NOTE: Updated graphs can be found in article 9A

A TRADE BALANCE WEIGHTED DOLLAE INDEX

Chih Kwan Chen

forcastglobaleconomy.com

November 17, 2006

Abstract

A dollar index based on the trade balances with five major trading partners of The United States of America is constructed. Those five partners are China, Japan, EU, Canada and Mexico. The relation between this trade balance weighted dollar index and the actual US trade deficits is discussed.




1. Introduction

                The relations between the run away US trade deficit and the economic growth are discussed extensively in articles 1, 2 and 2A. It has also been pointed out that the movements in the value of US Dollar can be used as a precursor for predicting the ups and downs of US trade deficit. In those articles the value of US Dollar is measured against Japanese Yen. At the time when Japan contributed a significant part of US trade deficit, this handling was more than adequate since the other major international currency, German Mark and then Euro, also moved in synchronization with Yen against US Dollar most of the time. However, in recent years China has replaced Japan as the major contributor to US trade deficit whereas Chinese Yuan is pegged to US Dollar through persistent dollar buying operations of Chinese government. The observation of the exchange rates between Yen-Dollar and Euro-Dollar becomes insufficient to forecast the movement of US trade deficit. Some more broad based standard is apparently desirable in order to measure the value of US Dollar.

                The Federal Reserve Board compiles dollar indices called "trade weighted dollar" indices. One of the two of such trade weighted dollar indices uses 10 major trading partners' currency values weighted by the total amount of trades with each partner; this series is called the major trade weighted dollar index and has a long history with the index at January of 1973 set as 100. The trade weighted dollar indices are not adequate for the consideration of US trade deficit. For example, at the first quarter of 2006, total trade between US and Canada amounted to roughly 2 times of the total trade between US and China, but US trade deficit with Canada was only about 50% of that with China. In other words US-Canada currency exchange rate is two times over weighted than US-China currency exchange rate in the trade weighted dollar indices and four times over weighted when trade deficit is in concern. The obvious remedy to this problem is to use trade balance weighted dollar index instead of trade weighted ones. We have compiled such a trade balance weighted dollar index based on the currencies and trade balances with five major trading partners, China, Japan, European Union, Canada and Mexico. The results are presented in this article. In the next section the methodology in the compilation of the index is laid out. In Section 3 the differences with the trade weighted major index are analyzed. The usage of this trade balance weighted dollar index to forecast the movements of US trade deficit is discussed in the final section.

2. Methodology

                Currency exchange rates of five major US trading partners, Chinese Yuan, Japanese Yen, Euro, Canadian Dollar and Mexican Peso, are taken from the monthly compilations of The Federal Reserve Board (from the website www.federalreserve.gov). Those exchange rates are expressed in the form of foreign unit per dollar format. The exchange rate of each foreign unit at January 2000 is set to 100, and the values of each currency at other months are normalized to the value of January 2000 respectively. The normalized currency exchange rates for the above-mentioned five currencies are multiplied by trade balance defined weights (in terms of percentages) respectively. The five products are then summed to form the trade balance weighted dollar index. By definition the index equals 100 at January of 2000.

                For the trade balance weighting of each currency, the following procedures are employed. The monthly trade balances (deficit taken as positive, surplus as negative) with each of the five trading partners are taken from The Census Bureau's monthly trade balance report. Since country-wise trade balance data are not adjusted for seasonal variations, 12 month moving averages are calculated to eliminate seasonal variations. The sum of 12 month moving averages of five trading partners at each month is used as the normalization factor, and the weight for each currency is calculated as the ratio of the 12-month moving average of the trade balance of the country to the normalization sum. Due to the delay of issuing the trade balance data compared to the monthly exchange rate data, the most recently available trade balance data are used for compilation of the index, and monthly revisions are applied when up-today data become available.

                Mexico experienced catastrophic inflation in early 1990's, and its currency by that time collapsed and was abandoned. A new Mexican Peso has been issued instead. The old Peso thus cannot be used for the calculation of the trade balance weighted dollar index. Before 1994 only four currencies, Chinese Yuan, Japanese Yen, Euro, and Canadian Dollar are used in the compilation. Before the official launch of Euro at the beginning of 1999, Ecu was used as the surrogate of Euro. Before Ecu was introduced, properly normalized German Mark was used in place of Euro.

3. Analyzing differences between the trade balance weighted and trade weighted dollar indices

                Monthly values of trade balance weighted dollar index are plotted as red dots in the graph at the right and monthly values of trade weighted dollar index (major series) compiled by The Federal Reserve Board are plotted as blue dots. During 1992 and 1993 two kinds of dollar indices behaved very differently. The difference was due to the fact that US trade deficit at that time was dominated by the trade deficit with Japan, and the behavior of the trade balance weighted dollar index simply reflected the behavior of Yen. Only from 1994 to the first half of 1995 other currencies, especially German Mark, used in the calculation of trade weighted dollar index started to follow the movements of Yen, and two indices synchronized by rising and falling in tandem. It should be noted that during 1992 and 1993 US ran a small trade surplus with European countries as a whole. It is only from 1994 US started to run trade deficits persistently with European trade partners and European currencies, especially German Mark, started to follow the movements of Japanese Yen. From the middle of 1995 Japan started the super low interest rate policy and ignited the sharp rise of US Dollar vs. Yen due to the unleash of Yen carry trades as depicted in article 1. It took German Mark some time to catch up with the rapid fall of Yen so the trade balance weighted dollar index rose rapidly while the trade weighted dollar index languished for nearly a year. From 1997 German Mark finally caught up with the pace of falling Yen and both dollar indices rose in tandem until the dollar debacle of the summer of 1998. Dollar fell sharply against Yen at the debacle and then staged a moderate rally from 2000 until the beginning of 2002 as indicated by the behavior of the trade balance weighted dollar index, the red curve. At the time of dollar debacle of 1998, the launch of Euro was in sight. The fear that the strong German Mark will be pulled down by weaker French Frank and Italian Lira once combined into a single European currency moderated the rise of German Mark compared to the rise of Yen, so the fall of trade balance weighted dollar index during the period of 1998 to 1999 was sharper than the fall of the trade weighted dollar index. As Euro was officially launched at the beginning of 1999, the euphoria about a single European market was quickly dashed and Dollar rose much more sharply against Euro than against Yen. That effect was reflected in the sharper rise of trade weighted dollar index (the blue curve) than trade balance weighted index (the red curve) from 2000 to the beginning of 2002. By 2002 China has emerged as a heavy weight in the picture of US trade deficit, and Chinese Yuan is strongly pegged to Dollar due to the currency market intervention of Chinese government. That is the reason why the fall of trade balance weighted dollar index from the beginning of 2002 is less pronounced than the fall of trade weighted dollar index.

                The pace of fall of trade balance weighted dollar index has been leveling off from the end of 2003, but the trade weighted dollar index has continued its rapid fall until the beginning of 2005. This latest divergence between two dollar-indices can be understood as due to the different behavior of Chinese Yuan and Canadian Dollar. While Chinese Yuan is pegged to US Dollar until the middle of 2005 and has allowed only to appreciate gradually against US Dollar since then, Canadian Dollar has staged an impressive recovery against US Dollar thanks to the strength of world wide prices of industrial raw materials, including crude oil. Since Canadian Dollar weights about twice more than Chinese Yuan in the trade weighted dollar index of FED, the index has kept falling as Canadian Dollar climbs. On the other hand Canadian Dollar only weights 50% of that of Chinese Yuan in the trade balance weighted dollar index, so the rate of descend of the index has moderated earlier than the trade weighted counter part.

4. Forecasting US trade deficit

                The trade balance data published by The Census Bureau are divided into six parts. They are, (1) Food, feed and beverages (simply called agriculture products from now on), (2) Industrial supplies and materials (called industrial materials here), (3) Capital goods except automotives, (4) Automotives and parts, (5) Consumer goods except automotives, and (6) Others. The category of industrial materials covers raw materials, including crude oil. The deficit of the category of industrial materials comes mainly from crude oil imports. This deficit depends on the price of crude oil, not on the movement of US Dollar. For example, US Dollar has fallen quite a bit since 2002 as discussed in the previous section. However, the deficit in industrial materials has risen sharply since the beginning of 2005 due to the skyrocketing crude oil price. The deficit in the agriculture products, though is relatively small, displays similar dollar-independent character. Thus we only consider trade deficits of goods less agriculture products and industrial materials.

                Monthly trade deficits of goods less agriculture products and industrial materials are plotted as green dots in the graph at the right in common logarithmic scale, with their time scale shown as green numbers at the bottom of the graph. Since major movements in Dollar take at least two years time lag to be reflected in the trade flow, as has been discussed in article 2, the trade balance weighted dollar index from the previous section is plotted as red dots on the same graph but with time scale shifted by two years toward the right. The time scale of the dollar index is written as red numbers on the top of the graph.

                Comparing the red curve and the green one, we can see that the prolonged fall of the red curve, the dollar index, prompts the green curve, the trade deficit, to stop growing or even to shrink. On the other hand when dollar index bottoms out and rebounds, the trade deficit expands quickly. This observation implies that US Dollar needs to fall much harder and for a very long period if we want to see a substantial shrinkage of the trade deficit.

                A closer inspection of two curves in the graph reveals following observations. The dollar index peaked at the early part of 1992 and fell sharply until the first half of 1995. The trade deficit of goods less agriculture products and industrial materials only started to flatten out in 1995, a three years time lag. Though is not shown in the graph, Dollar suffered a near 50% drop against Japanese Yen starting from 1995 after the Plaza accord. This drop of Dollar had forced US trade deficit to shrink starting from 1987, about two years of time lag. US trade deficit had dropped more than 50% from its 1987 peak by the middle of 1991. Since then US trade deficit was rebounding strongly from the very low level. It was the reason why there was so much trouble for the 1992 to 1995 dollar drop to just flatten out the trade deficit. As the dollar index rebounded in the middle of 1995, due to the super low interest rate policy of Japan and the unleash of Yen carry trades as discussed before, the trade deficit immediately took off, with just two years of time lag.

The sharp rise of the dollar index, the red curve, from the middle of 1995 to the middle of 1998 brought on the hot boom of the trade deficit of goods less agriculture products and industrial materials, from 1997 to 2000. The sharp fall of dollar from the middle of 1998 pushed down the trade deficit somewhat, starting from the end of 2000. However, as the fall of dollar moderated in 1999, the trade deficit already started a new phase of bounce back and expansion in 2001. The expansion of the trade deficit from 2001 to 2004 was due to the rise of dollar index from 2000 to the beginning of 2002. The subsequent fall of dollar index had some difficulty to control the rising trade deficit, but eventually make the deficit to flatten out in 2005.

The pace of the fall of the dollar index has moderated substantially since the middle of 2004. We may expect a renewed expansion of the trade deficit from the end of 2006. However, this renewed expansion may be weak since currently the dollar index is not rebounding like the case of 2000, but just moderating its pace of fall for a prolonged period. Also we should not overlook the fact that Chinese Yuan has started to appreciate gradually since the middle of 2005. How the trade deficit will respond to this Yuan's gradual appreciation in 2007 will be a test of usefulness of the trade balance weighted dollar index in forecasting the movement of the trade deficit.