How the rupee has ‘strengthened’ under Modi government

BETWEEN APRIL-END 2014 and now — roughly the time the Narendra Modi government has been in office — the rupee has depreciated by 27.6% against the US dollar, from Rs 60.34 to Rs 83.38.

That’s marginally higher than the 26.5% depreciation from April-end

2004 to April-end 2014. The rupee fell from 44.37 to 60.34 against the dollar, in the period when Congress-led UPA was in power.

As India engages in global trade, the strength or weakness of the rupee is a function of the exchange rate with the US dollar and other global currencies. The rupee’s “effective exchange rate” or EER is an index of the weighted average of its exchange rates

vis-à-vis the currencies of India’s major trading partners.

The currency weights in the index are derived from the share of individual countries in India’s total foreign trade. There are two measures of EER, nominal and real.

Nominal EER or NEER

The RBI has constructed the NEER indices of the rupee against baskets of six and 40 currencies.

The former is a trade-weighted average rate at which the rupee is exchangeable with a basic currency basket, comprising the US dollar, the euro, the Chinese yuan, the British pound, the Japanese yen and the Hong Kong dollar.

The latter index covers a bigger basket of 40 currencies of countries that account for about 88% of India’s annual trade flows.

The NEER indices are with reference to a base year value of 100 for 2015-16. Increases indicate the rupee’s effective appreciation against these currencies, and decreases point to overall exchange rate depreciation.

Chart 1 shows that the rupee’s 40-currency

basket NEER has fallen by around 32.2% (from 133.8 to 90.8) between 2004-05 and 2023-24. The decline is even more — 40.2%, from 139.8 to 83.7 — for the narrower six-currency basket NEER. During this period,

the rupee’s average exchange rate against the US dollar dropped by 45.7%, from Rs 44.9 to Rs 82.8.

Simply put, the rupee’s ‘effective’ depreciation of 32.2-40.2% against the currencies of India’s major trade partners over 20 years has been lower than its corresponding depreciation of 45.7% against the US dollar alone. The reason for that is its weakening less relative to other currencies than vis-àvis the dollar.

The chart also shows that the bulk of the NEER decline happened during 2004-05 to 2013-14. The rupee, in fact, strengthened thereafter until 2017-18, before resuming its weakening trend — albeit at a slower pace than during the UPA period.

Real EER or REER

The NEER does not factor in inflation, which reflects changes in the internal value of the rupee.

To illustrate, the Indonesian rupiah has fallen 8.5% against the US dollar in the last year. The Indian rupee has depreciated much less, by 1.7%, in this period. But India’s annual CPI inflation rate, at 4.9% for March, was more than Indonesia’s 3.1%. Thus, the Indonesian currency’s domestic purchasing power has suffered less erosion relative to its international purchasing power, whereas it has been the reverse for the rupee.

There er is basically the ne er adjusted for the inflation differentials between the home country and its trading partners. If a country’s nominal exchange rate falls less than its domestic inflation rate, as with india, the currency has actually appreciated in ‘real’ terms.

Chart 2 maps the rupee’s trade-weighted REER for the last 20 years, taking a base year value of 100 for 2015-16. It shows the rupee has strengthened in real terms over time, while ruling at 100 or above in 9 of the Modi government’s 10 years. This is opposite to the trend of weakening seen in the NEER or its exchange rate with the US dollar.

If one assumes that the rupee was ‘fairly’ valued in base year 2015-16, any value above 100 signifies overvaluation. To that extent, the rupee is overvalued today in terms of its REER.

Any increase in REER means the costs of products being exported from India are rising more than the prices of its imports. That translates into a loss of trade competitiveness — which may not be a good thing in the long run.