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GS Paper: Indian Economy – Currency and Banking

  • Does the RBI believe rupee is ‘undervalued’?

    Why in the News

    Reserve Bank of India (RBI) Governor has repeated, across two separate settings, that the rupee is undervalued in both nominal and real effective exchange rate (REER) terms. The remark is unusual because central bankers rarely comment on whether their own currency is priced fairly, and it comes as the rupee has depreciated 5.8% year-to-date against the US dollar.

    What is Real Effective Exchange Rate (REER) and why does it matter here?

    1. Definition: The real effective exchange rate (REER) measures a country’s currency value against a basket of trading partner currencies, adjusted for inflation.
    2. Contrast with nominal rate: The nominal exchange rate measures the rupee’s value against a single currency such as the US dollar, while REER captures relative price changes across multiple trading partners.
    3. Why economists prefer it: Economists rely on REER to assess overvaluation or undervaluation because it accounts for inflation differentials rather than only bilateral currency movements.

    What did the Governor actually say?

    1. First statement: It would be reasonable to think the rupee is not overvalued, and that “one could argue the rupee has become undervalued both in nominal and in REER terms.”
    2. Walk-back attempt: He initially disagreed that he had made such a statement, before again saying, “It is reasonable to think that it [Rupee] may not be overvalued.”
    3. No exchange rate target: He reiterated that the RBI does not target any specific exchange rate or band for the rupee.
    4. Market interpretation: Financial markets read the remarks as an indication that the central bank believes the rupee has weakened beyond what economic fundamentals justify.

    What is driving the rupee’s depreciation despite the RBI’s undervaluation claim?

    1. External pressure factors: Higher crude oil prices, geopolitical tensions, a stronger US dollar and intermittent foreign portfolio outflows from emerging markets have pressured the rupee.
    2. Capital outflows: Foreign portfolio investors have drained billions from the Indian stock market, increasing dollar demand while reducing capital inflows.
    3. Domestic fundamentals cited: The RBI points to over 6% annual growth, moderating inflation and forex reserves covering 11 months of imports as evidence the depreciation does not reflect domestic conditions.

    Can a Market-Determined Exchange Rate Be Undervalued?

    1. Non-intervention position: The RBI maintains it does not seek either a permanently strong or a permanently weak currency, and that its exchange rate policy is market-determined.
    2. Limited intervention purpose: The RBI’s foreign exchange interventions aim only to curb excessive volatility and ensure orderly market conditions, not to defend a fixed rupee value.
    3. The tension: By publicly labelling the rupee undervalued while disclaiming any exchange rate target, the Governor signals a view on fair value without committing to any corrective policy action, leaving markets to price in the central bank’s assessment without a stated mechanism to act on it.

    Conclusion

    The RBI Governor’s repeated undervaluation remark distinguishes short-term currency market pressure from India’s underlying macroeconomic fundamentals, without indicating any change in the central bank’s non-intervention stance. Whether the rupee corrects toward this “fair value” will depend on crude oil prices, US monetary policy and capital flows rather than any RBI trigger.

    Back2Basics:

    Real Effective Exchange Rate (REER)

    1. Definition: REER measures a currency’s value against a trade-weighted basket of partner currencies, adjusted for relative inflation.
    2. Custodian: The RBI publishes REER indices for the rupee using 6-currency and 40-currency trade-weighted baskets.
    3. Reading the index: A REER value above 100 relative to the base year typically signals overvaluation; below 100 signals undervaluation.

    Nominal Effective Exchange Rate (NEER)

    1. Definition: NEER measures a currency’s value against a trade-weighted basket of partner currencies, without adjusting for inflation.
    2. Core Concept: It shows the pure external value of the rupee against a group of foreign currencies based purely on market exchange rates.

    Key Differences: NEER vs REER

    1. Inflation Adjustment: NEER ignores inflation completely, while REER adjusts the NEER value for inflation differences between India and its trading partners.
    2. Economic Meaning: NEER tracks simple currency price movements, whereas REER reflects the actual price competitiveness of Indian goods in the global market.
    3. Formula Relationship: REER X (Domestic Inflation Index/Foreign Inflation Index)
    4. Policy Focus: If India’s inflation is higher than its partners, REER will rise faster than NEER, signaling that Indian exports are becoming more expensive despite a stable nominal exchange rate.

    PYQ Relevance

    [UPSC 2018] How would the recent phenomena of protectionism and currency manipulations in world trade affect macroeconomic stability of India?

    Linkage: It examines the impact of exchange rate movements on India’s macroeconomic stability and external sector. It extends the PYQ by explaining RBI’s REER-based assessment of the rupee’s valuation under a market-determined exchange rate regime.