MUMBAI: The Real Effective Exchange Rate (REER) of the rupee moderated to 107.20 in December 2024, down from its peak of 108.14 in November, according to the latest data from the Reserve Bank of India (RBI).
The decline reflects multiple underlying factors, including global currency dynamics, domestic economic conditions, and inflation trends.
REER, an inflation-adjusted and trade-weighted measure of a currency’s value relative to its trading partners, serves as an important indicator of external competitiveness. A lower REER suggests improved competitiveness for a country’s exports but also indicates a weakening currency in real terms.
Exploring reasons behind REER decline
Rupee depreciation against the dollar:In December, the rupee depreciated by 1.31 per cent, contributing to the moderation in REER. For the entire year 2024, the rupee weakened by approximately 3 per cent against the US dollar. The depreciation was driven by heavy foreign portfolio investor (FPI) outflows, which accelerated as US Treasury yields surged, making dollar-denominated assets more attractive.
Strength of the dollar index: The dollar index, which measures the greenback’s strength against a basket of six major currencies, rose by 2.75 per cent to 108.48 during December. A stronger dollar typically puts downward pressure on emerging market currencies like the rupee, reducing their relative value in trade-weighted terms.
US Federal Reserve’s monetary policy: The Federal Reserve surprised markets in December by delivering a smaller-than-expected rate cut of 25 basis points instead of the anticipated 50 bps reduction. This decision signaled a slower pace of monetary easing, bolstering the dollar further and contributing to the rupee’s depreciation.
India’s widening trade deficit: India’s merchandise trade deficit, which expanded significantly in November, added to the rupee’s weakness. A larger trade deficit implies greater demand for foreign currency to finance imports, exerting additional pressure on the rupee.
Record RBI interventions:To manage volatility in the forex market, the RBI engaged in record dollar sales in the spot market, selling $20.2 billion in November. While these interventions helped stabilise sharp movements, they did not fully offset the underlying factors contributing to the rupee’s depreciation.
Broader context of REER movement
The rupee’s REER peaked in November due to a combination of earlier stability in the currency and relatively favourable inflation differentials.
However, as external pressures mounted, including FPI outflows and the strengthening dollar, the rupee’s nominal depreciation began to outweigh these factors, causing REER to decline.
Economic experts believe that the rupee’s decline is likely to continue. Analysis shows that when (currencies of) major trading partners have depreciated at a pace of 3.6 per cent, the rupee has the potential to further depreciate by 1.4 per cent in the near-to-medium term, though this also depends on inflation differentials.
The pace of depreciation has accelerated in recent weeks, with the rupee hitting record lows in around 30 of the 47 trading sessions since November. Market participants expect January 2025’s REER data to show further moderation, reflecting continued depreciation in the rupee’s value.
Implications
While a lower REER can boost export competitiveness by making Indian goods and services cheaper globally, it also raises concerns about imported inflation. A weaker rupee increases the cost of imports, including essential commodities like crude oil, which can further strain India’s current account.
In summary, the rupee’s REER decline reflects a confluence of global monetary trends, domestic economic challenges, and inflationary pressures. As these factors continue to evolve, the trajectory of the rupee and its impact on India’s trade and inflation dynamics will remain critical areas of focus.
