Has Rupee strengthened in real term? What are NEER & REER?

Why in News?  The last 10 years have seen the Indian currency fall more against the dollar than during the previous 10 years. But the rupee has strengthened in ‘real’ terms when its exchange rate with all major global currencies is taken.

Between April-end 2014 and  April 2023,  the rupee has depreciated by 27.6% against the US dollar, from Rs 60.34 to Rs 83.38.

How Rupee has strengthened in real Term?

• India trades not only with the US. It exports goods and services to other countries as well, while also importing from them.
• The strength or weakness of the rupee is, hence, a function of its exchange rate with not just the US dollar, but also with other global currencies.
• In this case, it would be against a basket of currencies of the country’s most important trading partners – what’s called the rupee’s “effective exchange rate” or EER.
• The EER is measured by an index similar to the consumer price index (CPI). The CPI is the weighted average retail price of a representative consumer basket of goods and services for a given month or year, relative to a fixed base period.
• The EER is an index of the weighted average of the rupee’s exchange rates vis-à-vis the currencies of India’s major trading partners. The currency weights are derived from the share of the individual countries to India’s total foreign trade, just as the weights for each commodity in the CPI are based on their relative importance in the overall consumption basket.

There are two measures of EER.

The first is the Nominal EER or NEER.

• The Reserve Bank of India has constructed NEER indices of the rupee against a basket of six and also of 40 currencies.
• The former is a trade-weighted average rate at which the rupee is exchangeable with a basic currency basket, comprising the US dollar, the euro, the Chinese yuan, the British pound, the Japanese yen and the Hong Kong dollar. The latter index covers a bigger basket of 40 currencies of countries that account for about 88% of India’s annual trade flows.

 The second measure is the Real EER or REER.

• The NEER is a summary index that captures movements in the external value of the rupee against a basket of global currencies.
• However, the NEER does not factor in inflation, which reflects changes in the internal value of the rupee.
• To illustrate, the Indonesian rupiah has fallen 5% against the US dollar in the last one year. The Indian rupee has depreciated much less, by 1.7%, during this period. But India’s annual CPI inflation rate, at 4.9% for March, stood above Indonesia’s 3.1%.
• Thus, the Indonesian currency’s domestic purchasing power has suffered less erosion relative to its international purchasing power, whereas it has been the reverse for the rupee.