In this context, NEER being at 73.37 looks interesting
Why should we bother about ‘REER’ and ‘NEER’?
The nominal effective exchange rate or NEER
is an index of the weighted average of the exchange rates
of a basket or group of countries. The US dollar
versus Indian rupee numbers quoted regularly reflect the value of the rupee against the US dollar, and not against other currencies with which India has significant trading links. Over a period of time, the other currencies might also have depreciated against the dollar, with the result that the relative value of the rupee is very different against these currencies. The NEER
seeks to resolve part of this problem by measuring the rupee against a basket of trading partners by assigning each currency a weight, based on the trading done with the country.
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
— 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.
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.