Posted by: Deepa Vasudevan on Thu, Apr 23rd, 2015
Exchange Rate: A Nominal Depreciation, but not a Real one
The nominal rupee-dollar exchange rate plays an important role in international trade. When the rupee depreciates sharply against the dollar, imports become expensive. When it appreciates too much, exports suffer. Ideally, the exchange rate should move within a narrow range. The year 2014-15 was exactly like that: more stable than 2013, with the Rs/$ exchange rate depreciating by just 3.5% (Pic 1). One would think that it was a perfect year. Unfortunately, no. The exchange rate, it seems, is never quite right. Economists are now worried about a real appreciation of the rupee. What does that mean?
Pic 1 The Nominal Rs/$ Exchange Rate
The prefix “real” refers to prices. The real exchange rate is the nominal exchange rate adjusted for price differences between countries. It is calculated as Nominal exchange rate x (Foreign Price/Domestic Price). While the nominal Rs/$ exchange rate measures the number of rupees equivalent to a US dollar; the real exchange rate compares the purchasing power of the two currencies.
Table 1 shows the computation of real exchange rate between 2 currencies (US $ and Indian Rupee) for a single product. Consider a T-shirt, priced at Rs.120 in India. Suppose an identical T-shirt is priced at $2 in the US. At a nominal exchange rate of Rs.65/$, the real exchange rate is 1.08. This means that the purchasing power of the rupee is about 8% more than the US dollar; or, the cost of this item is 8% lower in India. Let us see how this relationship affects the trade account.
If an Indian exporter purchased a T-shirt at Rs.120, or a dollar cost of $1.85, and sold it at $2, he can earn a profit of 15 cents per T-shirt, a neat 8% on investment (Row 1 of the table). The implication: when domestic costs are relatively lower, exporters can capture this cost advantage as profits.
Table 1: How Real Exchange Rates Impact Export Competitiveness
Suppose the nominal exchange rate remains constant at Rs.65 per dollar, but domestic prices go up, so that the T-shirt now costs Rs.125 (Row 2 of Table1). The real exchange rate drops to 1.04, because the Indian product has lost some cost advantage. At the new cost of $1.92, profit per T-shirt drops to 7.7 cents. Note that the nominal exchange rate has not changed, but rising domestic prices have made exports less price competitive. This is known as an appreciation of the real exchange rate, or simply, a real appreciation in the exchange rate.
On the other hand, if the cost of the T-shirt falls to Rs.115 due to declining domestic prices, it is known as a real depreciation. Export profit will rise due to a gain in price competitiveness (Row 3).
The key takeaway is that export competitiveness depends on the nominal exchange rate as well as on the relative prices between India and other countries. A country experiencing higher inflation can remain competitive only if its nominal exchange rate depreciates sufficiently to compensate for the higher domestic costs. In the above example, a fall in the nominal Rs/$ rate to 67 could significantly set-off the adverse impact of a rise in domestic prices (Row 4). And a rise in the nominal Rs/$ rate, on top of rising domestic prices, would be a double whammy for export competitiveness (Row5).
Let’s put this example in the context of India’s current situation. Table 1 is about one hypothetical product, and the Rs/$ rate. But in the real world, India exports a basket of goods and services to several countries with different currencies and price levels. So a multi-currency index called the Real Effective Exchange Rate (REER) is commonly used to measure export competitiveness. REER is the weighted average of several bilateral exchange rates, each adjusted for price differentials between India and the countries included in the index. REER data is published by the Reserve Bank of India.
Picture 2 shows the trade-weighted 36-country REER. Note how the REER depreciated in 2013, when the nominal Rs/$ rate fell steeply. But since April 2014, it has appreciated, and since the start of 2015, it has appreciated very steeply.
Pic 2 The 36-country trade-weighted REER
Two factors are responsible for the REER appreciation. First, inflation in India is at 5%-6%, but inflation in many advanced and developing countries is near zero or even negative. As a result India’s cost advantage is at risk of reducing. Second, Central banks round the world have eased monetary policy, partly to beat deflationary forces, but largely in the hope of stimulating exports via a depreciating currency. The Euro and the Yen, in particular, have followed this path; in nominal terms, the rupee appreciated nearly 19% against the Euro, and 12% against the Yen in 2014-15. The outcome of both these forces is that the rupee is fast losing its price competitiveness.
Meanwhile, India is expected to end 2014-15 with more than $70 billion of foreign capital inflows, which have exerted a strong upward pressure on the nominal Rs/$ rate. If RBI had not intervened to purchase $ 49 billion in this period, the rupee may have actually appreciated against the dollar.
To sum up the situation: the rupee has experienced a real appreciation, which has already hurt export competitiveness. RBI intervention has ensured that there is no nominal appreciation of the Rs/$ exchange rate. In terms of Table 1, RBI’s actions have kept India in the relatively better row 4 scenario. If not, it would have fallen into the situation described in row 5!
 The real exchange rate is an index with no units
 RBI publishes a 6-country and a 36-country REER; each as a trade-weighted and an export-weighted index. The 36-country REER has 2004-05 as its base year, and uses consumer price inflation indices.
 Due to the way REER is computed, a decline in the numerical value of the REER index is depreciation, or an improvement in competitiveness. An increase is an appreciation, which implies a loss of price competitiveness. This is the opposite of the way we explained real exchange rate depreciation and appreciation. Exchange rate terms can be very confusing!
 Foreign Direct Investment plus portfolio investment. Data from RBI, for April 2014 to February 2015
 Period refers to April 2014-February 2015