The rupee fell to a fresh daily low against the US dollar, yet its exchange rate hit an all-time high in “real effective” terms.
The rupee’s real effective exchange rate (REER) index touched a record 108.14 in November, strengthening by 4.5 percent in the calendar year, according to the latest Reserve Bank of India (RBI) data.
REER measures the value of the rupee not only against the dollar but also against other global currencies. In this case, it is a weighted average of the rupee’s exchange rate against a basket of 40 currencies of countries that account for about 88 percent of India’s annual exports and imports. The REER also adjusts for inflation differences between India and each of these trading partners.
The rupee’s REER — the same index for consumer prices or industrial production, as the base year 2015-16 and derived from the share of individual countries in India’s total foreign trade with a currency weighting — fell from 105.32 to 99.03 in January 2022. April 2023. But since then, it has been on an appreciative trajectory, climbing to 107.20 in October this year and 108.14 in November. (see chart).
The main reason for the deviation – the simultaneous weakening and strengthening of the rupee – is related to the behavior of the dollar in the past three months, especially after the victory of Donald Trump in the US presidential election on November 5.
Between September 27 and December 24, Dollar Index Futures – a gauge of the greenback’s value relative to a basket of six currencies (the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc) with a March 1973 base. It has gone from 99.88 to 108.02. Most of that has been since last November 5, when the index stood at 102.98.
Between September 27 and December 24, the rupee depreciated from 83.67 to 85.19 against the dollar. However, during the same period it rose from 93.46 to 88.56 against the Euro, from 112.05 to 106.79 against the British Pound and from 0.5823 to 0.5425 against the Japanese Yen.
Why does it affect exports?
According to REER, a rupee value above 100 indicates overvaluation and the exchange rate has not depreciated sufficiently to offset high domestic inflation. To that extent, it is overvalued, making imports cheaper but exports less cost competitive.
In other words, the rupee is not weakening as much as the dollar is strengthening against all currencies. The dollar is strengthening due to Trump’s public announcements in favor of universal tariff increases (again, on imports of Chinese goods), deficit-financed income tax cuts and mass deportations of illegal immigrants. These, if translated into policy actions, are expected to increase inflation in the US and, in effect, force the US Federal Reserve to keep monetary policy tight. As the yield on 10-year government debt there rose from 3.75 percent to 4.59 percent between September 27 and December 24, it drove capital into the US from all countries, including India.
Over the longer term, the rupee has been depreciating against the dollar (from 74.30 to 85.19), the euro (from 84.04 to 88.56) and the pound (from 100.30 to 106.79) since the beginning of 2022, while the yen ( 0.6454 to 0.6454) has only strengthened. 0.5425). However, its REER has increased. And this is the result of high inflation in India compared to its major partners.
Assuming that the REER is set at 100 in 2015-16 as the “fair” value of the rupee, any value above 100 indicates that the exchange rate has not depreciated sufficiently to offset overvaluation and high domestic inflation. To that extent the rupee is highly valued today, making imports into India cheaper and exports from the country less cost competitive. This also explains why the RBI is now allowing the rupee to depreciate – at least against the dollar.
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