The economic disruption due to the spread of the novel Coronavirus disease (COVID-19) over the past few months has adversely affected various aspects of the Indian economy.
One could look at the growth rates of gross domestic product and gross value added. Or, in the absence of such data, one could treat other high-frequency data like sales of automobiles etc. as a proxy. In this regard, the exchange rate of the rupee can also be an apt marker on the state of the Indian economy’s competitiveness.
Essentially, a currency’s exchange rate vis-a-vis another currency reflects the relative demand among the holders of the two currencies. This demand, in turn, depends on the relative demand for the goods and services of the two countries.
If the US dollar is stronger than the rupee, then it shows that the demand for dollars (by those holding rupee) is more than the demand for rupees (by those holding dollars).
Typically, stronger economies have stronger currencies. For instance, the US economy is relatively stronger than India’s and this is reflected in one US dollar being equal to around 76 rupees. The rupee has been losing value (or depreciating or weakening) against the dollar over the past few months.
The Reserve Bank of India tabulates the rupee’s Nominal Effective Exchange Rate (NEER) in relation to the currencies of 36 trading partner countries.
This is a weighted index — that is, countries with which India trades more are given a greater weight in the index. A decrease in this index denotes depreciation in rupee’s value; an increase reflects appreciation.
There is one more measure that is even better at capturing the actual change. This is called the Real Effective Exchange Rate (REER) and is essentially an improvement over the NEER because it also takes into account the domestic inflation in the various economies.
Even in REER terms, the rupee has depreciated in March and fallen to its lowest level since September 2019. As the graph shows, the difference between trends of NEER and REER was due to India’s domestic retail inflation being lower relative to the other 36 countries. As domestic inflation started rising, the REER, too, started depreciating like the NEER.
REER and NEER
The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index.
The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country's currency exchanges for a basket of multiple foreign currencies. The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency.