Article:
The Indian rupee has been experiencing a depreciation against the U.S. dollar over the past several months. This development is a significant marker in comparing the competitiveness of the Indian economy with other economies globally, especially in the face of the current COVID-19 pandemic. Other measures for this comparison include the analysis of growth rates of the Gross Domestic Product (GDP) and Gross Value Added (GVA), as well as high-frequency data like automobile sales.
Understanding the Exchange Rate
The exchange rate is defined as the price of one currency in terms of another. This rate mirrors the relative demand between the holders of the two currencies in question. For instance, if the U.S. dollar demonstrates greater strength than the rupee (indicating a higher value of the dollar when compared to the rupee), it signifies that the demand for dollars by those possessing rupees is higher than the rupee demand from those holding dollars. This currency demand relies on the relative demand for the goods and services produced by these two countries.
An Index for Exchange Rates
Since a nation often transacts with many different countries, it requires an index that encapsulates the movement of its domestic currency relative to all other currencies. The Reserve Bank of India compiles the Nominal Effective Exchange Rate (NEER) reflecting the rupee’s status concerning the currencies of 36 trading partner countries. This index is weighted, giving more weight to countries that India trades with more frequently. The fall in this index indicates rupee depreciation, while a rise reflects rupee appreciation.
Introduction to Real Effective Exchange Rate (REER)
The Real Effective Exchange Rate or REER improves the NEER by accounting for the domestic inflation in various economies. It is essentially the weighted average of NEER adjusted by the ratio of domestic to foreign prices.
Interrelation between Inflation and Exchange Rate
Several factors influence the exchange rate between two currencies, ranging from interest rates and political stability (with lower rates of either resulting in a weaker currency) to inflation levels. For instance, if there was parity between rupee-dollar exchange rate initially, where Rs 100 could buy something priced at $100 in the U.S., but if Indian inflation rose to 20% and U.S. inflation was nil, an Indian would require Rs 120 to buy the same item, leading to rupee’s depreciation to 1.20.
Comparison of NEER and REER
As the chart indicates, in NEER terms, the rupee has depreciated to its lowest since November 2018, steadily losing value indicating the declining competitiveness of the Indian economy since July 2019. In REER terms as well, the rupee has depreciated as of March and fallen to its lowest since September 2019. This difference can be attributed to India’s domestic retail inflation being lower than the other 36 countries. However, as domestic inflation began to rise, the REER started to depreciate, just like the NEER.
Understanding GDP and GVA
Gross Domestic Product (GDP) provides a measure of the economic activity or the total value of a country’s annual output of goods and services. The Gross Value Added (GVA), on the other hand, is the sum of a country’s GDP and net of subsidies and taxes, giving the rupee value for the amount of goods and services produced after deducting the cost of inputs and raw materials involved.