RBI Governor Says Indian Rupee is Undervalued Despite Depreciation, Highlighting Strong Macroeconomic Fundamentals and External Sector Resiliencev

Recent Developments:

• RBI Governor Sanjay Malhotra stated that the Indian Rupee is undervalued in both Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) terms despite depreciating by nearly 5.8% against the US Dollar during 2026.
• The RBI maintained that the recent weakness of the rupee primarily reflects global financial headwinds rather than deterioration in India's domestic macroeconomic fundamentals.
• RBI data showed that the 40-currency REER recovered from 89.08 in May 2026 to 91.26 in June 2026, although it remained below the equilibrium benchmark of 100, indicating an undervalued currency.

Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER):

Nominal Effective Exchange Rate (NEER):

• NEER is a trade-weighted average index measuring the nominal (face value) strength of the Indian Rupee against a basket of currencies of India's major trading partners.
• NEER reflects overall movements in the rupee rather than changes against a single foreign currency.
• The RBI publishes NEER using two trade-weighted baskets:
• 6-Currency Basket: US Dollar, Euro, Chinese Yuan, British Pound, Japanese Yen, Hong Kong Dollar.
• 40-Currency Basket: Covers around 88% of India's merchandise trade, providing a broader measure of the rupee's external value.
• The base year for the index is 2015–16 = 100.
• An increase in the NEER index indicates appreciation of the rupee, while a decline indicates depreciation.
• Limitation: NEER does not adjust for inflation differentials between countries and therefore cannot accurately measure international competitiveness.

Real Effective Exchange Rate (REER):

• REER is the inflation-adjusted version of NEER, measuring the value of the rupee after accounting for inflation differences between India and its trading partners.
• REER is considered a more reliable indicator of external competitiveness, currency valuation and trade performance.
• The RBI currently compiles REER using the Consumer Price Index (CPI) for inflation adjustment.
• Economists widely use REER as a proxy for assessing whether a currency is aligned with its Purchasing Power Parity (PPP).

Interpretation of REER:

• REER above 100: Indicates the currency is overvalued, making exports relatively expensive and imports relatively cheaper.
• REER below 100: Indicates the currency is undervalued, improving export competitiveness while making imports relatively costlier.

Limitations of REER:

• REER measures only price competitiveness and ignores non-price competitiveness, such as product quality, innovation, logistics efficiency, ease of doing business and technological capability.
• REER primarily reflects merchandise trade and does not adequately capture the growing importance of India's services exports.
• REER should therefore be interpreted along with other macroeconomic indicators rather than in isolation.

Exchange Rate Regime in India:

Managed Floating Exchange Rate System:

• Since March 1993, India has followed a market-determined managed floating exchange rate regime.
• The exchange rate is largely determined by market demand and supply.
• The RBI intervenes only to reduce excessive volatility and maintain orderly conditions in the foreign exchange market.
• The RBI does not target any fixed exchange rate level, but seeks to prevent disruptive fluctuations.

Importance of Exchange Rate:

• Influences exports and imports.
• Affects capital flows and foreign investment.
• Determines inflation, especially imported inflation.
• Impacts external debt servicing.
• Influences foreign exchange reserves, current account balance and overall macroeconomic stability.

Why Does the RBI Consider the Rupee Undervalued?

Shift from Overvaluation to Undervaluation:

• The rupee depreciated from around ₹84.4 per US Dollar (November 2024) to nearly ₹95.5 (May 2026).
• During the same period:
• NEER declined from 91.68 to 77.19.
• REER declined from 108.03 to 89.08, before improving to 91.26 in June 2026.
• The movement of REER below 100 indicates that the rupee has shifted from being overvalued to undervalued.

Strong Macroeconomic Fundamentals:

• India's GDP growth remains above 6%.
• Inflation has moderated.
• The external sector remains stable.
• Foreign exchange reserves remain sufficient to finance more than eleven months of imports.
• These indicators suggest that recent currency depreciation does not reflect deterioration in India's economic fundamentals.

Global External Headwinds:

• Higher crude oil prices increased India's import bill.
• A stronger US Dollar exerted pressure on emerging market currencies.
• Geopolitical tensions increased global risk aversion.
• Foreign Portfolio Investor (FPI) outflows increased demand for dollars, putting temporary downward pressure on the rupee.

REER-Based Assessment:

• RBI considers the rupee to be trading below its estimated equilibrium level based on REER, implying that the depreciation has exceeded what macroeconomic fundamentals would ordinarily justify.

Impact of an Undervalued Rupee on India's Economy:

Potential Benefits:

• Improves export competitiveness by making Indian goods cheaper in international markets.
• Encourages domestic manufacturing by making imported products relatively expensive.
• Supports the Make in India initiative.
• Can reduce the trade deficit if export growth exceeds import growth.
• Promotes higher employment in export-oriented industries.

Associated Risks:

• Raises the cost of crude oil, fertilizers, electronics, machinery and other imports.
• Increases imported inflation, particularly through higher fuel prices.
• Raises production costs for industries dependent on imported raw materials.
• Increases the repayment burden of External Commercial Borrowings (ECBs).
• May widen the Current Account Deficit (CAD) during periods of elevated commodity prices.

Need for Structural Competitiveness:

• Sustainable export growth requires improvements in:
• Productivity, logistics efficiency, infrastructure, technology adoption, manufacturing quality.
• Exchange rate competitiveness alone cannot ensure long-term export success.

Related UPSC Concepts:

Purchasing Power Parity (PPP):

• PPP states that identical goods should cost the same across countries after adjusting for exchange rates.
• Persistent deviations between REER and PPP may indicate currency overvaluation or undervaluation.

Current Account Deficit (CAD):

• CAD arises when the value of imports exceeds exports of goods and services.
• A weaker rupee can reduce CAD if exports rise sufficiently, but higher oil imports may offset this benefit.

Foreign Exchange Reserves:

• Managed by the RBI.
• Used to:
• Maintain confidence in the currency.
• Meet external payment obligations.
• Stabilise exchange rate volatility.
• Support financial stability.

Foreign Portfolio Investment (FPI):

• Sudden FPI outflows increase demand for foreign currency and often lead to depreciation of the domestic currency.

Conclusion:

• Short-term exchange rate fluctuations are an inherent feature of an open economy integrated with global financial markets.
• India's strong macroeconomic fundamentals provide a durable foundation for long-term currency stability.
• Maintaining a market-determined exchange rate regime, strengthening manufacturing competitiveness, diversifying exports, deepening financial markets, improving energy security and sustaining macroeconomic stability will remain critical for enhancing the long-term resilience of the Indian rupee.

Value Addition for UPSC:

Quick Revision Facts:

• Exchange Rate Regime: Market-determined Managed Floating Exchange Rate System (since March 1993).
• NEER: Trade-weighted nominal exchange rate index.
• REER: Inflation-adjusted trade-weighted exchange rate index.
• Base Year: 2015–16 = 100.
• REER > 100: Currency Overvalued.
• REER < 100: Currency Undervalued.
• RBI Inflation Measure for REER: Consumer Price Index (CPI).

REER is a better indicator of external competitiveness than NEER because it incorporates inflation differentials