What does the Real Effective Exchange Rate shift mean for India?

Here we shall look at how a small change in the REER methodology is going to give a very significant signal of how the rupee management could move.

Jan 25, 2021 07:01 IST India Infoline News Service

When it comes to exchange rates, one big challenge is to determine what the ideal rate of exchange is. For example, how do you decide that the US dollar should be worth Rs70 or Rs65 or Rs75. One model that is popularly used is the REER model; also called the Real Effective Exchange Rate model.

We will not go into the nuances of this model but broadly it says that the exchange rate movement should be determined by the inflation differential between two countries. For example, if average inflation in the US is 2% and in India if it is 5%, then the exchange rate of the country with higher inflation must weaken by 3% (5%-2%) each year.

This is not a hard-and-fast model because even if India’s inflation is higher than in the US but if India is getting robust FPI and FDI flows, then the rupee will strengthen. But, that is more of a real life problem and we shall come back to that later. Here we shall look at how a small change in the REER methodology is going to give a very significant signal of how the rupee management could move.

What has changed in the REER methodology?

Actually, two very important things have changed in the REER methodology.
  • Firstly, the base year for the REER calculation has been moved from 2004-05 to 2015-16. The logic is that the trade pattern has changed vastly since 2004-05 and hence the new REER methodology has to reflect that.
  • The currencies in the REER have also undergone a change. Out of the 36 currencies in the old model, 4 have been removed and 8 new currencies have been introduced taking the total currency count to 40. Currencies of Argentina, Pakistan, Philippines and Sweden were excluded. At the same time currencies of Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania and Ukraine have been added.
The new REER will represent 88% of India’s trade as against 84% in the old composition, making the REER index more comprehensive and competitive. One logic is that inflation differentials between India and the other nations has reduced in the last few years and this new mix and new base year will better reflect India’s external export competitiveness.

New REER basket 2015-16 versus REER basket 2020-21

There have been some key trend shifts in the India trade basket that have happened and that is better reflected in the new REER calculation as the comparison will show.
Year 2015-16 Year 2020-21
Country/Region Trade Weight Export Weight Trade Weight Export Weight
Euro Area 11.4% 14.0% 11.6% 14.7%
China 10.0% 5.0% 12.0% 5.6%
The Emirates 9.4% 12.4% 7.8% 10.4%
United States 9.1% 14.7% 11.6% 18.4%
Saudi Arabia 6.4% 4.1% 4.4% 2.1%
Data Source: RBI Bulletin

A few things clearly emerge from the above table. China may have a high trade weight in the basket but its export weight is very low since India runs a huge trade deficit with China. United Arab Emirates has a much higher export weight compared to Saudi Arabia as the UAE is a major market for Indian exports whereas the relationship with Saudi Arabia is limited to importing crude oil.

But the big story in the last few years is that the US has emerged as one of the big contributors to the Indian merchandise trade surplus. That is evident if you look at how the export weight of the US has gone up. In short, the new REER will be more reflective of the new trade interests of India.

How do you interpret the impact of the new REER on exchange rates?

Data Source: RBI Bulletin
The above chart plots the REER using the two bases viz. the 2004-05 base and the 2015-16 or the new base. You will see that both the Trade Weighted chart and the Export Weighted chart are showing that the graph has clearly shifted downward. That is because the new weights are more in tune with the recent trade numbers.

But how to interpret this chart shift lower? Remember that when it comes to the REER, a figure of 100 implies that the currency is fairly valued. When it goes below It basically implies that going ahead if the capital flows continue to be robust then the real concern would be how to prevent the rupee from getting too strong.

A weak currency is essential to boost exports and a strong currency actually deters exports. What the new REER/NEER shows is that going ahead the RBI policy framework may have to focus more on stemming the strengthening of the rupee rather than stemming the weakening.

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