Recent Trends in India’s Real Effective Exchange Rate

The Real Effective Exchange Rate (REER) of the Indian rupee experienced a decline in December 2024, settling at 107.20 after reaching a peak of 108.14 in November. This shift reflects a broader trend of depreciation against the US dollar, influenced by various economic factors. The Reserve Bank of India (RBI) reported that the rupee depreciated approximately 3 per cent throughout 2024, with a notable 1.31 per cent drop in December alone.

About REER

REER is an important economic indicator. It measures the inflation-adjusted, trade-weighted average value of a currency against its trading partners. A higher REER indicates stronger external competitiveness, while a lower value suggests potential weaknesses in international trade. The REER for the rupee was recorded at 103.66 in January 2024, indicating shift in competitiveness.

Factors Influencing the Rupee’s Decline

Several factors contributed to the rupee’s depreciation. Heavy outflows from foreign portfolio investors (FPIs) were triggered by rising US Treasury yields. The dollar index, which measures the dollar’s strength against six major currencies, increased by 2.75 per cent, reaching 108.48. Additionally, the Federal Reserve’s decision to reduce interest rates by 25 basis points, rather than the anticipated 50 basis points, further strengthened the dollar.

Trade Deficit Impact

India’s merchandise trade deficit widened in November, exacerbating the rupee’s decline. Analysts noted that poor trade data and capital outflows caused the rupee to fall to 85.50 per dollar. This situation led to a decrease in the REER, indicating reduced international competitiveness for Indian goods and services.

RBI Interventions

The RBI actively intervened in the foreign exchange market to stabilise the rupee. In November, it sold a record $20.2 billion to manage volatility. Despite these efforts, the rupee’s decline continued, with the net short position in the forward market rising to $58.9 billion. The RBI’s interventions included purchasing $30.8 billion while selling $51.1 billion in the spot market during the same month.

Future Projections

Economic analysts predict further depreciation of the rupee. Some suggest that under stable external conditions, the rupee could weaken by an additional 20-30 paise. Historical analysis indicates that when major trading partners depreciate by 3.6 per cent, the rupee could potentially decline by another 1.4 per cent in the near to medium term. This projection puts stress on the need to consider inflation differentials in future assessments.

Market Sentiment

Investor sentiment has turned cautious due to the rupee’s erratic performance. The rupee has reached record lows in approximately 30 of the last 47 trading sessions since November 2024. The rapid pace of depreciation has led to speculation regarding its future trajectory, creating uncertainty in the market.

Questions for UPSC:

1. Critically analyse the implications of a declining Real Effective Exchange Rate on India’s economy.
2. What are the potential consequences of heavy foreign portfolio investment outflows on the Indian financial market?
3. Explain the relationship between US Treasury yields and the performance of emerging market currencies like the Indian rupee.
4. What is the significance of trade deficits in determining a country’s currency value? Discuss with suitable examples.

Answer Hints:

1. Critically analyse the implications of a declining Real Effective Exchange Rate on India’s economy.

1. A declining REER suggests reduced international competitiveness, making exports more expensive and imports cheaper.
2. This can lead to a widening trade deficit, negatively impacting the current account balance.
3. It may result in inflationary pressures as imported goods become costlier, affecting domestic consumers.
4. Foreign investments may decline due to perceived economic instability, impacting growth prospects.
5. Long-term depreciation can lead to a loss of investor confidence and volatility in the currency market.

2. What are the potential consequences of heavy foreign portfolio investment outflows on the Indian financial market?

1. FPI outflows can lead to a depreciation of the rupee, increasing import costs and inflation.
2. It may create volatility in the stock market, leading to declines in equity prices.
3. Reduced liquidity in financial markets can hinder capital availability for businesses.
4. Increased borrowing costs may arise as investors demand higher returns for perceived risks.
5. Long-term outflows can negatively impact economic growth and investor sentiment towards India.

3. Explain the relationship between US Treasury yields and the performance of emerging market currencies like the Indian rupee.

1. Higher US Treasury yields attract global investors to US assets, reducing demand for emerging market currencies.
2. As US yields rise, capital flows away from emerging markets, leading to currency depreciation.
3. Increased yields in the US often signal tightening monetary policy, affecting global liquidity.
4. Emerging market currencies may weaken further as investors seek safer, higher-yielding investments.
5. The relationship marks the interconnectedness of global financial markets and investor behavior.

4. What is the significance of trade deficits in determining a country’s currency value? Discuss with suitable examples.

1. A trade deficit indicates that a country imports more than it exports, leading to increased demand for foreign currencies.
2. This can result in depreciation of the domestic currency as more local currency is exchanged for foreign goods.
3. For example, India’s widening trade deficit has contributed to the rupee’s decline against the dollar.
4. Persistent trade deficits can undermine investor confidence, leading to capital outflows and further currency depreciation.
5. Countries with trade surpluses, like Germany, often see their currencies appreciate due to higher demand for their goods.