Context: While the rupee is hitting fresh lows against the US dollar each day, its exchange rate has scaled an all-time-high in “real effective” terms. The real effective exchange rate (REER) index of the rupee touched a record 108.14 in November, strengthening by 4.5% during the calendar year 2024.
Relevance of the Topic: Prelims: Real Effective Exchange Rate, Nominal Effective Exchange Rate
What is Real Effective Exchange Rate (REER)?
- 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. The weights are determined by comparing the relative trade balance of a country's currency against that of each country in the index.
- Function: REER is used to understand how well a currency is doing with respect to other currencies and also with respect to itself in the past.
- Interpretation:
- An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper, reducing its trade competitiveness.
- 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.
What Is the Nominal Effective Exchange Rate (NEER)?
- Nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country's currency is exchanged for a basket of multiple foreign currencies.
- NEER is an economic indicator of a country's international competitiveness in terms of the foreign exchange (forex) market.
- 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.
- A nation's nominal effective exchange rate (NEER), adjusted for inflation in the home country, equals its real effective exchange rate (REER).
What are the implications of soaring REER?
- The real effective exchange rate (REER) index of the rupee touched a record 108.14 in November 2024.
- A rising REER indicates that India’s exports are becoming less competitive globally due to higher prices, while the imports are becoming cheaper. That translates into a loss of trade competitiveness and can potentially widen the trade deficit.