As rupee hits new lows, real effective exchange rate soars to an all-time high

Sub: Eco

Sec: External sector

Overview:

The rupee is hitting fresh lows against the US dollar each day, yet its exchange rate has scaled an all-time-high in “real effective” terms.
Real effective exchange rate (REER) index of the rupee touched a record 108.14 in November, strengthening by 4.5 per cent during this calendar year, according to the latest RBI data.

Factors Behind the Divergence:

The divergence between the rupee’s weakening against the US Dollar and its strengthening in the REER can be explained by two main factors:

Strengthening of the US Dollar:
- The US Dollar has strengthened significantly post Donald Trump’s victory in the US presidential elections with Dollar Index, which measures the dollar’s value against six major currencies (euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc)
- This has been primarily driven by expectations that US policies, such as tariff hikes, tax cuts, and mass deportations, will lead to higher inflation in the US.
- This, in turn, would keep US Federal Reserve policies tight, leading to higher interest rates and a stronger dollar.

Rupee’s performance against other currencies:
- Despite its depreciation against the dollar, the rupee has appreciated against other major currencies such as Euro, British pound and Japanese Yen in the same period.

Real effective exchange rate (REER):

The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies.
REER represents the inflation-adjusted, trade-weighted average value of a currency against its trading partners.
The REER is a more comprehensive measure of a currency’s value because it accounts for the rupee’s exchange rate not just against the dollar, but also against a basket of 40 global currencies, which represent 88% of India’s total trade.
Countries with the largest trading relationships would typically have the largest weightings in this comparative index, while countries with small trading relationships would have smaller weightings in the basket of currencies.

REER vs NEER:

Real Effective Exchange Rate (REER)

Nominal Effective Exchange Rate (NEER)

It is a weighted average of the rupee’s exchange rate against a basket of 40 currencies, with higher weights for countries with a larger share in India’s foreign trade.
The REER adjusts the nominal exchange rate for inflation differentials between India and its trading partners.

NEER is an index that measures the value of a currency relative to a basket of other currencies without adjusting for inflation.
The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency.
NEER also uses weighted averages of exchange rates but does not consider inflation.

Implications of High REER:

A REER value above 100 suggests that the rupee is overvalued relative to its trading partners. In this case, the rupee is not depreciating enough to offset inflation, leading to its overvaluation.
A stronger REER makes imports into India cheaper because foreign goods become less expensive in comparison to domestic goods.
An overvalued rupee makes Indian exports less competitive as the cost of Indian goods rises in foreign markets.