Explained: Rupee Turns Undervalued — REER 91.26, NEER at Record Low, RBI Governor's View

The statement: In an interview to a leading financial daily in late July 2026, the RBI Governor said the Indian rupee is "not overvalued" and could even be considered undervalued, assessed both in nominal terms and on the Real Effective Exchange Rate. He suggested that once conditions in West Asia stabilise, the rupee could appreciate, as has happened during comparable past episodes of shock-driven volatility.

Why it is unusual: Central bankers, as a rule, avoid publicly labelling their currency as overvalued or undervalued. Any such statement can be read by markets as a signal of an implicit target, invite speculative positioning, or attract the attention of trading partners who monitor currency valuation for trade-policy purposes. The RBI's long-standing formal position is that it does not target any level or band of the exchange rate and intervenes only to smooth excessive volatility.

What it signals: The remark serves two purposes. First, it pushes back against the reading that a falling rupee reflects deteriorating domestic fundamentals; the Governor located the cause in external conditions. Second, it implicitly reassures markets that the central bank does not see the current level as a disequilibrium requiring aggressive defence, even as it continues to smooth day-to-day movement.

Exchange rate: An exchange rate is the price of one currency in terms of another. In India it is conventionally quoted as the number of rupees per US dollar. A rise in this number (say from 84 to 96) means more rupees are needed to buy one dollar, i.e. the rupee has weakened.

Depreciation and appreciation: Depreciation is a market-driven fall in the value of a currency under a floating or managed-floating regime, caused by demand for foreign currency exceeding its supply. Appreciation is the reverse. These are outcomes of market forces, not policy announcements.

Devaluation and revaluation: Devaluation is a deliberate, official reduction in the value of a currency by the monetary authority under a fixed or pegged exchange rate regime. India devalued the rupee in 1966 and again in two steps in July 1991. Since the transition to a market-determined system in 1993, India's currency movements are described as depreciation or appreciation, not devaluation.

Why the distinction matters: Confusing the two is a common error. A student should note that under India's present arrangement the RBI can influence the rupee through intervention, but it does not "fix" or "announce" a rate.

India trades with many partners: India exports to and imports from the European Union, China, the UAE, Saudi Arabia, Singapore, Japan, Korea, Bangladesh, Nepal and dozens of other economies. The competitiveness of Indian goods in Germany depends on the rupee-euro rate; in Vietnam, on the rupee-dong rate. Judging the rupee only against the dollar therefore captures a fraction of the picture.

The dollar may itself be moving: If the US dollar strengthens against every currency in the world, the rupee will fall against the dollar even if it is unchanged or stronger against the euro, yen and yuan. The rupee's "weakness" in such a period is really dollar strength.

Hence the need for an index: To capture the rupee's value against many currencies at once, the RBI constructs an Effective Exchange Rate (EER) index — a weighted average of the rupee's bilateral exchange rates against the currencies of India's principal trading partners.

Definition: The NEER is an index of the weighted average of the bilateral exchange rates of the rupee against a basket of trading-partner currencies, with weights derived from those partners' shares in India's foreign trade. It is computed as a geometric weighted average, not a simple arithmetic mean.

How weights are assigned: The weight of each currency reflects the share of that country in India's total trade, exactly as the weight of each commodity in the Consumer Price Index reflects its share in the household consumption basket. The RBI uses time-varying weights derived from the geometric means of India's trade with each partner over the preceding three years, normalised to 100.

How to read it: The index is set at 100 for the base year. A rise in NEER indicates nominal appreciation of the rupee against the basket; a fall indicates nominal depreciation. In November 2024 the NEER stood at 91.68, meaning the rupee had already weakened about 8.3 per cent against its trading partners' currencies relative to the base year.

Its limitation: The NEER is purely nominal. It ignores what is happening to prices inside India relative to prices abroad — that is, it ignores inflation differentials, which determine the actual purchasing power and cost competitiveness of Indian goods.

Definition: The REER is the NEER adjusted for the inflation differential between India and its trading partners. Formally, it is the NEER multiplied by the ratio of the domestic price index to the weighted average of trading-partner price indices. The RBI uses CPI-based REER indices.

The core intuition: Suppose the rupee's nominal exchange rate does not move at all, but Indian prices rise 6 per cent in a year while prices in partner countries rise only 2 per cent. Indian goods have become 4 per cent more expensive for foreign buyers even though the exchange rate is unchanged. The REER rises to capture exactly this loss of competitiveness.

The mirror case: If a currency's nominal exchange rate falls by less than the domestic inflation rate over a period, the currency has in fact appreciated in "real" terms. This is precisely what happened to the rupee for much of the decade to 2024 — it fell steadily against the dollar in nominal terms, but not fast enough to offset India's higher inflation, so its REER kept climbing.

How to read the number: A REER above 100 means the currency is overvalued relative to the base year — exports become dearer, imports cheaper, and trade competitiveness declines. A REER below 100 indicates undervaluation — exports become cheaper for foreign buyers, imports dearer. A REER of exactly 100 corresponds to the currency's "fair" or base-year competitive value.

A caution on interpretation: "Fair value" here is defined only relative to a chosen base year, not against any absolute economic ideal. Rebasing the index shifts the benchmark, so cross-series comparisons must be handled carefully.

The 2021 revision: In an article published in its January 2021 Bulletin titled "Effective Exchange Rate Indices of the Indian Rupee", the RBI introduced an updated series with two innovations — the base year was shifted from 2004-05 to 2015-16, and the broad basket was expanded from 36 to 40 currencies.

Why 2015-16 was chosen as base: A suitable base year should approximate both internal and external balance. The RBI selected 2015-16 because that year recorded real GDP growth of 8.0 per cent, CPI inflation of 4.9 per cent and a current account deficit of only 1.1 per cent of GDP — a reasonably "normal" year on both counts.

Changes to the basket: Eight currencies were added — Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania and Ukraine — together accounting for 5.4 per cent of India's merchandise trade. Four were dropped — Argentina, Pakistan, the Philippines and Sweden — accounting for 1.4 per cent. Trading partners with extremely high and volatile inflation, such as Venezuela and Argentina, are excluded because their rapid nominal declines would destabilise the index.

Coverage: The 40-currency basket represents 88 per cent of India's total merchandise trade, compared with 84 per cent under the earlier 36-currency basket. The RBI also publishes a narrower 6-currency index for monetary analysis, and both trade-weighted and export-weighted versions of each.

The numeraire: Bilateral rates are expressed against the IMF's Special Drawing Right (SDR) as the numeraire, which allows consistent aggregation across currencies.

The weight structure: In the base year 2015-16 the largest trade-based weights were the Euro Area (11.4 per cent), China (10.0), the UAE (9.4), the United States (9.1) and Saudi Arabia (6.4). By 2020-21 China had moved to the top with 12.0 per cent, with the US and the Euro Area at 11.6 per cent each. Emerging market and developing economy currencies accounted for 58.3 per cent of the trade basket in 2015-16 — a marked shift from earlier decades.

Purchasing Power Parity: Effective exchange rates rest conceptually on the Purchasing Power Parity (PPP) hypothesis, articulated by Gustav Cassel after the First World War. In its absolute form, PPP holds that a basket of goods should cost the same everywhere once converted at prevailing exchange rates. In its relative form, the nominal exchange rate should adjust over time to offset inflation differentials. The REER is essentially a measure of how far reality deviates from relative PPP.

Inflation differentials and the exchange rate: Consistent with PPP, the RBI's own analysis finds NEER to be strongly negatively correlated with inflation differentials — higher domestic inflation relative to partners induces nominal depreciation. Since India adopted flexible inflation targeting, with a CPI target of 4 per cent within a band of plus or minus 2 percentage points, these differentials have narrowed and stabilised, which is favourable for external competitiveness.

The Balassa-Samuelson effect: Named after Bela Balassa and Paul Samuelson, this hypothesis holds that a fast-growing economy experiencing rising productivity in its tradable sector relative to trading partners will see its real exchange rate appreciate over time. The RBI's analysis finds a positive and statistically significant correlation between India's REER and its per capita income relative to major partners, indicating that part of the rupee's long-run real appreciation was a productivity phenomenon rather than a policy failure.

Effective Relative Price: The gap between REER and NEER is captured by the "effective relative price" — the weighted ratio of domestic to foreign prices. A widening divergence between the two indices is a direct signal of an adverse inflation differential.

The starting point: In November 2024 the rupee-dollar rate averaged about 84.4. The NEER stood at 91.68 and the REER at 108.03. Read together, the numbers said something counter-intuitive: the rupee had weakened 8.3 per cent nominally against its trade basket since 2015-16, yet was over 8 per cent overvalued in real terms. Contemporary reporting placed the November 2024 REER at the most overvalued level recorded since 2004.

The turning point: The REER remained above the 100 threshold until July 2025, then declined through the second half of 2025 as the rupee weakened faster and India's inflation ran below that of several trading partners.

The sharp phase: Through the first half of 2026 the decline steepened. By April 2026 the REER had fallen to roughly 90.96 — its lowest reading in over a decade — and by May 2026 to 89.08, with the NEER at a record low of 77.19.

The current position: In June 2026 both indices recovered slightly, to a REER of 91.26 and a NEER of 78.21. Even after this recovery, the REER implies an 8.7 per cent real weakening of the rupee against the base year, placing it firmly in undervalued territory and confirming the Governor's characterisation.

The symmetry: It is worth noting the neat arithmetic symmetry — the rupee has moved from being roughly 8 per cent overvalued to roughly 9 per cent undervalued in under two years, a swing of about 17 percentage points on the REER.

The energy channel: India imports the overwhelming majority of its crude oil requirement, and a large share of that transits the Strait of Hormuz. Disruption to shipping through this waterway during the West Asia conflict pushed Brent crude sharply higher, with the benchmark crossing $126 per barrel at the end of April 2026. A higher oil import bill directly raises dollar demand from oil marketing companies, weakening the rupee. A rule of thumb used by analysts is that a $10 per barrel rise in crude widens India's current account deficit by 40-50 basis points.

The trade channel: India's merchandise trade deficit widened to $30.43 billion in June 2026, from $19.10 billion a year earlier, as import growth in petroleum, electronics and precious metals outpaced export growth. A wider goods deficit means a structurally larger net demand for foreign exchange.

The capital account channel: Global risk aversion during periods of geopolitical stress typically triggers portfolio outflows from emerging markets into US assets. Foreign portfolio investors selling Indian equities and bonds convert rupees into dollars, adding to depreciation pressure.

The dollar and interest-rate channel: A firm dollar index and elevated US Treasury yields raise the relative attractiveness of dollar assets. When the interest rate differential narrows in the dollar's favour, capital flows respond accordingly.

The safe-haven and gold channel: Elevated gold and precious metal prices inflate India's import bill independently of oil, since gold is India's second-largest import category by value in stressed years.

The inflation differential channel: Paradoxically, part of the REER's decline is benign. India's CPI inflation ran unusually low through 2025 — for a stretch below 2 per cent — relative to trading partners. Lower relative inflation mechanically pulls the REER down and genuinely improves competitiveness, distinct from the shock-driven nominal fall.

The BIS broad index: In addition to the RBI's own series, the Bank for International Settlements (BIS) publishes Real Broad Effective Exchange Rate indices for more than sixty economies, using a wider group of trading partners and the year 2020 as base. These series are widely redistributed through the Federal Reserve Bank of St. Louis's FRED database.

India's trajectory: On this broad measure India's index peaked in November 2024 and has since fallen steeply, reaching the low nineties by mid-2026 — a decline of roughly 15 index points.

The comparison with China: In November 2024 the yuan's broad real index was materially below the rupee's, which made China's currency the more competitive of the two. By June 2026 the ordering had reversed: the rupee's index reads slightly below the yuan's.

What this implies: On this specific metric, the rupee is today not merely undervalued but marginally more price-competitive than the yuan. For a manufacturing sector competing directly with Chinese producers in third markets, this is a meaningful shift — though price is only one determinant of competitiveness alongside scale, logistics, credit cost and non-tariff barriers.

A methodological caution: The BIS index and the RBI index use different baskets, different base years and different partner sets. Their levels are not directly comparable; only the direction and relative movement should be read across the two series.

The Marshall-Lerner condition: A depreciation improves the trade balance only if the sum of the absolute values of the price elasticities of demand for exports and imports exceeds one. If demand is inelastic — as it largely is for India's crude oil imports — a weaker currency raises the import bill in rupee terms without reducing volumes.

Indian estimates: RBI analysis has placed the real exchange rate elasticity of India's exports in the range of 0.7 to 0.9 and of imports in the range of 0.3 to 0.5, though other studies have estimated the export elasticity higher, at 0.9 to 2.3. On the lower estimates the Marshall-Lerner condition is only marginally satisfied.

The J-curve effect: Even when the condition holds, the improvement is not immediate. Existing contracts are priced in advance and volumes take time to respond, so the trade balance typically worsens first and improves later — tracing a shape resembling the letter J.

The import-content problem: A large share of India's manufactured exports — electronics, engineering goods, petroleum products, gems and jewellery — embeds substantial imported inputs. A weaker rupee raises the cost of those inputs at the same time as it lowers the export price, muting the net competitiveness gain. This is the standard limitation of exchange-rate-driven competitiveness in global value chain production.

Non-price constraints: Where exports are constrained by tariffs, quality standards, logistics bottlenecks or demand weakness in destination markets, a cheaper currency cannot substitute for the missing structural conditions.

Imported inflation: A weaker rupee raises the domestic price of every imported good — crude oil, edible oils, fertilisers, electronics, machinery and coking coal. This is the principal macroeconomic cost. The transmission is visible in the data: retail inflation rose to 4.38 per cent in June 2026, with the transport component rebounding after months of deflation as the energy shock passed through to consumer prices.

External debt servicing: A weaker rupee raises the rupee cost of servicing External Commercial Borrowings and foreign currency convertible bonds for Indian corporates, compressing margins for firms that borrowed abroad without adequate hedging.

Fiscal and subsidy pressure: Higher rupee prices for imported fertilisers and fuel raise the subsidy bill or, if not absorbed, feed directly into retail prices.

Monetary policy constraint: Persistent depreciation limits the room for policy rate cuts, since easing can widen the interest differential and accelerate outflows. The June 2026 decision to hold the repo rate at 5.25 per cent with a neutral stance, alongside a raised inflation projection, reflects precisely this constraint.

Balance sheet and confidence effects: Sustained one-way depreciation can become self-reinforcing if it prompts importers to advance their hedging and exporters to delay repatriation of proceeds, both of which worsen the immediate demand-supply imbalance in the currency market.

The gainers: Against these costs, exporters of services and goods with low import content — information technology, business services, pharmaceuticals, textiles, agricultural commodities — gain, as do recipients of inward remittances, whose dollar receipts convert into more rupees.

India's stated regime: India's de jure (officially declared) exchange rate arrangement is floating. The rupee's rate is determined in the interbank market. The RBI's stated intervention objective is to curb excessive volatility, not to defend a level.

The IMF's de facto classification: The IMF classifies members' arrangements not by declaration but by observed behaviour, using data from its Article IV consultations. In 2023 it moved India from "floating" to a "stabilised arrangement", citing the frequency of RBI intervention. In November 2025, following an Article IV review, it reclassified the arrangement as a "crawl-like arrangement".

The technical definitions: Under the IMF's framework, a stabilised arrangement exists where the spot rate stays within a 2 per cent margin for six months or more; a crawl-like arrangement exists where the rate stays within a 2 per cent margin relative to a statistically identified trend for six months or more. Both fall within the "soft peg" family rather than "floating".

What the change signalled: The reclassification indicated that the rupee was being allowed to depreciate gradually along a discernible trend, with intervention limiting volatility around it, rather than being pinned within a narrow band. The RBI's Deputy Governor publicly characterised the label as a technical sub-classification within managed floating and cautioned against over-reading it.

The wider taxonomy: Students should be familiar with the IMF's ladder of arrangements — no separate legal tender, currency board, conventional peg, pegged within horizontal bands, crawling peg, crawl-like arrangement, stabilised arrangement, managed float with no predetermined path, and free float.

Spot market intervention: The RBI sells dollars from reserves when the rupee is under pressure and buys dollars when there are large inflows. It typically transacts through public sector banks. Reports indicate a sale of around $7 billion across onshore and offshore markets in late July 2026 as the rupee approached its record low.

Forward and swap operations: Beyond the spot market, the RBI operates in the forward market and through buy-sell and sell-buy swaps, which allow it to influence rupee liquidity and forward premia without immediately depleting spot reserves. Its outstanding net forward position is disclosed with a lag.

Non-deliverable forward market: A significant share of rupee trading occurs offshore in the Non-Deliverable Forward (NDF) market. The RBI has permitted Indian banks with IFSC banking units to participate in this market, which improves the transmission of policy across onshore and offshore prices.

Sterilisation: When the RBI buys dollars it injects rupees, which can be inflationary. To neutralise this it can conduct open market sales of government securities, vary the cash reserve ratio, or issue securities under the Market Stabilisation Scheme, introduced in 2004 specifically for sterilising capital inflows.

The impossible trinity: The Mundell-Fleming trilemma states that a country cannot simultaneously have a fixed exchange rate, free capital mobility and an independent monetary policy. India's compromise is a managed float with partial capital account convertibility — the current account is fully convertible under IMF Article VIII since 1994, while the capital account remains partially controlled, allowing the MPC to set rates for domestic objectives.

Reserves as the buffer: India's foreign exchange reserves comprise foreign currency assets, gold, Special Drawing Rights and the reserve tranche position in the IMF. They stood at $676.237 billion in mid-July 2026, having peaked at $728.494 billion in late February 2026, the fall reflecting both intervention and valuation effects on gold.

The June package: On 5 June 2026 the RBI announced a set of measures aimed at reinforcing the balance of payments without raising domestic interest rates.

FCNR(B) swap facility: Foreign Currency Non-Resident (Bank) accounts are term deposits that non-resident Indians hold with Indian banks denominated in foreign currency, so the depositor bears no exchange rate risk. Under the facility operationalised on 8 June 2026, an authorised dealer bank accepting a fresh three-to-five-year FCNR(B) deposit may sell those dollars to the RBI and receive rupees, reversing the transaction at the same exchange rate on maturity. Because the rate is fixed at both ends, the bank bears no currency risk — the RBI absorbs it. Since banks would otherwise pay a hedging cost of roughly 3.5 per cent a year, this allows them to offer materially higher deposit rates to non-resident depositors.

Deposit rate ceilings relaxed: The interest rate ceiling on fresh FCNR(B) deposits of three to five years was withdrawn with effect from 17 June 2026, and restrictions on Non-Resident External deposits of three years and above were relaxed, both up to 30 September 2026.

Debt market liberalisation: The universe of securities available under the Fully Accessible Route was expanded to include all new issuances of 15-, 30- and 40-year government securities. Separately, the government removed capital gains tax and interest income tax for foreign institutional investors in government securities, applied retrospectively from 1 April 2026.

Corporate borrowing and equity measures: A concessional foreign exchange swap facility was extended to incentivise External Commercial Borrowings by public sector undertakings, and investment limits for non-resident Indians in listed equity without SEBI registration were raised. The period for realisation of export proceeds in dollars was restored to nine months.

The result so far: The Governor stated that these measures had attracted close to $40 billion since June 2026, with banks mobilising about $32 billion — largely through FCNR(B) deposits — and overseas investors putting more than $7 billion into government securities.

The 2013 precedent: A comparable FCNR(B) swap window was operated during the 2013 taper tantrum, when banks raised roughly $26 billion in a few months, helping stabilise the rupee and rebuild reserves. The arithmetic in 2026 is tighter, because US yields are far higher than they were in 2013, narrowing the interest rate advantage India can offer.

The pegged era: From 1947 the rupee was pegged first to the pound sterling and later to a basket of currencies. A major devaluation was carried out in 1966 in the aftermath of drought, war and a balance of payments strain.

The 1991 turning point: Facing a severe external crisis, the government devalued the rupee in two steps on 1 and 3 July 1991, by a cumulative 18-19 per cent. This was accompanied by the pledging of gold reserves and the beginning of structural reform.

LERMS and unification: In March 1992 the Liberalised Exchange Rate Management System (LERMS) introduced a dual exchange rate, under which 40 per cent of export earnings were converted at the official rate and 60 per cent at the market rate. In March 1993 the two rates were unified, marking the shift to a market-determined exchange rate.

Current account convertibility: In August 1994 India accepted the obligations of Article VIII of the IMF Articles of Agreement, making the rupee fully convertible on the current account.

Capital account convertibility: Two committees chaired by S. S. Tarapore — in 1997 and again in 2006 — recommended a phased roadmap towards fuller capital account convertibility, conditional on fiscal consolidation, low inflation and a strong financial system. India has proceeded cautiously; the capital account remains partially open.

Episodes of stress: The rupee has faced recurring pressure episodes — the East Asian crisis of 1997-98, the global financial crisis of 2008, the taper tantrum of 2013, the global monetary tightening of 2022, and the geopolitical and energy shocks of 2024-26. A common pattern across them is a deteriorating trade account, portfolio outflows and heightened global risk aversion.

Internationalisation of the rupee: Alongside these developments, the RBI has permitted the settlement of international trade in rupees through Special Rupee Vostro Accounts, an incremental step towards reducing dependence on third-currency settlement, though volumes remain modest relative to total trade.

Sustain the distinction between smoothing volatility and defending a level, so that the exchange rate continues to act as a genuine shock absorber rather than accumulating a one-way bet against the central bank.

Prioritise the durability of capital inflows over their volume — deposit-based and long-tenor debt flows attracted by time-bound windows must eventually give way to foreign direct investment and stable long-term portfolio flows.

Plan for the maturity profile of the current inflows, since the FCNR(B) window closes in September 2026 while the underlying energy and geopolitical risks may persist well beyond it.

Reduce the structural energy vulnerability through accelerated deployment of renewables, expansion of strategic petroleum reserves, diversification of crude sourcing and progress on the National Green Hydrogen Mission and electric mobility.

Convert the present real undervaluation into durable export gains by addressing non-price constraints — logistics costs, port turnaround, customs facilitation, quality infrastructure and free trade agreement utilisation.

Deepen domestic value addition in export sectors so that a weaker rupee lowers final export prices rather than being offset by dearer imported inputs, in line with the objectives of the production-linked incentive framework.

Strengthen corporate hedging discipline, since unhedged external commercial borrowings transmit currency shocks directly into balance sheets and amplify systemic risk.

Continue the incremental internationalisation of the rupee through Special Rupee Vostro Accounts, local currency settlement arrangements and deeper onshore derivative markets, reducing dependence on third-currency settlement.

Improve the transparency and timeliness of intervention data, including forward positions, so that markets can distinguish valuation effects from actual intervention in the reserves numbers.

Preserve the credibility of flexible inflation targeting, because a low and stable inflation differential relative to trading partners is the only durable route to a competitive real exchange rate that does not depend on nominal shocks.