Key Facts and Data Points

Exchange Rate Statistics

  • Rupee depreciation: From Rs 84.4 per USD (November 2024) to Rs 95.5 (May 2026)
  • NEER decline: From 91.68 to 77.19
  • REER movement: From 108.03 to 89.08, recovering marginally to 91.26 (June 2026)
  • Depreciation rate: Approximately 5.8% against the US dollar in 2026

Currency Basket Composition

  • 6-Currency Basket: USD, Euro, Chinese Yuan, British Pound, Japanese Yen, Hong Kong Dollar
  • 40-Currency Basket: Accounts for nearly 88% of India's annual merchandise trade
  • Base Year: 2015-16 (Index value fixed at 100)

Understanding NEER and REER

Nominal Effective Exchange Rate (NEER)

  • Definition: Weighted average index measuring the nominal (face-value) strength of the Indian rupee against a basket of currencies of India's major trading partners
  • Limitation: Does not account for inflation or price-level differences between countries

Real Effective Exchange Rate (REER)

  • Definition: Inflation-adjusted version of NEER; a trade-weighted exchange rate index measuring the rupee's value against major trading partners after adjusting for inflation differentials
  • Significance: More reliable indicator of external competitiveness and currency valuation
  • Interpretation:
  • REER > 100: Currency is overvalued (exports become costlier globally)
  • REER < 100: Currency is undervalued (improves export competitiveness)

Limitations of REER

  • Captures inflation differentials but ignores non-price competitiveness factors (product quality, logistics efficiency, technological integration)
  • Less effective in capturing dynamics of India's services-led export economy (traditionally weighted toward merchandise trade)

India's Exchange Rate Regime

Since March 1993, India follows a market-determined managed floating exchange rate regime:

  • Exchange rate determined by market forces of supply and demand
  • RBI intervenes only to curb excessive volatility and maintain orderly market conditions
  • Exchange rate influences trade, capital flows, inflation, external debt, forex reserves, and export competitiveness

Why RBI Assesses Rupee as Undervalued

Strong Macroeconomic Fundamentals

  • GDP growth above 6%
  • Moderating inflation
  • Stable external sector
  • Foreign exchange reserves sufficient to cover over 11 months of imports

External Global Headwinds (Temporary Factors)

  • Elevated crude oil prices
  • Stronger US dollar
  • Geopolitical tensions
  • Foreign Portfolio Investor (FPI) outflows

REER-Based Assessment

  • Rupee trading below equilibrium value
  • Recent depreciation has exceeded what India's macroeconomic fundamentals would ordinarily justify
  • Transition from overvaluation (REER >100) to undervaluation (REER <100)

Impact of Undervalued Rupee on India's Economy

Potential Benefits

  • Improves export competitiveness: Indian goods become relatively cheaper in international markets
  • Enhances domestic manufacturing competitiveness against imports
  • Supports Make in India initiative by encouraging domestic production
  • May reduce trade deficit if export growth outpaces import growth

Associated Risks

  • Imported inflation: Raises cost of crude oil, fertilizers, electronics, and other imports
  • Higher input costs: Industries dependent on imported raw materials face cost pressures
  • Increased ECB burden: Raises cost of servicing External Commercial Borrowings
  • CAD widening: Current Account Deficit may widen during periods of elevated oil prices

Significance for India/Governance/Policy

  1. Policy Implications: Exchange rate competitiveness alone cannot sustain export growth without improvements in productivity, logistics, and manufacturing efficiency
  2. Strategic Measures: Preserving market-determined exchange rate regime, diversifying exports, deepening domestic financial markets, strengthening energy security
  3. Long-term Goals: Enhance rupee's long-term competitiveness and external sector resilience

Related Previous Year Questions

Prelims (2019): Which measure is NOT likely to stop rupee slide? (Answer: Expansionary monetary policy)

Prelims (2021): Effect of currency devaluation - only statement about improving export competitiveness is correct

Mains (2018): Impact of protectionism and currency manipulations on India's macroeconomic stability