The Chief Economic Advisor, Arvind Subramanian, raised many interesting points for future debate in the Economic Survey presented last week. One of these was the suggestion that the manner in which the exchange rate is valued could be imperfect.
He pointed out that the Real Effective Exchange Rate (REER) that is popular in evaluating the competitiveness of the country’s currency against its trading partners might not be painting the right picture because of the way it is calculated. He suggested that it would be better to give higher weights to countries which actually competed with Indian exporters in various markets.
While this point will be discussed in detail in the days to come, let us first look at what REER is and what it indicates.
Understanding REER
Effective exchange rates are indicators that capture the movement of the home currency against a basket of currencies of the country’s trade partners. This rate seeks to capture the competitiveness of the currency. As a thumb-rule, a value above 100 indicates that the currency is not too competitive vis-à-vis its competitors, and vice-versa.
The RBI computes both Nominal Effective Exchange Rate (NEER), that does not take into account any change in price levels, and the Real Effective Exchange Rate (REER), which takes inflation into account. While computing the NEER, the movement of the home currency and the trade partners’ currencies is captured by their movement against IMF’s Special Drawing Rights (SDRs) in indexed form. Since the SDR value is derived from a weighted average of a basket of major currencies (such as the dollar, euro, yen and pound), pegging the NEER against the SDR ensures that the effective exchange rate captures the broader trend in the currency.
The REER further adjusts the NEER to account for the CPI inflation in the countries concerned. The RBI releases 6- and 36-currency NEER and REER. The weights accorded to the currencies could be based on the extent of trade India does with the country or the quantity of exports. The three-year moving average trade weights are considered, to ensure that spikes in trading activity in one period does not impact the rate too much.
The six-currency weighted effective exchange rate is computed against China, Hong Kong, the Euro zone, Japan, the UK and the US. The Euro zone has the highest weight in this basket, followed by China and the US.
The 36-currency weighted rate includes a host of other countries, such as the UAE, Vietnam, Turkey and Thailand. The highest weight in this basket too is given to the Euro. But the country with the second highest weight in this basket is the UAE, followed by China.
Interpreting the REER
The focus of most analysts is on the REER as it shows how inflation is eroding the competitiveness of our currencies. The six-currency, trade-based REER, with the base of 2004-05, was at 128.5 towards the end of December 2016 while the 36-currency trade-based REER was at 116.7.
These high rates are causing some consternation among the exporting community as it is among the highest recorded in recent times. Many use the REER to show that the rupee is grossly overvalued against its trading partners and needs to be devalued in order to boost exports. The sustained decline in export growth only bolsters these arguments.
While that could be partially true, the REER only factors in the erosion in competitiveness brought about by the relative change in exchange rates of various currencies. It is not the only measure to understand the true value of the rupee. The Indian currency is affected by a host of other factors, including underlying growth in the economy, external account including the trade deficit, and capital flows into and out of the country. It would be wrong to make a case for currency devaluation based on the REER alone.
The reason for weak exports is the fall in commodity prices including crude oil. Revival in commodity prices has already resulted in an uptick in export growth. While the CEA’s suggestion regarding a review of the weights in the REER is a good idea, it would be best not to draw too many inferences from the value of the REER alone.