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The rupee is in a free fall against the dollar since the beginning of this year, losing 16 per cent. This rate that is tracked by everyone is the nominal exchange rate that includes changes in value of the rupee due to changes in prices of goods and services within the country.
The picture is however somewhat different, when we look at the real effective exchange rate (REER), a metric used to gauge the real value of the rupee.
Like any other ‘real’ measure, the REER gives the value of the rupee (relative to a basket of currencies) that is devoid of the influence of inflation. The rupee has fallen 5 per cent, according to this metric, till July this year.
The RBI releases monthly data on 6 – country and 36 – country REER indices.
These are countries with which India has trading ties.
The index is a weighted average of the bilateral exchange rates (for instance, rupee–dollar, rupee–yen and so on) adjusted for differences in inflation between India and the other country.
Each of the bilateral exchange rate is weighted by the respective country’s share in India’s trade.
What does the REER indicate? This index shows the external competitiveness of the country.
A rise in the index indicates appreciation of the rupee relative to other currencies and vice versa.
While the nominal exchange rate is determined by the demand and supply of currencies relative to each other, the REER goes a step further by also adjusting for inflation that erodes a currency’s purchasing power.
Even as depreciation of the rupee would make Indian goods cheaper (improving our external competitiveness), a higher inflation relative to other countries would negate a part of that.
When the REER is at a value of 100, the rupee is said to be rightly valued. When the index dips below 100, the currency is undervalued in relation to its trading partners.
Similarly, value above 100 means the rupee is overvalued and needs to decline in value.
The sharp correction in the rupee since this May has made the currency heavily undervalued in relation to its trading partners.
This is reflected in the July REER index that is at 88.
This is the lowest value since April 1993. Much lower index values were seen only during the first part of the 1990s.
The index averaged 67 and 64 in 1991 and 1992 respectively. Since then, the index has fluctuated within a band of 90 to 100.
More recently, the index averaged 93 in 2009 going up to 100 in 2010 and 2011 to return to 93 in 2012.
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