A real effective exchange rate (REER) is the NEER after factoring in relative inflation (consumer price-based index) using some measure of relative prices or costs; changes in the REER thus take into account both nominal exchange rate changes and the inflation differential vis-à-vis trading partners. In the current context, REER is more relevant as it takes into account a whole host of factors that actually determine an exchange rate, the key being inflation differential.
How does one arrive at the REER and the NEER?
The Reserve Bank of India (RBI) publishes the two measures of REER and NEER — one on a 36-currency basis, and the other on a six-currency basis. Weights are added based on how much trade is done with one particular country. Needless to say, the actual calculations are more complex than this.
The base is a year to which a value of 100 is assigned. Anything more than that would imply an overvaluation of the rupee (that means it should depreciate to reflect parity) and less than 100 would mean undervaluation (that means the currency should be allowed to appreciate).
Let us take the 36-currency basket. On a trade-based weight, REER, at the end of August, was at 114.54. This means that since 2004-05, adjusting for inflation, the Indian rupee has appreciated 14.54 per cent against the average of these 36 currencies, weighted as per their trade with India.
Does it mean that a mere 14.54 per cent devaluation from the rupee level at 2004-05 would reflect the true value of rupee now? Not necessarily. Based solely on the REER construct, the statement that the REER is 14.54 per cent overvalued relative to the 2004-05 is algebraically correct, but extrapolating this to a “true value” of the rupee faces problems. Instead, REER gives an indication whether the rupee is overvalued or undervalued.
But why is the six-currency REER higher?
On a six-currency trade-based weight, REER was at 122.70 in August. These six currencies essentially constitute the major trade partners of India. As India is a net importer (70 per cent of India’s oil needs are imported), it makes sense for the country to keep the currency strong against these countries. It makes the import bill smaller to that extent (say we need to give Rs 70 for one litre of oil, against Rs 100).
In this context, NEER being at 73.37 looks interesting. Since it is not adjusted to inflation, this means that since 2004-05 the rupee has depreciated 26.6 per cent against the 36-currency basket in nominal terms. That may seem a lot, but remember, the NEER doesn’t take into consideration any inflation adjustment. When looked in conjunction with the REER, NEER may indicate that we should have depreciated much more. At the risk of being overly simplistic, NEER may mean that if rupee’s purchasing power against the 36 countries was 100 in 2004-05, it is now only 73.87.
How are exchange rates and inflation related?
Usually, inflation differentials are a key driver of exchange rates. Let’s consider a simple example. Suppose a pen costs one dollar to make in a developed country. Now, say, it takes Rs 35 to manufacture the pen in India. With India’s exchange rate being at Rs 70 to the dollar, the buyer can buy two pens made in India. But what if India’s pen-making competitor country has an exchange rate of Rs 105 equivalent to a dollar? The buyer can purchase three pens, instead of two. India, in this case, loses the business. For any meaningful competition in the pen market, India must let its rupee touch 105 against the dollar. This depreciation of the rupee, or erosion in its value, is also inflation from India’s perspective. REER can be used as a yardstick here to find out how much depreciation would be needed to compete against the 36 countries in the global pen market.