RDP 9005: Real Exchange Rates and Australian Export Competitiveness 2. Conceptual Issues

At a conceptual level there are two possible measures of competitiveness. The first is a domestic relative price (the ratio of traded to non-traded goods) which determines the flow of productive resources within the economy to and from the traded goods sector. The second measure of competitiveness focuses on the ability of Australian exports to compete in international markets – our prices compared with foreign prices, adjusted for exchange rates. For the purposes of this paper, we consider the latter: a measure of international price competitiveness, adjusted for exchange rates.

There are several other issues involved in the construction of an exchange rate index. The first issue to consider is whether to use a real or nominal index. As Maciejewski (1983, p. 494) suggests, a nominal exchange rate index only measures changes in the value of a basket of currencies arising from exchange rate changes, relative to a specific base period.

One commonly used nominal measure of the exchange rate is the Trade Weighted Index (TWI). Nominal indices such as the TWI do not take account of inflation differentials, an important determinant of competitiveness.^[1] It is necessary to use a real exchange rate measure to remove the influence of price movements on the effective exchange rate. The purpose of this paper is to develop an index which measures the real effects of exchange rate and price movements on Australia's export competitiveness. This requires an index of real exchange rates.

Weighting Schemes

Another important consideration involved in the construction of an exchange rate index is the particular weighting scheme to use. Ideally, the weights in an index of export competitiveness should reflect the effects of exchange rate changes on export receipts. Such a weighting system should, therefore, take account of the effects of different forms of competition upon trade flows: competition between our exporters and home producers in export markets, and competition with other exporters selling to the same market.^[2] For this paper we use two alternative weighting schemes. Firstly, we calculate weights using aggregate bilateral export data. Secondly, we use data that is disaggregated by product, market, and competitor to calculate multilateral export weights.

Weighting bilateral exchange rates according to the value of our exports to that country assumes that the trade balance effects of exchange rate changes are proportional to bilateral export shares. This ignores the third country competition which Australia faces in its export markets. As an example, although we have only a small amount of direct trade with Canada, both Canada and Australia export very similar products to the USA – one of our major trading partners. Even if there was no change in the $A/$US real exchange rate, a change in the $A/$Canadian real exchange rate is likely to have an impact on Australia's real exports to the USA.

A bilateral index also takes no account of different supply and demand elasticities between commodities. Estimating the weights according to respective demand and supply elasticities is beyond the scope of this paper.^[3]

As an alternative, we examine an index based on disaggregated third country weights. Following McGuirk (1987), we use disaggregated export data to calculate third country export weights, which take some account of third country competition in our export markets.^[4]

Price Deflators

Another consideration involved in the construction of a real exchange rate index is which price index is most appropriate. It is important to select a measure which provides an indication of the competitiveness of the export sector. The clearest alternatives are factor price measures (real unit labour costs or producer input prices), or final product or expenditure prices. Neither type of price index provides a full indication of changes in the competitiveness of the export sector.

Ideally, an index based on the prices of traded goods should be used to measure competitiveness, but such indices have a very narrow coverage and are not widely available for most countries. The price indices that are most widely available are the consumer price index, wholesale price index, GDP deflator, or an index of real unit labour costs. Whilst none of these indices provides an ideal measure of price competitiveness,^[5] our choice of price index is largely constrained by data availability. The CPI is used in this paper because it is the only price index readily available on a consistent basis for the countries included in the index.

The CPI can be used as a proxy for the costs of production by assuming that changes in unit costs are reflected in final consumption prices. The disadvantage of using the CPI is that it excludes capital goods and includes non-traded goods and services that are not relevant to trade flows, and it only measures final consumption prices. Using the consumer price index may also distort cost comparisons if production structures vary widely between countries. Despite its limitations, this index gives a broad indication of the pattern of price changes between countries.

Footnotes

A discussion of the TWI is presented in the ‘Nominal Measures’ section of the Appendix. [1]

Disaggregated export data are used in this paper to ensure that only competition between relatively close substitutes is captured by the index. [2]

The IMF's Multilateral Exchange Rate Model (MERM) index does estimate the different demand and supply elasticities for several countries. See Rhomberg (1976) and Artus and McGuirk (1981) for a discussion of this index. [3]

The construction of third country export weights assumes that an equiproportionate change in the product prices of all countries leaves real trade flows unchanged, and that there is a uniform elasticity of substitution between all pairs of suppliers of all commodities in all markets. [4]

A competitiveness measure based on labour costs excludes other costs of production and is not specific to the traded sector. GDP deflators are based on current weights and (usually) market prices (not factor costs) so they may not be adequate for international comparison. Wholesale price indices differ widely in their coverage from country to country and may be distorted by indirect taxes and subsidies. [5]