Rupee at Record High in Real Effective Terms Despite Dollar Weakness

The Indian rupee is hitting new lows against the US dollar, but its value has surged to an all-time high in “real effective” terms.

According to the Reserve Bank of India (RBI), the rupee’s Real Effective Exchange Rate (REER) index reached a record level of 108.14 in November, showing a 4.5% appreciation this calendar year. The REER is a measure that compares the rupee’s value not only against the US dollar but also against other global currencies. This index accounts for inflation differences between India and its trading partners and is calculated as a weighted average of the rupee’s exchange rates with 40 currencies, covering around 88% of India’s annual trade.

The rupee’s REER, using 2015-16 as the base year and assigning currency weights based on trade shares, initially declined from 105.32 in January 2022 to 99.03 in April 2023. However, it has been on an upward trend since then, climbing to 107.20 in October and peaking at 108.14 in November.

Why the Divergence in Rupee Trends?

The apparent contradiction—where the rupee weakens while simultaneously strengthening—can be attributed to the US dollar’s movements over the last three months, especially following Donald Trump’s victory in the US presidential elections on November 5.

During the period from September 27 to December 24, the dollar index futures, which measure the dollar’s value against six other major currencies (euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc), rose from 99.88 to 108.02. Much of this increase occurred after November 5, when the index was at 102.98.

In the same timeframe, the rupee depreciated from 83.67 to 85.19 against the dollar. However, it appreciated against other major currencies: from 93.46 to 88.56 against the euro, 112.05 to 106.79 against the British pound, and 0.5823 to 0.5425 against the Japanese yen.

Challenges for Exporters

A REER value above 100 indicates an overvalued rupee, meaning its exchange rate has not depreciated enough to balance out India’s higher domestic inflation. This overvaluation makes imports cheaper but reduces the competitiveness of Indian exports in global markets.

Effectively, while the rupee has weakened against the dollar, it hasn’t depreciated as much as the dollar has strengthened relative to other currencies. This strengthening of the dollar has been driven by Trump’s policy outlook, which includes proposed tariff hikes, particularly on Chinese imports, deficit-funded tax cuts, and plans for mass deportations of undocumented immigrants. If implemented, these policies could fuel inflation in the US, compelling the Federal Reserve to maintain a tight monetary stance.

The tightening monetary environment in the US has led to a surge in 10-year government bond yields, which rose from 3.75% to 4.59% between September 27 and December 24. This, in turn, has triggered capital outflows from countries like India to the US, further pressuring the rupee.

A Broader Perspective

Since the beginning of 2022, the rupee has generally weakened against major currencies. It declined from 74.30 to 85.19 against the dollar, 84.04 to 88.56 against the euro, and 100.30 to 106.79 against the pound. The only exception was the Japanese yen, where the rupee strengthened from 0.6454 to 0.5425.

Despite this depreciation against most currencies, the REER index for the rupee has risen. This paradox is mainly due to India’s inflation rate outpacing those of its major trading partners.

Assuming the rupee was “fairly” valued in 2015-16, when the REER base was set at 100, any value above 100 indicates overvaluation. This suggests that the rupee’s exchange rate has not fallen enough to compensate for India’s higher inflation. As a result, imports have become cheaper, and exports less competitive.

RBI’s Stance on the Rupee

The RBI seems to be tolerating a depreciation of the rupee, at least against the dollar, to address these imbalances. Analysts point to the central bank’s efforts to allow market forces to guide the currency, thereby improving the competitiveness of Indian exports.

“The rupee is highly overvalued today, making imports into India cheaper and exports less cost-competitive,” experts note. This overvaluation underscores the challenges faced by exporters, particularly in a global environment where the dollar’s dominance affects currency markets worldwide.

In summary, while the rupee’s REER highlights its relative strength in real effective terms, its simultaneous depreciation against the dollar reflects the broader pressures of global economic dynamics, driven significantly by US policies and market expectations.