The indices of Nominal Effective Exchange Rate (NEER) and Real
Effective Exchange Rate (REER) are used as indicators of external competitiveness.
NEER is the weighted average of bilateral nominal exchange rates of the home
currency in terms of foreign currencies. Conceptually, the REER, defined as
a weighted average of nominal exchange rates adjusted for relative price differential
between the domestic and foreign countries, relates to the purchasing power
parity (PPP) hypothesis.
The Reserve Bank of India (RBI) has been constructing five-country
and thirty six-country indices of NEER and REER as part of its communication
policy and to aid researchers and analysts. Theses indices are published in
the Bank’s monthly Bulletin. Three major developments as set out in the following
paragraphs have necessitated a review of the existing indices.
First, introduction of the Euro (notes and coins) with effect
from January 1, 2002 necessitated the need to replace the existing national
currencies of the Euro zone by the common currency for the members, which formed
part of RBI’s 5-country and 36-country REER/NEER indices. The European Commission
(Eurostat) introduced a harmonised index of consumer prices (HICP) for the member
countries, which entailed individual consumer price indices to be replaced by
HICP in the construction of the REER. Second, there has been a significant shift
in India’s trade relations across countries/regions, mainly towards developing
and emerging economies during the last decade, requiring a change in the currency
basket and the weights assigned to India’s trading partners included in the
REER. Third, the base year of the Wholesale Price Index of India (WPI), was
changed to 1993-94, necessitating a change in the base year for 36-country REER
and NEER indices.
Against the above backdrop, the Reserve Bank has now decided
to replace its existing 5-country indices with new six-currency indices of NEER/REER.
The thirty six-country indices have also been revised and replaced with new
36-currency indices of NEER/REER. In this regard, the RBI Press Release dated
November 4, 2005 had set out the broad outline of the revision of the REER/NEER
indices. As indicated in the Press Release, this is a detailed article elaborating
upon the methodology adopted in the construction of the new series and the conceptual
issues involved such as the coverage, the base year, prices and weights that
are chosen and the rationale there-in. The time series data on the new 6-currency
and 36-currency indices along with their broad trends have also been examined.
I. THE METHODOLOGY
The NEER is the weighted geometric average of the bilateral
nominal exchange rates of the home currency in terms of foreign currencies.
Specifically,

The REER is the weighted average of NEER adjusted by the ratio of domestic
price to foreign prices. Specifically,
Where e : Exchange rate of Indian rupee against a numeraire,
i.e., the IMF’s Special Drawing Rights (SDRs) in indexed form,
* Prepared jointly in the Division of International Finance, Department
of Economic Analysis and Policy and the Department of External Investments and
Operations, Reserve Bank of India.

As set out in the methodology, the REER has four parameters/variables pertaining
to country/currency coverage (n), relative prices (P/Pi), weights (wi) and exchange
rates (e/ei). The revision of REER relating to the above parameters/variables
is as follows.
II. COVERAGE
The new six-currency indices represent the US, the Eurozone
(comprising of 12 countries), UK, Japan, China and Hong Kong SAR. Two currencies
in the existing five-country series, viz., French franc and Deutsche
mark have been replaced by the Euro in the new indices. Two new currencies have
been included in the new indices, both being Asian - the Chinese yuan and the
Hong Kong Dollar.
The rapid growth in India’s foreign trade with China and Hong Kong in the recent
years has been the underlying factor for including these two countries in the
new six-currency REER. China and Hong Kong SAR together accounted for around
9 per cent of India’s foreign trade in 2004-05. China’s share in India’s foreign
trade has surged from 0.2 per cent in 1991-92 to 6.1 per cent in 2004-05. The
increase in India’s trade with China has been more pronounced in the last four
years. The inclusion of China and Hong Kong SAR reflects an increasing recognition
of the Indian economy’s rapidly growing integration with the developing and
emerging Asian economies. The six countries/regions, represented by the six
currencies, together accounted for around 40 per cent of India’s total foreign
trade in 2004-05 as compared with a lower coverage of around 22 per cent of
India’s total foreign trade in the case of the existing five-country index.
The coverage has also been revised for the 36-country
REER/NEER indices. The old indices comprised 36 countries including five members
of the Euro Area1 . With an objective to broad base the REER/NEER
and also to highlight India’s changing trade pattern, countries have been chosen
in the new series based on three broad criteria: (i) the share in India’s exports
and trade, (ii) regional representation and (iii) the regular availability of
data on exchange rates and prices on a monthly basis. The new countries included
in the revised series are Hong Kong SAR, Denmark, Iran, Kuwait, Qatar, Russia,
South Africa, Sweden and United Arab Emirates (Annex). Besides, with the inclusion
of the Euro zone, the new 36-currency indices include all the twelve countries
that have Euro as common currency. Thus, the revised 36-currency REER indices
effectively represent 47 countries. The revised thirty-six countries/regions,
represented by the thirty-six currencies, together accounted for, on an average,
77 per cent and 89 per cent of India’s total foreign trade and exports respectively
during 2002-03 to 2004-05 as against a lower coverage of around 61 per cent
and 66 per cent of India’s total foreign trade and exports, respectively in
the existing indices.
III. PRICES
In line with the existing practice, the revised indices (both
6-currency and 36-currency) use the wholesale price index (WPI) as a proxy for
Indian prices and the consumer price index (CPI) as a proxy for foreign partner
countries. While CPI is more representative of the cost/ inflationary conditions
in the markets to which most of India’s exports are directed, WPI reflects the
producer costs. The weekly wholesale price index (WPI) for all commodities is
used as an index of inflation for India in calculating six-currency REER/NEER
indices. While the 6-currency index updates the WPI data every week, it is updated
monthly for the 36-currency index. China provides year-on-year monthly CPI growth
rates, which have been converted into indices by taking 1993-94 as the base
year.
Unlike in the case of the 6-currency index, the CPI data are
not readily available for few of our trading partners, which form part of the
36-currency index. Hence,
1 The Euro area was representative of five countries namely Belgium, France,
Germany, Italy and Netherlands.
suitable alternatives have been used. WPI is used as a proxy
for prices for Australia since the CPI data are available on a quarterly basis.
CPI data are not readily available for United Arab Emirates (UAE), which remains
an important trading partner for India and for Quatar. Hence, CPI for the Middle
East region as given in the International Financial Statistics (IFS) of IMF
is used as a proxy for prices for these countries.
IV. EXCHANGE RATE
The Special Drawing Right (SDR) has been chosen as the numeraire
currency in the construction of REER/ NEER indices since the exchange value
of the SDR is determined by a weighted average of a basket of currencies, which
would offset fluctuations in individual currencies. Moreover, from a statistical
perspective, the choice of SDR as numeraire facilitates inclusion of the US,
which is a major trading partner of India. The exchange rate of a currency is
expressed as the number of units of numaraire (SDRs) per ith currency. A rise
in ‘e’ or ‘e/ei,’ thus represents an appreciation of rupee relative to the currency
i and vice versa, where e represents exchange rate of Indian rupee against the
numeraire, SDR in indexed form and ei represents exchange rate of foreign currency
‘i’ against the numeraire (SDRs) in indexed form.
V. BASE YEAR
The monthly average of the REER and NEER for the base year
is benchmarked to the level of 100. As against the practice of having three
base years in the case of existing five-country indices, viz., 1991-92,
1993-94 and 2003-04, the last being a moving base updated every year to facilitate
comparison with a more recent period, the new six-currency indices will have
two base years, 1993-94 as fixed base and 2003-04 as a moving base, which would
change every year as at present. As regards, the broad-based indices, the old
36-country indices were constructed with 1985 as the base period. The year 1993-94
is chosen as the base year for the revised 36-currency REER/NEER series in line
with the WPI base year. In this connection, it may be mentioned that though
the choice of the base year affects the level of REER/NEER for rest of the time
period, the indices being geometric series, the percentage difference between
any two periods remains same, whatever be the base year.
The choice of the base year 1993-94 is attributable to the
significant changes in the macroeconomic environment due to structural reforms
introduced in the wake of balance of payments crisis in 1990-91. India adopted
a market determined exchange rate regime since April 1993. This is also supported
by generally stable macroeconomic and external sector performance during that
year.
VI. WEIGHTS
The existing five-country indices use fixed trade weights,
which are based on the average of India’s bilateral trade (exports plus imports)
with the countries in the index during the five-year period from 1992-93 to
1996-97. The new six-currency indices use a 3-year moving average trade weights
in place of the present fixed trade weights with a view to suitably reflect
the dynamically changing pattern of India’s foreign trade with its major trading
partners. In order to calculate the weights, the geometric average of
India’s bilateral trade (exports plus imports) with countries/regions represented
by the six-currencies during the preceding three years has been taken. This
has then been normalised to arrive at the requisite weights (wi), which are
provided in Table 1.
As in case of the revised indices of the six-currency REER/NEER,
the thirty six-currency indices also use 3-year moving average normalized weights
(both exports and trade weights) in the construction of the new series, keeping
in view the rapid change in the destinations of India’s foreign trade in contrast
to the fixed weights used hitherto for constructing REER/NEER series. Table
2 gives the normalized weights for the 36-currencies for the year 2005-06, which
is based on trade shares of previous three years.
Table 1: Normalised weights for 6-currency REER/NEER Indices
The use of bilateral trade and export weights is based on the
restrictive assumption that from buyer’s point of view, the elasticity of substitution
between the sources of supply is zero. The domestic producers are the only competitors
of India’s export and competition from third country exporters do not exist.
An ideal measure of effective exchange rate should attempt to use estimated
measures of elasticities. However, data limitations normally favour the use
of bilateral weights. Secondly, including China and some other East Asian countries,
which are big competitors of India in the international market, in the revised
currency basket has taken account of third country competition in a limited
way.
VII. DATA SOURCES
For computation of 6-currency indices, the daily morning eastern
market exchange rates of five currencies, except euro, are crossed with RBI
reference rate for the US dollar. In the case of Euro, RBI’s reference rate
is taken into account. The CPI data are taken from online information system
like Bloomberg as soon as these are announced by them. Later, these CPI data
are substituted, wherever possible, by the price indices available from the
International Financial Statistics (IFS), International Monetary Fund, which
comes with a time lag.
The basic source for data on monthly exchange rates and prices
for 36 currencies is the IFS of the International Monetary Fund2 .
With the IFS providing data on exchange rate and prices with a lag of at least
three months, the 36-currency monthly indices have also been computed with a
lag of three months. Data on India’s trade with these 36 countries/regions has
been taken from Directorate General of Commercial Intelligence and Statistics
(DGCI&S) and Direction of Trade Statistics of the International Monetary
Fund.
VIII. THE REVISED REER/NEER SERIES
Based on the above methodology, the revised 6 currency (trade
weighted) and 36-currency (both trade and export weighted) REER/NEER series
have been computed. It may be noted that there is a high degree of correlation
between the new 6-currency indices of NEER/ REER and the 5-country indices (Chart
1). The revised


36 currency REER/NEER series also provide a better reflection
of India’s trade competitiveness (Chart 2 & 3). Despite the appreciating
trend witnessed in the recent months in the REER Trade indices, both the six-currency
and the 36-currency revised REER Trade indices have remained around the benchmark
over long horizon during the sample period 1993-94 to 2005-06 (so far).
Table 3: Indices of Real Effective Exchange Rate (REER) and Nominal
Effective Exchange Rate (NEER) of the Indian Rupee (6-Currency Trade Based Weights)