EFFECTIVE EXCHANGE RATES

EFFECTIVE EXCHANGE RATE (EER)

The EFFECTIVE EXCHANGE RATE (EER) is an Index which describes the strength of a currency relative to a basket of other currencies. This rate measures the value of domestic currency against the weighted value of a basket of foreign currencies. The weights used to derive the rates, reflect the foreign countries’ share in the trade of the domestic country. Thus the EER is used to compare the domestic country’s performance against its most important trading partners. The Effective Exchange Rates are always derived as an Index i.e. out of 100.

The EER is used as an indicator to comprehend the domestic currency’s international competitiveness in terms of a group of foreign exchange rates which cannot be understood by just examining the individual exchange rates of the domestic currency and other foreign currencies.

EER is used in studies in economics as well as policy analysis for international trade. Foreign Exchange Traders who engage in currency arbitrage make use of EERs. It is used to measure the equilibrium value of the domestic country’s currency, to identify the underlying factors of the domestic country’s trade flow and analysing the impact of factors such as competition and technological changes on the country and also the trade weighted index.

NOMINAL EFFECTIVE EXCHANGE RATE (NEER):

The Nominal Effective Exchange Rate (NEER) is calculated as an unadjusted weighted average rate at which the domestic country’s currency exchanges for a multiple foreign currency basket. The NEER is an indicator of domestic country’s international competitiveness in terms of the Foreign Exchange Market.

REAL EFFECTIVE EXCHANGE RATE (REER):

The Real Effective Exchange Rate (REER) is the NEER which is adjusted to relative movements in any national price or cost indicator of the domestic country and the foreign countries. REER relates to the Purchasing Power Parity (PPP) Hypothesis.

While the fluctuation in NEER accounts only for the variation in the nominal exchange rate of the domestic currency against basket of foreign currencies, the REER also accounts for the variations in the inflation differential in relation to the foreign countries.

CALCULATION OF THE EFFECTIVE EXCHANGE RATES BY THE RESERVE BANK OF INDIA (RBI)

The Reserve Bank of India (RBI)    derives the Effective Exchange Rates (EER) in Nominal and Real Terms. These rates are calculated by the institution on a monthly and annual basis. The RBI calculates two Indices – Broad and Narrow.

  1. Narrow Index – The Narrow Index is calculated taking 6 major Trading Partner countries of India into consideration. The countries are USA, UK, China, Japan, Hong Kong, and EURO Area. The EURO Zone comprised of 12 countries in 2004-05 which further increased to inclusion of 19 countries. These 6 currencies together accounted for around 40% of India’s International Bilateral Trade in the year 2004-05. China and Hong Kong together accounted for 9% in 2004-05.

  2. Broad Index – The Broad Index is calculated taking 36 Trading Partners of India into consideration. They are Argentina, Australia, Bangladesh, Brazil, Canada, Taiwan, Egypt, Indonesia, Iran, Israel, Kenya, Korea, Kuwait, Malaysia, Mexico, Vietnam, Nigeria, Pakistan, Philippines, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Sri Lanka, Sweden, Switzerland, Thailand, Turkey, UAE, China, Hong Kong, Euro, Japan, UK, USA. The Euro Zone comprised of 5 countries which further increased to inclusion of 12 countries. These 36 regions accounted for nearly 61% of India’s Foreign Trade and 67% of India’s Exports in the base year i.e. 2004-05.

FORMULA

  • Nominal Effective Exchange Rate (NEER)
  • Real Effective Exchange Rate (REER)

TERMS OF THE FORMULA

e

Exchange rate of Indian rupee against a numeraire

ei

Exchange rate of Foreign Currency ‘i’ against the numeraire

(e/ei)

Exchange rates

Numeraire

IMF’s Special Drawing Rights (SDRs) in indexed form.

P

Price index of India (CPI is used as proxy prices)

Pi 

Price index for trade partner country ‘i’ (CPI is used as proxy prices)

(P/Pi)

Relative prices (Or called as Deflator)

n

Number of countries covered in the Index other than Home country

wi

Normalised, Geometric average of India’s Bilateral Trade (Exports + Imports) of preceding 3 years

CERTAIN MAJOR DEVELOPMENTS WHICH HAVE TAKEN PLACE IN NEER AND REER BY RBI

  • With effect from January 1, 2002, common currency EURO replaced the existing national currencies of the EUROZONE. This is due to the introduction of EURO – Notes and Coins.
  • The European Commission (Eurostat) introduced the Harmonised Consumer Price index (i.e. HICP) which is now used in place of the individual consumer price indices.
  • There was a significant shift in Trade Relations of India across different countries. Thus, a change was also made in the currency basket and trade weights. These changes were mainly because of the developing and emerging economies.
  • During the year 2002, the Base Year for the Wholesale Price Index (WPI) used for the calculations was changed to 1993-94. This brought a change in the Base Year for the 36 Currency Basket Index.
  • With effect from November 2005, the 6 Currency Index replaced the 5 Currency Index.
  • With the launch of the new Consumer Price Index (CPI), REER based on CPI has been calculated. The base year for the index is chosen to be 2004-05, this is to make the CPI based REER consistent to the WPI based REER.
  • Although from January 2011, the New CPI-C (i.e. Consumer Price Index – Combined) whose Base Year is 2010, is available, a back casted index CPI-IW (Consumer Price Index- Industrial Workers), since January 2001, is used for calculations.

CENTRAL BANKS AND INSTITUTIONS WHICH DERIVE THE EFFECTIVE EXCHANGE RATES

  • Central Bank of each Country derives the Effective Exchange Rates for their respective Domestic Currencies.
  • Here are some Central Banks and Institutions which calculate the Effective Exchange Rates (EER).

Institution

Reserve Bank of India (RBI)

Bank for International Settlements (BIS)

Organisation for Economic Co-operation and Development (OECD)

European Central Bank (ECB)

International Monetary Fund (IMF)

Federal Reserve Board

Bank of England (BOE)

World Bank

Currencies

Indian Rupee

52 Currencies

43 Currencies

Mainly EURO and certain other currencies

184 Currencies

United States Dollar

Sterling and 10 Non-Sterling Countries

94 Currencies

 

Calculate Indian Rupee Effective Exchange Rates

Do not calculate Indian Rupee Effective Exchange Rates

Base Year / Reference Year

2004-05

2010

2015

1999

2010

2006

1990

2010

Basket Size

Narrow- 6 Currencies; Broad- 36 Currencies

Narrow- 27 Currencies; Broad- 52 Currencies

46 Currency Basket

EER-18, EER-19 and EER-38

184 Currency Basket

Advanced Foreign Economies – 7 Currencies; Emerging Market Economies- 19; Broad- 26 Currencies

Narrow- 15 Currencies; Broad- 24 Currencies

 

Trade Weights

Bilateral (i.e. Import + Export)

Double Weighting

Double Weighting

Double Weighting

Double Weighting

Bilateral (i.e. Import + Export)

Double Weighting

Double Weighting

Base Period for Weights

2004-05

Updated every 3 years & Chain-Linked

Updated Annually & Chain-Linked

Updated Discretely & Fixed

Updated Discretely & Fixed

Updated Annually & Chain-Linked

Updated Annually & Chain-Linked

Updated Discretely & Fixed

Deflator

Consumer Price Index

Consumer Price Index

Consumer Price Index

Consumer Price Index, Producer Price Index, Unit Labour Cost in manufacturing (ULCM), Unit Labour Cost in total economy (ULCT) and GDP deflator

Consumer Prices is the deflator used for most of the countries. For certain countries even Unit Labour Cost and Normalised Unit Labour Costs

Consumer Price Index

Consumer Price Index

Unit Labour Cost in manufacturing

  • The above Graph shows a comparison of the Real Effective Exchange Rate for the Indian Rupee calculated by the different Institutions RBI, BIS, OECD and ECB on a monthly basis.
  • The indices are calculated by shifting the base year to April 2010 using the splicing technique to make the indices of the different institutions comparable.
  • From the graph it can be observed that the movement of all the indices is in the same direction.

REVISIONS TO THE EFFECTIVE EXCHANGE RATES

The following revisions have been proposed for the Narrow Index i.e. 6 Currency Basket Effective Exchange Rate which is calculated by RBI.

NARROW INDEX

 

Existing

Revised

Index

6 Currency

8 Currency – Advanced Countries

8 Currency – Important Trading Partners

Notation

6C

8CA

8TP

View

 

Similar to the Advanced Foreign Economy Basket of Federal Reserve Board.

Incorporation of the Major Trading Partners of India of the past 10 years

Basket Size

6 Currencies

8 Currencies

8 Currencies

Countries Included

USA, UK, China, Japan, Hong Kong, Euro Area

USA, Australia, Canada, Hong Kong, Sweden, Switzerland, UK, Euro Area

USA, UK, United Arab Emirates, China, Hong Kong, Saudi Arabia, Singapore, Euro Area

Total Trade Weights of the Basket for the year 2010-11

39%

20%

49%

Base Year

2004-05

2010-11

2010-11

Deflator

Consumer Price Index (2004-05)

Consumer Price Index (2010)

Consumer Price Index (2010)

Methodology

Fixed Base

Chain-Linked

Chain-Linked

  • The above graph shows a comparison of the Narrow Basket REERs with the USD/INR Exchange Rate.
  • The Effective Exchange Rates for 6 Currency Basket, 8 Currency Basket for Advanced Countries and 8 Currency Basket for Important Trading Partner Countries are plotted on the primary axis with Base Year 2010, while the USD/INR Exchange Rate is plotted on the secondary axis.
  • The existing 6 Currency Basket REERs with 2004-05 as original Base Year have the Base Year shifted to 2010 using splicing method in order to make the indices comparable with the revised indices.
  • From the graph it can be observed that the existing and revised REERs are having a similar trend and are moving in the same direction.
  • The Effective Exchange Rates and the Exchange Rates share an Inverse Relationship.
  • This means that when REER appreciates (increases in value), the Indian Rupee strengthens i.e. it appreciates. [ (Foreign Currency / Indian Rupee) drops in value]
  • On the other hand when REER depreciates (decreases in value), the Indian Rupee weakens i.e. it depreciates. [ (Foreign Currency / Indian Rupee) increases in value]
Author
Vhabiz Lala
Volunteer – Equity Research & Valuation (M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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