REER NEER India Forex Advisors IFA Classroom: Understanding NEER and REER Dated- 14 th August, 2014

Transcription

1 The exchange rate is the weighted average value of a country's currency relative to all major currencies being traded within an index or pool of currencies. There are two exchange rate regimes: NEER (Nominal effective exchange rate) and REER (Real effective exchange rate). NEER NEER reflects the relative value of the home country s currency compared to the other major currencies being traded. NEER on the other hand is impacted by the inflation differential between the country and its trading partners. NEER is a trade weighted index. REER REER reflects the relative inflation adjusted value of the home country s currency compared to the other major currencies being traded. In REER, we nullify the impact of inflation differential between the currencies and focus on the exchange rate differential alone. NEER is a trade weighted index. For inflation adjustment, the CPI is used for foreign currencies while in India both WPI and CPI are used. Now, moving forward RBI will be using CPI only for adjustment in India also. Trade weighted index means that the weights used for currencies in the calculation are based on the share of that currency s trade in the total trade of the home country. There are two indices based on 6 currencies and 36 currencies. The weights are determined by the importance a home country places on all other currencies traded within the pool, as measured by the balance of trade. REER is an average rate, hence even if a country s currency is overvalued relative to one of its trading partners, REER may still be in equilibrium (ie. Display no overall misalignment), as then the country s currency would be undervalued relative to its other trading partners.

2 Use of REER REER is used for a wide variety of purposes. It can be used to assess: The equilibrium value of a currency The change in price or cost competitiveness The drivers of trade flows or incentives for reallocation production between the tradable and the non-tradable sectors Interpreting REER values: The REER is a common measure of the alignment of a currency relative to its base year value. In India for computation of REER, FY is taken as the base year. If REER > 100 : Rupee is overvalued and should depreciate If REER = 100 : Rupee is fairly valued If REER < 100 : Rupee is undervalued and should appreciate For example: If REER is 108 it means rupee is overvalued by 8% and should depreciate by nearly 8%. Similarly, if REER is 92, we can infer that REER is undervalued and hence should appreciate.

3 Understanding the true value of currency: $-Re and REER (CPI based, exports based, 36 currencies): Financial Year Average value of $-Re REER Over the years, we have seen that REER has remained above 100 indicating that the rupee should depreciate. The average value of $-Re exchange rate has moved from in FY to 60.4 in FY and confirms this trend. A REER value of in FY implies that the rupee should depreciate by nearly 5.5%. REER value for June 2014 stand at while for July 2014 stands at indicating a downward trend. If REER continues to increase, then we can safely assume that room for depreciation of rupee is widening. However, the actual depreciation of a currency depends on various other parameters such as capital flows, interest rate changes, trade by other nations.

4 Understanding export competitiveness Table showing Exports, Average value of $-Re, REER-CPI FY Exports (in USD bn) Average value of $- Re REER-CPI Generally currency depreciation is seen as favorable to exporters as exporters can get higher amount of domestic currency in exchange for the foreign currency received through the trade transaction. The above table confirms this. We can see that REER based on CPI has remained above 100 in the recent financial years. This has led to depreciation in rupee against the dollar. Also the exports have increased in that duration.

5 Comparing REER-CPI and REER-WPI CPI and WPI based REER comparison CPI base REER WPI based REER The above graph gives a comparison between the REER based on CPI and WPI for the recent few years. From the graph, we see that the REER based on WPI and CPI moved together till FY 2009, but after that there has been a divergence between them. REER calculated using CPI gives a better picture than REER based on WPI. Use of the CPI for computing REER is also consistent with the RBI s move to make CPI as the main inflation gauge. Also greater focus is put on CPI inflation as the primary objective of domestic monetary policy. REER index constructed using a CPI for both India and trade partner countries would ensure a higher degree of comparability of former's international competitiveness vis-a-vis its trading partner countries.

6 Annexure: Table 1: 6 currency normalized weights for (in %) Country Trade Weights Export Weights China Hong Kong Euro Japan UK USA

7 About us India Forex Advisors Pvt. Ltd is one of India's leading global Forex and treasury consulting company. We help companies explore extra-ordinary opportunities, manage and sustain growth, and maximize their revenue by minimizing the risks. Since 2005, we have been a trusted partner in Forex Consulting, Treasury Management and Forex Operational Excellence. We have always believed that every client needs a customized offering and we have a long history of serving mandate clients and tailoring the offering to their needs. We provide the right people and the right skill sets to ensure that our clients' solutions are specifically tailored and done right the first time. Contacts Anita Joshi anita@indiaforex.in Alisha Bajaj alishabajaj@indiaforex.in Aditi Aggarwal aditi.aggarwal@indiaforex.in Company Address 7th Floor- Sangita Ellipse Sahakar Road Vile Parle (East) Mumbai - 57 Tel No.: Fax No.: Disclaimer These views/ forecasts All are Interbank rates and do not include bank margins Copyright@ INDIA FOREX ADVISORS PVT LTD. The report and information contained herein is strictly confidential and meant solely for the selected recipient and may not be altered in any way, transmitted to, copied or distributed, in part or in whole, to any other person or to the media or reproduced in any form, without prior written consent of India Forex Advisors Pvt Ltd. These views/ forecasts/ suggestions, though proffered with the best of intentions, are based on India Forex reading of the market at the time of writing. They are subject to change without notice. Though the information sources are believed to be reliable, the information is not guaranteed for accuracy. Those acting in the market on the basis of these are themselves responsible for any profits or losses that might occur, without recourse to us. World financial markets, and especially the Foreign Exchange markets, are inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved.