The Real Effective Exchange Rate (REER) of the rupee has remained around the benchmark with the base year value of 100 for most part of the last 15 years, reflecting India’s better external competitiveness, a Reserve Bank of India study said. Inflation differentials between India and its major trading partners have declined and stabilised since the adoption of Flexible Inflation Targeting (FIT) framework, which is also boding well for India’s external competitiveness, the RBI paper reported.

Going forward, large capital inflows unless fully absorbed through current account deficit and/or mopped up as foreign exchange reserves can cause appreciation of the rupee and potentially undermine the export competitiveness, the RBI paper said. “In such a milieu, focus on price stability under the flexible inflation targeting regime should remain a policy priority to offset the erosion in external competitiveness which may emanate from appreciation of the rupee in nominal terms,” it said.

Effective exchange rates (EERs) serve as a gauge for assessing the fair value of a currency, the external competitiveness of an economy and even serve as guideposts for setting monetary and financial conditions. An EER is a summary indicator of movements of the home currency against a basket of currencies of trading partners

Given the fact that the global trade environment is undergoing a shift, it is important that the nominal effective exchange rate (NEER) and real effective exchange rate (REER) basket of the rupee is reviewed regularly, the RBI paper said. In the case of India, the relative importance of trading partners has shifted mainly towards emerging markets and developing economies (EMDEs) since 2004-05. The NEER is an index of the weighted average of bilateral exchange rates of home currency vis-a-vis currencies of trading partners, with weights derived from their shares in the trade basket of the home currency. A REER is the NEER adjusted by relative prices or costs, typically captured in inflation differentials between the home economy and trading partners.

Taking cognisance of these factors, the broad basket of NEER/ REER indices of the rupee has been expanded from 36 to 40 currencies and rebased to 2015-16, the RBI study said. The new REER, on average, was 0.8 per cent above its base year level during 2016-17 to 2019-20, a period coinciding with moderate inflation observed since the adoption of FIT framework. This implies that the inflation differentials between India and its trading partners were less of a concern for former’s external competitiveness under FIT regime, the paper said. The new REER indices (both trade- and export-weighted), which have remained around the benchmark (i.e., base year value of 100), show a modest appreciation/higher depreciation relative to the old series during November 2015 to May 2019.

In fact, the issue relating to under/overvaluation of currencies has been at the core of several global trade disputes. The International Monetary Fund (IMF) uses REER models (along with current account model) to make external balance assessments for individual economies and produce multilaterally consistent estimates for the current account and real exchange rate norms and gaps, the RBI said. Effective exchange rates (EERs) serve as a gauge for assessing the fair value of a currency, the external competitiveness of an economy and even serve as guideposts for setting monetary and financial conditions. An EER is a summary indicator of movements of the home currency against a basket of currencies of trading partners.