# Understanding NEER and REER

#### ByAshish Agrawal

Nov 9, 2023

The rupee has depreciated by about 9% against the dollar since the Fed started raising interest rate in March’22. Over last ten years, it has depreciated by over 30%. However, REER (real effective exchange rate) of rupee has appreciated nearly 13% over last ten years and has remained nearly constant since March’22. So, what exactly is the difference between the two and what level of exchange rate should India target. Here is an attempt to understand that.

To understand the concept of REER, it would be useful to consider an example. Assume an exchange rate of Rs 80 to a dollar on a particular day and a product costing one dollar in USA and Rs 80 in India. Due to inflation, a year later, the cost of product increases to Rs 88 in India and \$1.02 in US (assuming inflation of 10% and 2% in the two countries). While the inflation differential is not so high at the moment, over last ten years, CPI based prices in US have increased by about 35% against about 70% in India. So, if rupee does not depreciate during the period, an arbitrage opportunity would arise whereby a trader can import the product from the US at Rs 81.6 (\$1.02*80) and sell at Rs 88. For an equilibrium, rupee should depreciate to 86.28 per dollar (80*1.10/1.02).

However, in reality, that doesn’t happen so for variety of factors. Let’s assume exchange rate settles at Rs 84 per dollar after one year. This would mean rupee has depreciated by 5% (84/80-1) in nominal terms, but has appreciated by 2.6% (84/86.28 – 1) in real terms. As a result, the cost of Indian pen would work out to \$1.05 (88/84) in dollar terms, costlier than the price of \$1.02 prevailing in USA, making it uncompetitive. (The depreciation of rupee is widely resented as it increases the cost of overseas travel, education etc and therefore, politically ill-advised. However, it is essential that it depreciates sufficiently so that nation’s exports do not suffer and imports do not flood the market).

The above discussion forms the basis of Nominal Effective Exchange Rate (NEER) and Real effective Exchange Rate (REER), used by central banks to track composite exchange rate movement. NEER is derived by calculating the composite value of rupee against the basket of currencies with each currency getting a weight equal to its share in the total trade (or total exports). REER is calculated by multiplying the inflation differential factor to NEER for each currency as shown in the attached table. Both NEER and REER are expressed with respect to a base of 100.

As stated earlier, central bank has to intervene in case of highly erratic movement of capital flow. A sudden sell-off by FPIs (Foreign Portfolio Investors) or increase in interest rates is US can lead to flight of dollars leading to pressure on rupee. (Remember ‘taper tantrum’ in 2013 when rupee depreciated by 15% in just about three months). Or a rush of inflow, such as seen during Covid due to ultra-low monetary policy in US, can cause appreciation even in nominal terms. As mentioned earlier, country’s central bank buys or sells dollars from its reserves in such cases and tries to stabilize the currency. Actual figures from RBI’s database illustrate this. RBI’s foreign exchange reserves had reached all time high of \$642 bn on 3rd Sept’21 as it had to purchase dollars coming into the country. Subsequent monetary tightening in US led to outflow of dollars and RBI had to sell dollars to meet this demand. As a result, its reserves declined sharply to \$524 bn by 21st Oct’22. Increase in inflow prompted RBI to start its purchase again with reserves rising to \$609 bn by 14th July’23 and falling again to \$586 bn by 27th Oct’23.

This brings us to the actual performance of the rupee. As per RBI data, since 2004, 40-currecny trade-weighted NEER has depreciated by as much as 34% whereas REER has appreciated by about 14%. Between Feb’13-Oct’23, while rupee has depreciated by 14% in terms of NEER, it has appreciated by 7% in terms of REER. This reduces the competitiveness of Indian products and clamour from the exporters to allow rupee to depreciate.

While the narrative paints a disappointing picture with regards to India’s international trade, there are factors such as price movement of individual products, improving productivity, tariff barriers etc which still work to defend the exports. Further, companies exporting services mostly quote prices on dollar basis which protects their competitive edge from exchange rate movement. Yet, in the long run, India’s inflation rate should come down to global average which would reduce the divergent movement of NEER and REER.

NEER REER calculation

#### Annual Survey of Indian Industries – Part I

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