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| CAD, inflows, inflation push Re towards real value |
| Abhijit Lele / Mumbai Dec 22, 2011, 02:11 IST |
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The REER index, which helps economies value currencies on a relative basis, stands at 103.52.
The increasing current account deficit, a dip in capital inflows and rising inflation have brought the rupee closer to its real value. The real effective exchange rate (REER) index, which reflects the fundamental strength of the Indian currency, had declined from 116.67 for June to 103.52 in end-November, a fall of 11 per cent.
However, in nominal terms, the loss in rupee value against the US currency has been much higher, at 17 per cent. The rupee stood at 44.70 against the dollar as on June-end. On November 25, it stood at 52.26 at close, according to the latest data available with the Reserve Bank of India’s website.
The REER model helps economies value their currencies on a relative basis. It is also relative to a domestic country’s own currency value at some time in the past. The value of the currency is adjusted by the inflation differential between the domestic economy and the reference economy. As a result, there is a difference in the rates of fall because of the high inflation in India, compared to inflation in key trading partners, including the US, Japan, China, the UK, Hong Kong and the euro zone.
When the REER touches a level of 100, the currency reflects its real value. “At this level, the Indian currency would be in a balanced position. It neither favours exporters, nor importers,” said an economist with a large public sector bank.
According to Brinda Jagirdar, head of economic research, State Bank of India, the rupee is less overvalued now, in terms of six currency trade baskets, including the US, Japan, China and countries in the euro zone. Fluctuation in international currencies also has some impact on the REER index.
The dynamics of the market value of the rupee is shaped by many factors. Besides inflation, the changes in the value of international currencies and speculation in the market also weigh on the nominal value, said Madan Sabnavis, chief economist with CARE.
The last time the REER value of the rupee declined sharply was in 2008-09, the year when the fall of Lehman Brothers triggered a global financial crisis. The REER value had fallen from 115.28 in April 2008 to 93.90 in March 2009.
With a gradual recovery in the economic and business environment in 2009-10, the REER value began rise, crossing the 100 mark in October 2009. It began to lose strength again since May this year, according to RBI data.
This exchange rate is used to determine an individual country’s currency value relative to the major currencies in the index and is adjusted for the effects of inflation. All currencies within the index are the major currencies being traded on Wednesday, including the dollar, the yen and the euro. This is also the value an individual consumer would pay for imported goods at the consumer level. This would include any tariffs and transactions costs associated with importing the goods.
The competitiveness of a country’s exports is decided not only by the nominal exchange rate, but also by relative price movements in domestic and foreign markets. For instance, even if the nominal exchange of the rupee remains unchanged with respect to, say, the dollar, India’s exports to the US would become less competitive if inflation in India is higher than that in the US. This means the nominal exchange rate would have to be adjusted for the effect of inflation.
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