Context: The rupee has depreciated by 27.6% against the US dollar between April-end 2014 and now, from Rs 60.34 to Rs 83.38. This is marginally higher than the 26.5% from April-end 2004 to April-end 2014, where the rupee had fallen from 44.37 to 60.34.
How Do We Measure a Currency’s Strength?
- India trades not only with the US. It exports goods and services to other countries as well, while also importing from them.
- The strength or weakness of the rupee is, hence, a function of its exchange rate with not just the US dollar, but also with other global currencies.
- In this case, it would be against a basket of currencies of the country’s most important trading partners – what’s called the rupee’s “effective exchange rate” or EER.
- The EER is measured by an index similar to the consumer price index (CPI).
- The CPI is the weighted average retail price of a representative consumer basket of goods and services for a given month or year, relative to a fixed base period.
- The EER is an index of the weighted average of the rupee’s exchange rates vis-à-vis the currencies of India’s major trading partners.
- The currency weights are derived from the share of the individual countries to India’s total foreign trade, just as the weights for each commodity in the CPI are based on their relative importance in the overall consumption basket.
Nominal Effective Exchange Rate (NEER)
- The Reserve Bank of India has constructed NEER indices of the rupee against a basket of 6 and also of 40 currencies.
- The former is a trade-weighted average rate at which the rupee is exchangeable with a basic currency basket, comprising the US dollar, the euro, the Chinese yuan, the British pound, the Japanese yen and the Hong Kong dollar.
- The latter index covers a bigger basket of 40 currencies of countries that account for about 88% of India’s annual trade flows.
- The NEER indices are with reference to a base year value of 100 for 2015-16: Increases indicate the rupee’s effective appreciation against these currencies and decreases point to overall exchange rate depreciation.
- The NEER is a summary index that captures movements in the external value of the rupee against a basket of global currencies. However, the NEER does not factor in inflation, which reflects changes in the internal value of the rupee.
Real Effective Exchange Rate (REER)
- The REER is basically the NEER that is adjusted for the inflation differentials between the home country and its trading partners. If a country’s nominal exchange rate falls less than its domestic inflation rate – as with India – the currency has actually appreciated in “real” terms.
- A decrease in REER denotes depreciation in rupee’s value, whereas an increase reflects appreciation.
- REER above 100 denotes that the home currency is overvalued and more expensive compared to its competitors.
- Implications:
- The rupee is overvalued today in terms of its REER.
- Any increase in REER means that the costs of products being exported from India are rising more than the prices of imports into the country. That translates into a loss of trade competitiveness – which may not be quite a good thing in the long run.