Making sense of the real exchange rate of the rupee

If the REER is to be restored to its 2004-05 level, the rupee has to depreciate a lot, says V K Sharma.

It is a stock refrain of business and industry in India, as indeed globally, that they consistently need a competitive exchange rate to succeed in a highly competitive global trade environment. Of course, a competitive and fairly valued exchange rate is also a macroeconomic policy imperative for a sustainable balance of payments. But competitive exchange rate shouldn't be at the expense of productivity and efficiency of domestic production.

However, given an optimal level of productivity and efficiency of domestic production, competitiveness of exports may still be compromised by higher domestic inflation relative to that in trading partner countries and in third countries which also compete in a country's export market.

But it is noteworthy that former British Prime Minister Margaret Thatcher reportedly pursued a strong real exchange rate policy to compel British business and industry to significantly improve productivity and efficiency of domestic production to stay competitive in their export markets, quite apart from making imports cheaper and lower inflation in the process.

By now it is clear that even if the nominal exchange rate of the rupee remains stable or depreciates, the real exchange rate may still appreciate unnoticed over a short horizon due to domestic prices rising more than prices in our trading partner countries and in our competitor countries.

To measure the real appreciation and depreciation of a currency, Real Effective Exchange Rate (REER) is globally the most widely used metric. But this metric is derived from what are called Nominal Effective Exchange Rate (NEER), and Effective Relative Price (ERP). NEER is not a single currency exchange rate but a (geometric) weighted average index comprising currencies of countries which are India's major trading partners and countries which are our competitors in our export markets with weights being shares of respective countries in India's total trade basket.

Thus, in its concept and design, it is exactly like Consumer Price Index (CPI). NEER of the Indian rupee is thus the weighted average of the ratios of exchange rate of the rupee expressed as one rupee in terms of a numeraire (SDR) and one unit of select countries’ currencies also expressed in terms the same numeraire (SDR). As per the RBI website, this is what the RBI has done but any other common numeraire will equally do.

ERP is nothing but again the weighted average of the ratios of CPI in India and CPIs of select countries included in the NEER. And finally, REER is simply NEER multiplied by ERP and obviously, like in the case of any index, is normalised to 100 in the chosen base year. Thus, in the base year, all the three metrics are normalised to 100. The way the above indices are constructed, increase in their values represents appreciation of the Indian rupee and vice versa.

For the rupee's NEER, ERP and REER, the base year used by RBI is 2004-05. Also, RBI computes and publishes these metrics on a monthly basis. As of the date of writing this column, the latest month for which NEER and REER are available on the RBI website is May 2015. RBI computes and publishes 6 currency and 36 currency NEERs and REERs.

In May 2015, the 6 Currency NEER was 68.94 with REER of 122.21 and dollar rupee exchange rate was 63.80. Although the RBI website doesn't give ERP, it can be back-calculated from the NEER and REER as 122.21/68.94 = 1.7727*100= 177.27. Thus, we see that while the rupee depreciated in nominal terms by 31 per cent in real terms, it appreciated by 22.21 per cent because of relative prices in India rising by 77.27 per cent over the 10 year period since the base year 2004-05.

But it is more insightful and useful to make real sense of the real exchange rate of the rupee by looking at what this means in terms of where the dollar rupee ought to be for restoring the REER back to 100 as in the base period 2004-05. And the way to do this is simply to multiply the relevant dollar rupee exchange rate of Rs 63.80 by the latest REER/100, that is 63.80 * 1.2221 which gives Rs 78.

In other words, to make Indian exports as competitive as they were in the base year 2004-05, ceteris paribus, the dollar rupee nominal exchange rate needs to depreciate to Rs 78. Another instructive way to make real sense of the real exchange rate is to work out the base period  REER reading in terms of the dollar rupee exchange rate back out from the latest available REER reading of 122.21.

However, it must be noted that this dollar rupee exchange rate will not be the actual dollar rupee exchange rate used in the REER computation. And the way to do this is simply to divide the current dollar rupee exchange rate of Rs 63.80 by the current REER 1.2221 which gives Rs 52.20.

In other words, what exporters were getting in May 2015 was not Rs 63.80 but actually only Rs 52.20 per dollar in real terms and, therefore, for exporters to continue to get what they were getting in base year 2004-05, ceteris paribus, the rupee needs to depreciate in nominal terms from the current Rs 63.80 to Rs 78.

Based on the 36 Currency REER, the rupee needed to depreciate from Rs 63.80 to Rs 70 and for every one dollar, exporters were getting in May 2015 not Rs 63.80 but only Rs 58. This then is the useful way of making real sense of the real exchange rate of the rupee.

V K Sharma is former executive director, Reserve Bank of India