Syllabus: GS3/Economy
Context
- The Reserve Bank of India (RBI) Governor has stated that the Indian rupee is undervalued in both nominal and Real Effective Exchange Rate (REER) terms.
About
- The RBI Governor stated that the RBI does not target any specific exchange rate but intervenes in the foreign exchange market only to contain excessive volatility and maintain orderly market conditions.
Undervaluation of a Currency
- A currency is considered undervalued when its market exchange rate is lower than the level justified by a country’s underlying economic fundamentals.
- In other words, the currency is trading at a weaker value than the level suggested by factors such as economic growth, inflation trends, productivity levels, external sector stability, foreign exchange reserves, and investor confidence would normally indicate.
- When temporary external shocks cause a currency to depreciate beyond its equilibrium value, economists generally describe the currency as undervalued.
Why has the rupee depreciated?
- Rising global crude oil prices: Increased international oil prices increase India’s import bill, and increase demand for US dollars, putting downward pressure on the rupee.
- The geopolitical conflicts in the West Asia region generate a sense of uncertainty in the global markets, disrupt energy supply and add pressure to the emerging market currencies like rupee.
- Strengthening of the US Dollar: A stronger US dollar, driven by global demand for dollar assets and expectations of tighter monetary conditions in the United States, reduces the relative value of other currencies.
- Higher global risk aversion: During periods of global uncertainty, investors prefer safe-haven assets such as the US dollar, leading to capital outflows from emerging markets and weakening their currencies.
- Foreign Portfolio Investor (FPI) outflows: Withdrawal of foreign investments from Indian equity and debt markets increases demand for dollars as investors convert their rupee holdings into foreign currency, contributing to rupee depreciation.
Challenges associated with an undervalued rupee
- Imports become more expensive, increasing the country’s import bill.
- Higher crude oil prices can lead to imported inflation.
- Industries dependent on imported raw materials face increased production costs.
- Servicing external debt denominated in foreign currency becomes more expensive.
- Persistent depreciation may reduce investor confidence if driven by structural weaknesses.
Advantages of a weaker rupee
- A weaker rupee improves the price competitiveness of Indian exports.
- Exporters receive higher earnings in rupee terms.
- Domestic industries may benefit from increased export demand.
What is the Nominal Effective Exchange Rate (NEER)?
- The Nominal Effective Exchange Rate (NEER) is a weighted average index of the value of the Indian rupee against the currencies of India’s major trading partners.
- It measures the rupee’s movement against a basket of currencies. The RBI currently calculates the NEER using a basket of 40 currencies, which together account for nearly 88% of India’s total merchandise trade.
- The base year is 2015–16, with the index value fixed at 100.
- The weights assigned to each currency are based on the respective country’s share in India’s foreign trade. However, the NEER does not account for inflation differences between countries.
Real Effective Exchange Rate (REER)
- The Real Effective Exchange Rate (REER) is the inflation-adjusted version of the NEER.
- It measures the value of the rupee against the currencies of India’s major trading partners after adjusting for differences in inflation.
- REER is regarded as the most reliable indicator of a country’s external competitiveness.
Source: TH
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