Understanding Real Effective Exchange Rate
A nominal effective exchange rate (NEER) is calculated as a geometric weighted averages of exchange rates of domestic currency in terms of a foreign currency.
The real effective exchange rate (REER) can be
defined as the weighted average of nominal effective exchange rates (NEER) that
have been adjusted for relative price levels or interest rate differentials.
Traditionally, India’s central bank Reserve Bank
of India (RBI) was using REER for managing rupee exchange rate. That was till
1997. But since 1997, RBI changed its stance as REER takes care of only
merchandise trade and does not consider services. And from 1997, RBI had
shifted its exchange rate policy to ‘control of excess volatility,’ as stated
officially time and again.
The official policy stance of RBI for long has
been ‘containing exchange rate volatility.’ RBI also wants Indian exchange rate
to be competitive for India’s trade against other countries. Some argue rupee’s
exchange rate should have been 71-72 versus USD, as against the actual 66.83 as
on today, that is, 06Jan2016—based on USD-INR interest rate differentials.
However, the exchange rate of the rupee is by
and large market-determined, subject to RBI’s market intervention through sale
and purchase of US dollars in foreign exchange market.
A country’s exchange rate depends on a number of
factors like elasticity of exports and imports, import intensity of exports,
relative prices of domestic and global products, and others. In terms of REER,
there has been a rupee appreciation of 3.7% in 2015-16 (April-October) compared
to 2014-15 (April-October).
Increase in indices
(NEER and REER) indicates appreciation of rupee and vice versa. REER figures
are based on Consumer Price Index - CPI (combined).
If the REER is more than 100, then the rupee is
“overvalued” and is expected to depreciate. If REER is less than 100, the rupee
is “undervalued” and is expected to appreciate in future. But in a practical
sense, nobody in foreign exchange markets takes REER very seriously, as
fundamentals could take a very long time to adjust in financial markets. RBI
too follows a variety of metrics (most of them are not known to the public) to
control what it calls ‘excess exchange rate volatility.’
Countries with highest trade weights in RBI’s
36-country REER index (2013-14) are Euro area (highest at 12.69%), UAE, China,
USA, Saudi Arabia, Switzerland, Hong Kong, Singapore and Indonesia.
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