CERI) on a daily basis. 1 Te CERI was viewed as an improvement over te earlier C-6 index because te weigts accounted for bot direct trade links and tird-market competitiveness effects. Recent developments ave focused attention on Canada s international competitiveness. Since 2002, Canadian exports ave made up an ever smaller sare of te U.S. non-energy import market (Barnett and Carbonneau, 2015). More recently, exports ave underperformed wat would ave been expected, given growt in foreign economic activity and movements of te Canadian dollar vis-à-vis oter currencies. Against tis backdrop, we ask weter te CERI is still an accurate measure of Canada s international competitiveness. Overall, we find tat te CERI as several drawbacks tat make it less well suited to address current competitiveness issues. Most importantly, te CERI focuses on a narrow set of trading partners and uses fixed weigts based on trade patterns tat are over 15 years old (1999 to 2001). Since tat time, tere ave been large canges in global trade patterns, and emerging markets, particularly Cina, ave become increasingly important drivers of global growt. Togeter, tese factors suggest tat te CERI assigns too little weigt to emerging-market economies (EMEs). Unfortunately, te CERI s weigts cannot be updated more frequently, since tey are based on International Monetary Fund (IMF) calculations tat are only released once every 10 years. In order to address tese deficiencies, we develop a new measure, te Canadian effective excange rate (CEER) index. Te new measure includes a broader set of countries and as weigts tat are built in-ouse and can terefore be updated annually. Te remainder of te paper is structured as follows. First, we discuss te criteria for a desirable weigting structure and survey practices across a number of central banks and international organizations. Next, we construct weigts based on our preferred metodology, compare tese 1 See Ong (2006) for a description of te CERI. 1

8 weigts to te CERI and sow ow tese canges affect te index. Finally, we investigate te implications of te new index for assessing Canada s relative competitiveness in recent years due to excange rate movements. 2. International comparison of effective excange rate metodologies Nominal and real effective excange rate indexes are constructed using a weigted average of a country s nominal and real bilateral excange rates against a group of countries. Tese indexes are typically built to measure a country s overall international competitiveness compared wit tat of its trading partners. However, tere is no universally agreed-upon metod for calculating effective excange rate indexes. Comparing approaces across a wide set of central banks and international organizations sows tat weigting metodologies, te types of trade included and te frequency wit wic weigts are updated vary significantly across countries (Table 1). Among te central banks and international organizations tat we surveyed, 2 two weigting metodologies are widely used: Trade weigting: Weigts are based on direct export sares, import sares or bot. Competition weigting: Weigts account for te fact tat a country s exports face competition from bot domestic producers in te destination country and exports from oter countries, referred to as tird-market competition. Trade weigting is te least common metod for constructing weigts and is used by Australia, New Zealand and Norway. Competition weigting, on te oter and, is by far te most popular metodology for constructing effective excange rates, including te CERI. Te type of trade tat is included in calculations of country weigts also varies considerably across institutions. Some institutions focus exclusively on manufacturing goods (for example te Bank for International Settlements (BIS) and te European Central Bank (ECB)); oters focus only on goods (some wit and oters witout oil), and a small number also include services (for example Australia, New Zealand and te United Kingdom). 3 Moreover, for tose tat calculate tird-market competition effects, te level of disaggregation can vary. For example, te U.S. 2 For additional information, see Alsterlind (2006); Bayoumi, Lee and Jayanti (2005); Klau and Fung (2006); Leay (1998); Loretan (2005); Lync and Witaker (2004); Ong (2006); and Steenkamp (2014). 3 Altoug including services is desirable, data limitations often make it difficult to do so. For example, two of te central banks tat include services (Australia and New Zealand) bot look just at direct trade links and ave only incorporated services in recent years (2011 and 2009, respectively), tus introducing a break in teir weigts. 2

9 Federal Reserve calculates tird-market competition effects using its aggregate export and import weigts, wile te IMF calculates tis effect using a sligtly more disaggregated approac. Te CERI uses IMF weigts tat include non-energy commodities, manufactured goods, domestic sales of manufactured goods, and services trade. However, it is important to note tat te weigts te IMF attributes to trade in services are assumed to follow a similar pattern to trade in manufactured goods, implicitly up-weigting manufactured goods in te calculation of te effective excange rate (Bayoumi, Lee and Jayanti, 2005). Finally, te frequency at wic trade weigts are updated across countries typically falls into one of tree time frames: annually, every 3 years, or approximately every 10 years. Annual updates of te weigts is te most popular approac, wit 6 of 8 central banks examined aving at least one publised index were te weigts are updated yearly. Many of te central banks examined ave moved to annual updating to ensure tat te weigt assigned to eac trading partner reflects a country s current trade structure. Te Canadian CERI and Swedis TCW, on te oter and, are te only central bank indexes tat are updated every 10 years due to teir reliance on te IMF weigts. Tis feature implies tat te trade weigts can become quite out of date, particularly during periods of structural cange. Moreover, altoug te weigts were updated at te end of 2005, tey are actually based on 1999 to 2001 trade patterns and tus do not reflect te rising importance of emerging markets in global trade. However, in Sweden, tere is an alternative index (known as te KIX) tat is updated annually, wic te Riksbank as used to supplement te TCW weigts due to te importance of canging trade patterns. 4 4 For more information see KIX Index Better Reflects Sweden s International Dependence in te Riksbank s October 2012 Monetary Policy Report. 3

10 Table 1: Comparison of effective excange rate metodologies for selected countries Name of index Weigting sceme Number of countries Trade captured Weigt update frequency Central banks Australia TWI Trade 18 + euro area Mercandise goods and services (since 2011) Annually CERI Competition 5 + euro area IMF weigts Approx. every 10 years Broad CEER Competition 16 + euro area Mercandise goods (excl. oil) Annually Canada Major currencies Competition 6 + euro area Mercandise goods (excl. oil) Annually CEER OITP CEER Competition 10 Mercandise goods (excl. oil) Annually ECB EER-19 Competition 19 Manufacturing only Every 3 years New Zealand TWI Trade 16 + euro area Goods and services (since 2009) Annually Norway Sweden United Kingdom United States TWI Trade 25 OECD weigts Annually I-44 Import 44 Mercandise imports Annually TCW Competition 21 IMF weigts Approx. every 10 years KIX Competition 32 Manufacturing Annually Broad ERI Competition 42 Manufacturing and services Annually Narrow ERI Competition 35 Manufacturing and services Annually Broad Competition 25 + euro area Goods only Annually Major currencies Competition 6 + euro area Goods only Annually OITP Competition 19 Goods only Annually International organizations Broad Competition 40 + euro area Manufacturing only Every 3 years BIS Narrow Competition 14 + euro area Manufacturing only Every 3 years IMF All fund members Competition 184 Advanced economies Competition 26 + euro area Manufactured goods, primary products (excl. oil) and services (travel only) Manufactured goods, primary products (excl. oil) and services (travel only) Approx. every 10 years Approx. every 10 years OECD Nominal effective excange rate Competition 46 Goods only Annually 4

11 3. Building a new Canadian effective excange rate index Given te comparison presented in te previous section, we believe a new Canadian effective excange rate sould be constructed by drawing on lessons from international experience. In particular, we believe a new Canadian effective excange rate index sould ave te following features: i) Country coverage sould be broadened to better reflect Canada s trading patterns; ii) Trade weigts assigned to a given country sould reflect bot direct bilateral trade wit a country and te competition Canada faces from tat country in tird markets; iii) Tese weigts sould be updated on a regular basis, preferably annually, to ensure tat tey reflect Canada s trade patterns over time; iv) A set of measures sould be constructed, since different indexes can serve different purposes. For example some indexes better capture competitiveness-related issues, wile oters are more suited to assessing financial market pressures on te dollar; v) Finally, bot nominal and real indexes sould be constructed. Tis is particularly important, since broadening te country coverage almost certainly ensures tat some countries wit muc iger rates of inflation tan Canada will now be included in te index, making nominal movements less relevant over longer time periods. Te CERI only meets te second criteria, and terefore we develop a new index, te Canadian effective excange rate (CEER) index. Selecting te currencies to include in te new index In order to broaden te country coverage in te new index, we lowered te inclusion tresold so tat countries wit at least 0.5 per cent of Canadian imports or exports of non-energy goods trade, on average, over te past 10 years are now captured in te index. In contrast, te CERI uses a 2 per cent tresold wit te IMF-calculated trade weigts. Under tis new criterion, 16 countries (Australia, Brazil, Cina, Hong Kong, Japan, Sout Korea, Malaysia, Mexico, Norway, Peru, India, Sweden, Switzerland, Tailand, te United Kingdom and te United States) plus te euro area are included in te new index, compared wit te five countries (Cina, Japan, Mexico, te United Kingdom and te United States) plus te euro area in te CERI. Altoug trade in energy products is important for Canada, tey ave been excluded for te purposes of calculating te weigts, as tey are in te CERI, to be consistent wit te international standard. Typically, trade in energy is excluded, since prices are determined in global energy markets, and excange rate movements are not expected to affect a country s 5

12 relative competitiveness in suc primary commodities. Excluding energy products also as te potential benefit of minimizing swings in trade weigts tat could occur due to large swings in crude oil prices, suc as tose experienced in late To assess te importance of excluding oil, we also constructed indexes were oil was included. Te results sow tat including oil would ave ad very little impact on te index (see Appendix A). Overall, we believe tat our new nominal and real CEER measures strike an appropriate balance across a number of te criteria/weigting scemes currently used by oter central banks and international organizations. Specifically, by including all countries tat accounted for at least 0.5 per cent of Canadian non-oil exports or imports, our new measure accounts for over 93 and 91 per cent of Canadian non-oil exports and imports, respectively (Table 2). Table 2 Sare of Canadian imports and exports, by economy (per cent) Exports Imports Euro area Australia Brazil Cina Hong Kong India Japan Malaysia Mexico Norway Peru Sout Korea Sweden Switzerland Tailand USA United Kingdom CERI countries Major currencies OITP Total CEER

13 Calculating te weigts To be able to update te weigts on a regular basis, it was imperative tat we move away from using te IMF s weigts, wic are updated only once every 10 years, and build te weigts internally. We cose to use bilateral trade data from te United Nations (UN) Comtrade database rater tan from te IMF s Direction of Trade database. Te UN Comtrade data ave te advantage of being available by disaggregated good. However, we also constructed te CEER using te IMF Direction of Trade data and found tat it did not significantly cange our results. An added advantage of broadening te country coverage and constructing te weigts ourselves is tat it facilitated building alternative indexes, suc as major currencies versus oter important trading partners and export-weigted versus import-weigted indexes, wic may provide different insigts on ow excange rate movements are affecting oter economic variables. Te calculation of te weigts for te CEER follows a metodology similar to tat used by te Federal Reserve and presented in Leay (1998) and Loretan (2005). Te nominal CEER at time t is given by N I t = I t 1 e j,t e j,t 1 ω j,t, j=1 were e j,t is te bilateral excange rate wit country j at time t (te price of Canadian dollars in terms of te currency of country j), ω j,t is te weigt given to country j at time t and N is te number of currencies included in te index. Note tat j ω j,t = 1. In te real CEER, te nominal excange rate,e j,t, is replaced by its real counterpart, e j,t p t p j,t, were p t and p j,t are te consumer price indexes of Canada and country j. Te weigts are designed to capture te competitiveness of Canadian goods in international trade. A country can be important for Canada for tree reasons: (1) because Canada imports a large amount from tis country, (2) because Canada exports large amounts to tis country, or (3) because tis country exports large amounts to countries were Canada also exports significantly. Te total weigt given to a country in te effective excange rate index is terefore a weigted average of import weigts, export weigts and tird-market competition weigts. 7

14 Import weigts play a role in measuring Canada s international competitiveness because Canadian goods sold domestically compete wit imported goods. Te import weigt of country j at time t is given by tis country s sare of total Canadian imports: N j=1 μ CCC,j,t = M CCC,j,t M CCC,j,t, were M CCC,j,t represents mercandise imports from country j to Canada in year t. Here, and for te calculation of te oter weigts, we exclude energy goods (category 3 in te Standard Industrial Trade Classification (SITC) revision 2) for te reasons discussed earlier. 5 Note tat tese weigts, as wit all oter weigts, are calculated using annual trade data and are terefore constant witin a calendar year. Canadian exports also compete wit goods from country j in two different ways. First, country j can be a direct purcaser of Canadian goods. Tis is measured by te sare of total Canadian exports tat go to country j at time t: ε CAA,j,t = X CCC,j,t X CCC,j,t, were X CCC,j,t represents mercandise exports to country j from Canada in year t. Second, Canadian exports may compete wit country j s exports in a tird-market country, k. To measure tis type of competition, we calculate tird-market competition weigts. One contribution of tis paper is tat we depart from more conventional metods by calculating tese weigts at te level of te good (2-digit SITC rev.2, wic represents 55 different products). We believe tat tis metod can better capture te competition Canadian exporters face in tird markets by empasizing trade in products tat are important for Canada. 6 We define a product-specific import weigt by were M k,j,t μ k,j,t = M k,j,t N j=1 N M k,j,t, j=1 represents country k s mercandise imports of product from country j in year t. 5 We also exclude special transactions (category 9 of te SITC rev. 2) due to data-reporting issues. 6 We also constructed te indexes using total trade (excluding energy) as opposed to constructing te tird-market competitiveness effect product-by-product. As illustrated in Appendix B, calculating te weigts product-byproduct ad te largest impact on te oter important trading partners index. 8

15 Similarly, we define a product-specific export weigt by ε CCC,j,t = X CCC,j,t N X CCC,j,t, j=1 were X CCC,j,t represents Canada s mercandise exports of product to country j in year t. We also define te sare of product in total Canadian exports as ε CCC,t N = X CCC,j,t j=1 H N X CCC,j,t, =1 j=1 were H is te total number of products exported by Canada. Wit tose weigts, we can ten build te tird-market competition weigt: H τ CCC,j,t = ε CCC,t ε CCC,k,t =1 N k j,k CCC μ k,j,t 1 μ k,ccc,t. Note tat te multiplicative factor 1 1 μ k,ccc,t ensures tat te weigts sum to 1. For eac product, te tird-market competition weigt for country j is a weigted average of te tirdmarket countries sares of Canadian exports of product, were te weigts are given by country j s import sares of product from tose countries. Te total tird-market competition weigt of country j is te weigted average of tose product-specific competition weigts, were te weigts are given by te sare of eac product in total Canadian exports. Terefore, a country receives a large tird-market competition weigt if it as large import sares in countries wit large export weigts for Canada, and tis weigt increases as te similarity between te products traded increases. Te total weigt of country j in year t is ten given by ω j,t = 1 2 μ j,t ε CCC,j,t τ CCC,j,t. Tis measure gives equal weigt to imports and exports. We computed an alternative measure were te weigts assigned to te tree submeasures were given by te actual sare of 9

16 imports and exports in Canada s international trade. Again, tis made little difference to te overall index. Te weigts attributed to some of Canada s trading partners, suc as te United States, Cina and Mexico, differ greatly between te CERI and te CEER. For example, as of 2014, te CEER put 26.4 p.p. less weigt on te United States, and 9.6 and 4.6 p.p. more weigt on Cina and Mexico, respectively (Table 3). We also followed te Federal Reserve practice of calculating a major currencies index and an oter important trading partners (OITP) index. Te weigts in te major currencies index are similar to tose in te CERI, wile te OITP index puts significant weigt on countries like Cina and Mexico, primarily because of te competition Canada faces from tem in tird markets. Table 3 Currency weigts across te broad CEER and te CERI Broad CEER Major currencies OITP CERI Australian dollar Brazilian real Cinese renminbi (yuan) Euro Hong Kong dollar Indian rupee Japanese yen Malaysian ringgit Mexican peso Norwegian krone Peruvian new sol Sout Korean won Swedis krona Swiss franc Tai bat U.K. pound U.S. dollar Total Over te past 20 years, te weigts attributed to te United States and Japan ave decreased steadily, wile tose given to Cina, Mexico and emerging markets in general ave increased 10

17 (Figures 1 and 2). Tese trends reflect te rising competition tat Canada faces in te U.S. market from emerging-market economies and can ave a large impact on te sort-run dynamics of te new excange rate index. Figure 1: Weigts of major currencies Per cent Figure 2: Weigts of oter important trading partners Per cent Cina Brazil Oters Mexico Euro area Japan Oter major currencies U.S. (rs) Sources: United Nations Comtrade and autors calculations Sources: United Nations Comtrade and autors calculations Using tese weigts, we also constructed indexes based on direct imports from, direct exports to, and tird-market competition against, our trading partners. Eac index could provide different insigts. For example, te import-weigted index could be used to assess inflationary pressures coming from abroad due to excange rate movements, wile te export index could elp us understand ow canges in our excange rate affect te competiveness of our exporters relative to domestic producers in our main export markets. Te index based on tirdmarket competition, on te oter and, could be used to assess ow excange rate movements migt affect our import market sares in key markets. Overall, te weigts from tese alternative indexes igligt tat wile te major currencies ave te largest weigt in our new index, tis is largely attributable to te importance of direct bilateral trade wit tese countries (Table 4). On te oter and, te weigt associated wit our oter important trading partners is due to te importance of tird-market competition effects. As noted earlier, tese tird-market competition effects are particularly important for Cina and Mexico because of te competition Canada faces from tem in tird markets, suc as te United States. 11

18 Finally, wen considering mainly advanced economies, inflation differentials between countries are relatively limited, and, terefore, te nominal excange rate measure can provide a fairly accurate representation of te relative competitiveness of Canadian goods. However, wit te larger set of countries included in te CEER, inflation differentials must be taken into account. Most importantly, te ig rates of inflation in some countries can cause a nominal appreciation of te Canadian dollar tat as no impact on our competitiveness. For example, te Canadian dollar as appreciated significantly against te Brazilian real since 1992, but tis as largely reflected te yperinflation Brazil experienced in te early 1990s. Moreover, many emerging-market economies ave experienced periods of ig inflation over te past two decades, wile inflation as been low and stable in Canada and most advanced economies. Table 4 CEER indexes weigts, by type of trade in 2014 Total Import Export Tird-market Total Major currencies U.S Euro Japan U.K Switzerland Australia Sweden Oter important trading partners Cina Mexico Sout Korea Brazil India Tailand Peru Malaysia Hong Kong Norway

19 4. Te CEER: performance and limitations Te nominal indexes Like te Federal Reserve, we selected currencies to include in tree separate indexes: te broad index, te major currencies index and te oter important trading partners (OITP) index. Te broad index includes all 16 countries plus te euro area, following te criteria and metodology detailed in te previous section. Te major currencies index includes seven currencies tat are traded widely in currency markets outside teir respective ome areas: te U.S. dollar, euro, Japanese yen, Britis pound, Swiss franc, Australian dollar and Swedis krona. 7 Te remaining 10 currencies are included in te OITP index. Tese last two indexes allow us to disentangle competitiveness-related issues tat are closely tied wit te OITP index from financial pressure on te Canadian dollar, wic is better captured by te major currencies index. Overall, te broad index puts increasing weigt on EMEs, mainly reflecting te rising importance of tese countries in global trade and, consequently, in tird-market competition for Canadian goods. Increasing te weigt on EMEs as important implications, especially for te nominal measure, because doing so boosts te level of te nominal CEER (Figure 3). Te upward pressure on te broad CEER is exclusively related to te OITP index, due to te significant inflation rate differentials between Canada and some EMEs over te past two decades. In particular, te yperinflation in Brazil during te early 1990s accounts for almost all te large appreciation of te OITP index over tat period. To address tis issue, we introduce real indexes in te next subsection. 7 To select tese currencies, we followed te same rule as te Federal Reserve and included te currencies of te G-10 countries plus te Australian dollar. 13

20 Figure 3: Nominal Canadian effective excange rates Broad index Major currencies index OITP index Figure 4: Nominal CERI versus major currencies index Major currencies index CERI Sources: U.N. Comtrade, Wall Street Journal and autors calculations On te oter and, te CERI is very similar to te major currencies index (Figure 4), wic igligts te fact tat te difference between te CERI and te broad CEER is mainly due to te inclusion of a larger set of countries rater tan to te difference in te weigts attributed to te main countries. Te real indexes As mentioned above, we also compute real measures of te effective excange rate using CPI differentials between Canada and eac of our trading partners. All of te indexes are muc more alike once we control for relative inflation differentials (Figure 5 and Figure 6). We believe te real indexes to be more accurate indicators of Canadian competitiveness, especially wit respect to our OITP. In particular, te real OITP better reflects te competition tat Canadian exporters face in our most important market (i.e., te United States) and may elp explain te performance of Canadian exports. Over istory, te real OITP as, at times, diverged from te major currencies index. For example, it did not appreciate as muc as te major currencies index after te global financial crisis, but it also depreciated less in recent years. 14

21 Figure 5: Real Canadian effective excange rates Broad index Major currencies index OITP index 65 Figure 6: Relative CPI differentials wit Canada Index, January 1992 = Broad 0.4 Major currencies Oter important trading partners (OITP) 0.3 Sources: U.N. Comtrade, Wall Street Journal and autors calculations Since 2014, te major currencies index and te CERI ave diverged considerably from te OITP index (Figure 7). Te first two ave depreciated by more tan 15 per cent, wile te latter depreciated by only 6 per cent. In fact, since February 2015, te OITP index as remained largely uncanged, wile te major currencies index and te CERI ave depreciated significantly. Tis reflects an appreciation of te Canadian dollar vis-à-vis te Mexican peso and te Brazilian real. Compared wit previous periods, te Canadian dollar depreciated less tan te Cinese renminbi (considering te depreciation of te Canadian dollar against te U.S. dollar), due to te decision by Cinese autorities to allow te renminbi to depreciate relative to te U.S. dollar. Anoter way to decompose recent movements of te broad CEER is to look at wat an excange rate index tat is based on eac of te tree types of weigts included in te CEER would suggest. Effective excange rate measures based on direct trade eiter imports or exports ave depreciated considerably since te middle of 2014 by 17 per cent and 15 per cent, respectively (Figure 8). In contrast, te index based on tird-market competition weigts as depreciated by only 5 per cent. Since tis index largely reflects competition in te U.S. market, tis could elp explain wy Canada s sare of te U.S. import market as continued to decline despite te recent large depreciation of te Canadian dollar against te currencies of a number of advanced economies, especially te U.S. dollar. 15

22 Figure 7: Effective excange rates, by type of currency Index, January 2014 = Figure 8: CEER, by type of trade Per cent Broad CEER 85 Major currencies Oter important trading partners (OITP) CERI 80 Jan-2014 Apr Jul Oct Jan-2015 Apr Jul Oct Sources: United Nations Comtrade and autors calculations 90 Broad CEER 85 Import Export Tird-market 80 Jan-2014 Apr Jul Oct Jan-2015 Apr Jul Oct Sources: United Nations Comtrade and autors calculations Limitations Altoug we view our new measure as an important improvement over te CERI, te CEER still as a couple of limitations related to data availability tat are wort noting. First, unlike te CERI, te weigts used in te CEER do not include services, primarily due to data limitations. As detailed in Section 2, trade in services is frequently excluded wen building effective excange rate indexes, wit most countries limiting temselves to trade in manufacturing or mercandise goods. Some, for example, te IMF, include services but ave to make simplifying assumptions in order to do so. Given current data limitations, we opted to exclude trade in services for te time being. A second limitation is tat te CEER does not account for domestic production. Tis implies tat wen calculating te weigts, we do not take into account Canada s propensity to import or tat of its trading partners. We know tat, in certain cases, for example, motor veicles, domestic competition (U.S. production of motor veicles in te U.S. market) as important implications for Canadian exports. However, consistent data on domestic production across te trading partners and goods we examined are not currently available and are tus also excluded from our current weigts. For now, bot trade in services and measuring domestic production remain interesting topics for future work. 16

23 5. Conclusion In tis paper, we developed a new Canadian effective excange rate (CEER) index. We believe te CEER is an improvement over te CERI because it better reflects Canada s current and future trade patterns by increasing te number of trading partners included in te index and by introducing annual updating of te weigts. To accomplis tis, we ave ad to construct te weigts as opposed to relying on te IMF s weigts. Tis as te added advantage of allowing us to construct a number of complementary indexes based on different weigt scemes. We ope tese indexes will prove to be useful for oter researcers. Overall, we find tat te new index increased te weigt assigned to EMEs, primarily reflecting te competition Canada faces against tese countries in our most important export markets. Te increasing importance of EMEs may explain part of te underperformance of exports in recent years and could elp explain wy Canada s sare of te U.S. import market as continued to decline despite te recent large depreciation of te Canadian dollar against te currencies of a number of advanced economies, especially te U.S. dollar. 17

24 References Alsterlind, J Effective Excange Rates Teory and Practice. Sveridges Riksbank Economic Review (1/2006): Barnett, R. and K. Carbonneau Decomposing Movements in U.S. Non-Energy Import Market Sares. Bank of Canada Staff Discussion Paper No Bayoumi, T., J. Lee and S. Jayanti New Rates from New Weigts. IMF Working Paper No. 05/99. Klau, M. and S. S. Fung Te New BIS Effective Excange Rate Indices. BIS Quarterly Review (Marc): Leay, M. P New Summary Measures of te Foreign Excange Value of te Dollar. Federal Reserve Bulletin (October). Loretan, M Indexes of te Foreign Excange Value of te Dollar. Federal Reserve Bulletin (Winter). Lync, B. and S. Witaker Te New Sterling ERI. Bank of England Quarterly Bulletin (Winter): Ong, J A New Effective Excange Rate Index for te Canadian Dollar. Bank of Canada Review (Autumn): Steenkamp, D Measuring New Zealand s Effective Excange Rate. Reserve Bank of New Zealand Bulletin 77(6). Sveridges Riksbank Monetary Policy Report. October. 18

25 Appendix A: Te Broad, MC and OITP CEER wit and witout oil Cart A1: Nominal broad CEER 150 Cart A4: Real broad CEER Wit oil Witout oil Wit oil Witout oil Cart A2: Nominal major currencies CEER Cart A5: Real major currencies CEER Wit oil 105 Wit oil 110 Witout oil 100 Witout oil Cart A3: Nominal OITP CEER Cart A6: Real OITP CEER Wit oil Witout oil Wit oil Witout oil

26 Appendix B: Te Broad, MC and OITP CEER by total trade or product-by-product Cart B1: Nominal broad CEER 150 Cart B4: Real broad CEER Total trade Product-by-product Total trade Product-by-product Cart B2: Nominal major currencies CEER Cart B5: Real major currencies CEER Total trade 105 Total trade 110 Product-by-product 100 Product-by-product Cart B3: Nominal OITP CEER Cart B6: Real OITP CEER Total trade Product-by-product Total trade Product-by-product