Real Effective Exchange Rate (REER)

Why in news?

Therupeehas been hittingrecord lowsagainst the US dollar but has simultaneously reached anall-time high in real effective terms. In November 2024, theReal Effective Exchange Rate (REER)index of the rupee touched108.14, strengthening by4.5%during the year, according to the RBI.

What is REER?

The Real Effective Exchange Rate (REER) is a measure of a currency's value relative to a basket of other major currencies, adjusted for inflation differentials between the country and its trading partners. REER provides a more accurate reflection of a currency's purchasing power and its competitiveness in international trade.

Key Points:

1. Effective Exchange Rate (EER):

• EER measures the value of a currency in relation to a basket of foreign currencies, specifically those of its major trading partners.
• It is a weighted average of exchange rates, with more weight given to currencies from countries that are more important to the country's trade.

1. Types of EER:

• Nominal Effective Exchange Rate (NEER):
• A weighted average of the currency's exchange rate with its trading partners' currencies, without adjusting for inflation.
• It represents only the nominal change in the value of the currency.
• Higher NEER indicates a stronger domestic currency relative to the basket of currencies.
• Real Effective Exchange Rate (REER):
• REER adjusts NEER for inflation differentials between the domestic country and its trading partners.
• REER > 100 indicates an overvalued currency, reducing the competitiveness of exports.
• REER < 100 indicates an undervalued currency, enhancing export competitiveness.

REER and Its Impact on Exports:

1. When REER > 100 (Overvalued Currency):

• Exports: Become less competitive, as Indian goods and services are more expensive in global markets.
• Imports: Increase, as foreign goods become cheaper compared to domestic goods.
• Trade Deficit: Likely to widen, as imports rise and exports fall.

1. When REER < 100 (Undervalued Currency):

• Exports: Flourish, as Indian goods and services become more competitively priced in global markets.
• Imports: Decline, as foreign goods become more expensive relative to domestic goods.
• Trade Surplus: Can improve, supporting domestic industries and employment.

Example:

As of November 2024, the REER of the Indian rupee reached 108.14, which indicates an appreciation of the rupee in real terms despite its depreciation against the US dollar. This signifies that the rupee is currently overvalued relative to the basket of currencies of India’s major trading partners, potentially making Indian exports more expensive and imports cheaper.

Conclusion:

REER is an important indicator of a currency’s international competitiveness. A higher REER (above 100) can hurt exports, while a lower REER (below 100) can boost exports by making the country's goods more affordable globally. This impacts trade balances and the overall economy.