The Effective exchange rate (EER) is the weighted average of a domestic currency relative to a basket of foreign currencies. The weights in the basket reflect the relative trade importance to the economy. In the chart above, China’s EER is expressed in nominal terms: without accounting for the differences in purchasing power between the currencies. Naturally, to better assess an economy’s international price and cost competitiveness EER can be evaluated in real terms.
An appreciation of China’s EER indicates the strengthening of the Renminbi (RMB) relative to the basket of currencies, in this case, the largest component in the basket is the USD, whilst a depreciation is the weakening of the RMB. A rising EER is often indicative of a loss of competitiveness for Chinese producers due to their exports becoming more expensive abroad and imports from foreign producers becoming less expensive. The opposite holds true for a decreasing EER.
China’s EER has been steadily increasing since 2005. As a result, we would expect China’s exports to shrink over time. However, data shows that Chinese exports have risen at a tremendous pace, reaching all-time highs in 2020. One reason for the rise in exports is the relatively slow growth of export prices. The Bureau of Labour Statistics estimates that import prices to the US have been rising at 0.13%/year. Whereas prices for Canada and the EU have been growing at 2.66% and 1.84% year respectively.
Additionally, the export sector is becoming of lesser importance for the Chinese economy. The share of export of goods and services in GDP represents ‘only’ 18%, down from a whopping 35% in 2006. This aligns with the agenda and pivotal shift wanted by the CCP-the development of a domestic market and the emergence of a middle class.