Effective Exchange Rate (EER)

Context (IE): The last 10 years have seen the Indian currency fall more against the dollar than during the previous 10 years.
Since April-end 2014, the rupee has depreciated by 27.6% against the US dollar. However, the rupee strengthened in real terms when its exchange rate with all major global currencies was taken.

The rupee’s strength or weakness depends on its exchange rate with the US dollar and other global currencies. This includes a basket of currencies from India’s major trading partners, known as the rupee’s effective exchange rate or EER.
The Effective Exchange Rate (EER) is measured using an index similar to the Consumer Price Index (CPI).
- The CPI calculates the average retail price of a standard consumer basket of goods and services for a specific period compared to a fixed base period.
- Similarly, the EER measures the weighted average of the rupee’s exchange rates against the currencies of India’s major trading partners.
Currency weights in the EER are determined by each country’s share in India’s total foreign trade.
There are two measures of Effective Exchange Rate (EER).
- Nominal EER or NEER.
- Real Effective Exchange Rate (REER).

Nominal EER or NEER

RBI has developed NEER indices for the rupee against two baskets of currencies.
One basket has six currencies: US dollar, euro, Chinese yuan, British pound, Japanese yen, and Hong Kong dollar.
The other NEER index covers a larger basket of 40 currencies, representing countries contributing to about 88% of India’s annual trade.
NEER indices are calculated based on a reference base year value of 100 for 2015-16.

Increases in NEER values indicate the rupee’s effective appreciation against these currencies, while decreases suggest overall exchange rate depreciation.

While the Nominal Effective Exchange Rate (NEER) reflects movements in the rupee’s external value against a basket of currencies, it doesn’t consider inflation, which affects the rupee’s internal value.
- For example, the Indonesian rupiah has fallen by 8.5% against the US dollar in the past year, while the Indian rupee depreciated by only 1.7%.
- However, India’s March annual CPI inflation rate of 4.9% was higher than Indonesia’s 3.1%.
- This means the Indonesian currency’s domestic purchasing power suffered less erosion compared to its international purchasing power, while it was the opposite for the rupee.
REER adjusts the NEER for inflation differentials between the home country and its trading partners.

An increase in REER implies that the costs of products exported from India are rising more than the prices of imports into the country. This results in a loss of trade competitiveness, which may not be favourable in the long term.

The NEER against the 40-currency basket decreased by approximately 32.2% from 2004-05 to 2023-24, falling from 133.8 to 90.8.
The decline was even steeper for the narrower 6-currency basket NEER, around 40.2%, from 139.8 to 83.7 during the same period.
Meanwhile, the rupee’s average exchange rate against the US dollar decreased by 45.7%, from Rs 44.9 to Rs 82.8.

During 9 out of the 10 years from 2014 to 2024, the rupee’s REER has been at 100 or above.
This trend contrasts with the weakening trend observed when considering only the rupee’s Nominal Effective Exchange Rate (NEER) or its exchange rate against the US dollar.

A diagram of exchange rate Description automatically generated

The International Monetary Fund (IMF) has reclassified India’s de facto exchange rate regime from floating to stabilised arrangement for the period December 2022 to October 2023.