A 'REER' view perspective on rupee depreciation
Vidrum / 23 Dec 2011
Real Effective Exchange Rate (REER) is a concept that reflects the health of the economy. It measures the competitiveness of the domestic currency against foreign currency, and reflects its relative value.
Real Effective Exchange Rate (REER) is a concept that reflects the health of the economy. It measures the competitiveness of the domestic currency against foreign currency, and reflects its relative value. On a YTD basis, the rupee has depreciated approximately by 19% against the USD, and is currently at Rs 52.73.
While determining REER, the various factors that are to be considered include the current account deficit, capital inflows and inflation levels in the country. India has two REER indices. The first has 6 major currencies, while the second index includes 36 currencies. The former index is more commonly used, as the currencies it measures against belong to the country's major trading partners. The currencies included in the former index are the Euro, Yen, Pound Sterling, US Dollar, Hongkong Dollar and Renminbi.
As per the data from leading newspapers, the REER index (6 currencies) has fallen by almost 11% in the last 6 months. It declined from 116.67 in Jun 2011 to 103.52 in Nov 2011. A country is said to have a balanced position if its REER stands at levels of 100. If the index is above 100, then it indicates the relative strength of the currency and vice versa.
While determining REER, the various factors that are to be considered include the current account deficit, capital inflows and inflation levels in the country. India has two REER indices. The first has 6 major currencies, while the second index includes 36 currencies. The former index is more commonly used, as the currencies it measures against belong to the country's major trading partners. The currencies included in the former index are the Euro, Yen, Pound Sterling, US Dollar, Hongkong Dollar and Renminbi.
As per the data from leading newspapers, the REER index (6 currencies) has fallen by almost 11% in the last 6 months. It declined from 116.67 in Jun 2011 to 103.52 in Nov 2011. A country is said to have a balanced position if its REER stands at levels of 100. If the index is above 100, then it indicates the relative strength of the currency and vice versa.
Source: Economic Weekly (Oct 11) of Dhanalaxmi Bank
The rationale of how a currency moves come from its Purchasing Power Parity (PPP). Investopedia explains PPP as 'The exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency”. For example, the exchange rate for US and India is US$ 1 is equal to Rs 50. Therefore, if the price of a commodity is Rs 100 in India, then the same commodity's price in US should be US$ 2. However, if the price of commodities in India rises from Rs 5 to Rs 105, then people would buy from the US, where the commodities price is cheaper. This will result in a demand for US dollars, resulting in appreciation of the dollar and depreciation of the rupee. The rupee will depreciate by approximately by 5% to Rs 52.50, which will result in a change in the exchange rate. Hence, the price of the commodity will again remain the same in both the countries.
The current account deficit is reflected in terms of import and exports of goods and services of one country versus the other. Higher imports will result in payments in foreign currency, which will result in depreciation of the domestic currency. The trade deficit during Apr-Sep 2011(6 months) amounted to US$ 73.5 billion vs. US$ 71.2 billion in the similar period last year. The current account deficit is to widen further on the back of the rupee's depreciation and the rising oil prices.
Over the past, inflation has consistently remained above the RBI's forecast levels, and this is one of the reasons why the rupee has depreciated. Now, finally, inflation is showing some signs of cooling. This is evident from the fact that food inflation came in at 1.81% for the week ended Dec 10, 2011 versus 4.35%.
The capital inflows in a country will be higher if the rate of interest offered by that country is greater than that offered in others. For example, if the rate of interest in India is higher than that of US, more funds will be attracted towards the Indian markets and the demand for the Indian rupee will increase. This will result in the rupee appreciating proportionately against the dollar, which will then see the same kind of yield offered by both countries.
The flaw in the REER theory is that it takes a base year, which cannot be easily justified. The base year of the 6 currency REER Index is 2004-05, which may not be ideal. Also, there are other factors like technology that can change the production, productivity and efficiency in a country, which the theory does not account for.
Having said that, the REER Index is getting closer to 100 from the 116 levels in June 2011, and could decline below 100. If the rupee continues to remain around or above the 52 levels, we could see our current account deficit widening further going ahead. Again, the policy paralysed govt. is one of the reasons why funds are not flowing into the economy. Either of these 2 factors moving in a positive direction could help the REER Index to remain above the 100 levels, which would be considered good for our economy.
The current account deficit is reflected in terms of import and exports of goods and services of one country versus the other. Higher imports will result in payments in foreign currency, which will result in depreciation of the domestic currency. The trade deficit during Apr-Sep 2011(6 months) amounted to US$ 73.5 billion vs. US$ 71.2 billion in the similar period last year. The current account deficit is to widen further on the back of the rupee's depreciation and the rising oil prices.
Over the past, inflation has consistently remained above the RBI's forecast levels, and this is one of the reasons why the rupee has depreciated. Now, finally, inflation is showing some signs of cooling. This is evident from the fact that food inflation came in at 1.81% for the week ended Dec 10, 2011 versus 4.35%.
The capital inflows in a country will be higher if the rate of interest offered by that country is greater than that offered in others. For example, if the rate of interest in India is higher than that of US, more funds will be attracted towards the Indian markets and the demand for the Indian rupee will increase. This will result in the rupee appreciating proportionately against the dollar, which will then see the same kind of yield offered by both countries.
The flaw in the REER theory is that it takes a base year, which cannot be easily justified. The base year of the 6 currency REER Index is 2004-05, which may not be ideal. Also, there are other factors like technology that can change the production, productivity and efficiency in a country, which the theory does not account for.
Having said that, the REER Index is getting closer to 100 from the 116 levels in June 2011, and could decline below 100. If the rupee continues to remain around or above the 52 levels, we could see our current account deficit widening further going ahead. Again, the policy paralysed govt. is one of the reasons why funds are not flowing into the economy. Either of these 2 factors moving in a positive direction could help the REER Index to remain above the 100 levels, which would be considered good for our economy.
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