Coronavirus (COVID-19): The economic disruption due to the spread of the novel coronavirus disease (COVID-19) over the past few months has adversely affected various aspects of the Indian economy. But is the impact on India more than the impact on other economies?
There are different ways to answer this question. One could look at the growth rates of gross domestic product and gross value added. Or, in the absence of such data, one could treat other high-frequency data like sales of automobiles etc. as a proxy.
In this regard, the exchange rate of the rupee can also be an apt marker on the state of the Indian economy’s competitiveness.
What is currency exchange rate?
Essentially, a currency’s exchange rate vis-a-vis another currency reflects the relative demand among the holders of the two currencies. This demand, in turn, depends on the relative demand for the goods and services of the two countries. If the US dollar is stronger than the rupee, then it shows that the demand for dollars (by those holding rupee) is more than the demand for rupees (by those holding dollars).
Typically, stronger economies have stronger currencies. For instance, the US economy is relatively stronger than India’s and this is reflected in one US dollar being equal to around 76 rupees. The rupee has been losing value (or depreciating or weakening) against the dollar over the past few months.
But the US is not the only other country in the world; India trades with many other countries. To have a better understanding of the Indian economy’s overall competitiveness, one should look at how the rupee is behaving with its major trade partners.
What measures should we look at?
The Reserve Bank of India tabulates the rupee’s Nominal Effective Exchange Rate (NEER) in relation to the currencies of 36 trading partner countries. This is a weighted index — that is, countries with which India trades more are given a greater weight in the index. A decrease in this index denotes depreciation in rupee’s value; an increase reflects appreciation.
As the chart shows, in NEER terms, the rupee has depreciated to its lowest level since November 2018. The rupee has been steadily losing value — showing the Indian economy’s reducing competitiveness— since July 2019. The dip in March was likely influenced by the net outflow of foreign portfolio investments from the Indian equity and debt markets — they stood at $15.92 billion in March as against net inflows of $1.27 billion in February.
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There is one more measure that is even better at capturing the actual change. This is called the Real Effective Exchange Rate (REER) and is essentially an improvement over the NEER because it also takes into account the domestic inflation in the various economies.
And how does inflation affect exchange rates?
Many factors affect the exchange rate between any two currencies ranging from the interest rates to political stability (less of either results in a weaker currency). Inflation is one of the most important factors.
Here’s how. Imagine that the Re-$ exchange rate was exactly 1 in the first year. This means that with Rs 100, one could buy something that was priced at $100 in the US. But suppose the Indian inflation is 20% and the US inflation is zero. Then, in the second year, an Indian would need Rs 120 to buy the same item priced at $100, and the rupee’s exchange rate would depreciate to 1.20.
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What does REER show?
Even in REER terms, the rupee has depreciated in March and fallen to its lowest level since September 2019. As the graph shows, the difference between trends of NEER and REER was due to India’s domestic retail inflation being lower relative to the other 36 countries. As domestic inflation started rising, the REER, too, started depreciating like the NEER.
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