Context:
Between April-end 2014 and the present, the Indian rupee has depreciated by 27.6% against the US dollar, from Rs 60.34 to Rs 83.38. This depreciation is slightly higher than the 26.5% witnessed from April-end 2004 to April-end 2014, during which the rupee fell from 44.37 to 60.34 against the dollar.
Relevance:
GS III: Indian Economy
Dimensions of the Article:
- How is the Strength or Weakness of the Rupee Decided?
- Measures of EER
- Conclusion
How is the Strength or Weakness of the Rupee Decided?
- The strength or weakness of the rupee is determined by its exchange rate not only with the US dollar but also with other global currencies due to India’s diverse trade activities.
- The rupee’s effective exchange rate (EER) calculates its strength or weakness, which is an index similar to the consumer price index (CPI).
Understanding the EER
- The EER is an index that measures the weighted average of the rupee’s exchange rates against the currencies of India’s major trading partners.
- Currency weights are determined based on the share of each country in India’s total foreign trade, similar to how commodities are weighted in the CPI.
Measures of EER
Nominal EER (NEER):
- NEER indices are constructed by the Reserve Bank of India against a basket of six or 40 currencies.
- The six-currency NEER covers major currencies like the US dollar, euro, Chinese yuan, etc., while the 40-currency NEER includes currencies from countries representing 88% of India’s annual trade.
- NEER indices are referenced to a base year value of 100 for 2015-16, where increases indicate rupee appreciation and decreases signify depreciation.
Real EER (REER):
- REER is the NEER adjusted for inflation differentials between the home country and its trading partners.
- It reflects changes in the internal value of the rupee by considering inflation.
- If a country’s nominal exchange rate falls less than its domestic inflation rate, the currency has appreciated in “real” terms.
Interpreting the Data
- Chart 1 illustrates the decline in the rupee’s NEER against major currencies over the last two decades, showing a lesser depreciation compared to the US dollar.
- Chart 2 depicts the rupee’s trade-weighted REER, indicating a strengthening trend over time, implying potential overvaluation.
- A higher REER signifies increased export costs relative to import prices, leading to a loss of trade competitiveness.
Conclusion
- The rupee’s strength or weakness is evaluated based on its exchange rates against major currencies using EER indices.
- While NEER reflects external value changes, REER accounts for inflation differentials, providing a holistic view of the rupee’s performance in international trade.
-Source: Indian Express
