The real effective exchange rate (REER) is an indicator that is seldom tracked by the markets or even economists.
But REER, especially the newly refurbished one from the Reserve Bank of India (RBI), has consistently shown an overvaluation of the Indian rupee against 40 other peer global currencies. In other words, the indicator has given a reason to the central bank to intervene and soak up dollars.
In November, the REER showed that the rupee was overvalued by 6.24 percent. Since then, the rupee has weakened marginally. The REER is the rupee’s value against a basket of 40 currencies and not just the dollar.
The real effective exchange rate measures the health of a nation's currency against that of the countries it trades with and is an indicator of the international competitiveness of a nation in comparison with its trade partners. It is used to determine whether a nation's currency is undervalued or overvalued, allowing the central bank to adjust accordingly.
The central bank’s tactical interventions in the foreign exchange market are largely driven by dollar flows. That said, the REER serves as a key benchmark on which the exchange rate’s movements can be put in the context of the prevailing macroeconomic conditions.
For example, in 2020 the economy shrank but foreign institutional investors poured $14 billion into local equity and debt markets. No wonder, the RBI soaked up a chunk of these flows during that time.
In fact, the central bank bought $87 billion from the forex market and the rupee weakened 2.5 percent because of this intervention. At that time, the overvaluation based on the REER of a 36-currency basket was as high as 19 percent.
This year, too, the RBI has been a big buyer of dollars and has only throttled back in recent times. Its data shows that India’s central bank sold just $100 million in October, turning a net seller after six months. One reason is that dollar inflows have slowed down.
“During times of downward pressure, the RBI intervention has been mostly mild. They have preferred a weaker rupee,” said a currency dealer requesting anonymity.
In a note dated November 25, independent research firm QuantEco Research said the strength in capital flows has delayed the rupee’s depreciation. In REER terms, though the overvaluation is evident.
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