Effective Exchange Rate, Nominal Effective Exchange Rate (NEER) vs Real Effective Exchange Rate (REER), Overvaluation vs Undervaluation of Rupee

 

EFFECTIVE EXCHANGE RATE (EER):

• Effective Exchange Rate (EER) is an index that describes the relative strength of a currency relative to a basket of other currencies. 
• EER is an indicator of international Trade competitiveness.  
• EER can be either Real Effective Exchange Rate (REER) or Nominal Effective Exchange Rate (NEER).
•  Base year for calculating NEER and REER is shifted from 2004-05 to 2015-16.
• Both NEER and REER are calculated by Reserve Bank of India.

Nominal Exchange Rate (NER):

• Nominal Exchange Rate (NER) is the rate at which one currency will be exchanged for another foreign currency. 

• It is nothing but Exchange Rate.

Nominal Effective Exchange Rate (NEER):

• Nominal Effective Exchange Rate (NEER) is the unadjusted weighted average value of a country's currency relative to basket of currencies. 
• The weights of currencies are determined by weightage of trade done by the country in that currency, as measured by the Balance of Trade. 
• Nominal Effective Exchange Rate (NEER) focuses on the exchange of basket of currency.

Real Exchange Rate (RER) –

Real Exchange Rate (RER) is the value of currency wrt any foreign currency adjusted for the effects of inflation.

Real Effective Exchange Rate (RER) –

• Real Effective Exchange Rate (REER) is the weighted average of a country's currency relative to an index or basket of currencies adjusted for the effects of inflation. 
• Inflation component is measured in terms of CPI 
• The weights of currencies are determined by weightage of trade done by the country in that currency ,as measured by the Balance of Trade. 
• In India, Reserve Bank of India (RBI) compiles REER indices. 
• REER publishes two indices ie first one is based on six country’s trade-based weights and the second on 40-currencies’ export and trade-based weights. 
• The base year for calculating REER is taken as 100 and currently the base year is 2015-2016.

NEER vs REER: 

• Nominal Effective Exchange Rate (NEER) focuses on the exchange of currency while Real Effective Exchange Rate (REER) focuses on the exchange of goods and services.
• Increase in Real Effective Exchange Rate (REER) signifies appreciation of the Rupee and REER of more than 100 indicates that the rupee is overvalued.

 Overvaluation of the Rupee:

• Overvaluation of the rupee means that its price in terms of foreign currencies is too high ie appreciated.  
• Overvaluation of the Rupee makes our exports costly and our imports cheaper.

Undervaluation of the Rupee:

• Undervaluation of the rupee means its price in terms of foreign currencies is too low ie depreciated.
• Undervaluation of the Rupee is in favor of exports and against imports.

Analysis of REER and its correlation to NEER and Trade

As per RBI methodology, Exchange rate of Indian INR wrt $ is :

If 1 $=80 Rs ,then RBI calculates it as 1 INR =1/80 $ ie .0125 $/INR.

                      REER = NEER *Domestic Price/Foreign price

REER of INR vs U.S. $ = (Indian prices / US Prices in $)*Exchange rate of the INR vs. US $ * 100

*****Exchange Rate is as per RBI methodology ie 1 INR =1/80 $ ie .0125 $/INR and not 1 $=80 INR.

SIGNIFICANCE OF REER:

• REER focuses on the exchange of goods and services. 
• Increase in REER exchange rate means inflation is increasing.
• If a countries real exchange rate is rising it means its goods are becoming more expensive  relative to its competitors.

IMPACT OF CHANGES IN NEER UPON REER:

If prices in India and US remain constant and there is only change in NEER:

Assuming 1 INR =1/80 $ ie .0125 $/INR as basis for all calculations:

1.If INR appreciates then 1$=50 Rs ie .02 $/INR,

•                                                   then NEER will appreciate 
•                                                   and hence REER will also appreciate and 
•                                                    it will be non Trade-competitive .

2. If INR depreciates then 1$=100 Rs ie .001 $/INR,

•                                                then NEER will depreciate 
•                                                and REER will also depreciate 
•                                                and it will be Trade - competitive.

Analysis:

Assuming Exchange rate to remain constant,

1.If prices in the two countries are the same, then the REER is 100.

2. If Indian domestic prices are higher than US  prices, then REER > 100.

3.If U.S. prices are higher than Indian prices, the REER < 100.

If the REER > 100:

• Domestic prices are relatively high and hence domestic products are non-Trade competitive. 
• Domestic currency is overvalued. 
• In this case there is more imports in comparison to Exports, leading to widening of the Current Account Deficit (CAD).

If the REER < 100: 

• Domestic prices are relatively low and hence domestic products are trade competitive. 
• Domestic currency is Under-valued.
• In this case there is more exports in comparison to imports, leading to lowering of the Current Account Deficit (CAD).

Conclusively REER is:

•                                             Directly proportional to Domestic Prices 
•                                             Inversely proportional to Foreign prices 
•                                             Inversely proportional to Trade competitiveness.

Dollarisation vs De-Dollarisation, Hard currency /Safe-Haven Currency / Strong Currency, SOFT CURRENCIES

 

DOLLARIZATION: 

• An Economic situation in when citizens of a country use foreign currency in parallel to or instead of the domestic currency. 
• Foreign currency in Dollarization does not mean usage of  U.S dollar only but the use of any foreign   currency.
• Zimbabwe adopted dollarization after the collapse of the Zimbabwean dollar.

Benefits of Dollarization:

• Stable (foreign) Currency will attract investment and growth.
•  As the foreign currency can be earned only through exports and foreign capital inflows, exports would be promoted and conditions for capital inflows would be eased. 
• There is no possibility of monetization of deficit and so there is control on wasteful expenditure.

Negatives of Dollarization:

•          Central banks will loose control on monetary policy and can't influence the money supply 
•      Central banks can't devalue currency to promote exports

DE-DOLLARIZATION:

•      Reduction in the dependency upon Dollar as a reserve currency by nations, medium of exchange,  or basis for international trade
•      De-dollarization is in Favour of other currencies or alternative systems, like regional and national currencies, or even digital currencies like cryptocurrencies.
•    Russia-Ukraine war and call of BRICS for an alternative currency have given a voice for de-dolallarisation.
•      US Pres in his opening remarks has also warned BRICS for this.  

      Hard currency /Safe-Haven Currency / Strong Currency: 

• Globally traded currency issued by developed countries.
• These Currencies remain stable 
• These currencies draw power from the political & Economic stability of the country.
• Theses currencies are held by nations for trade purposes.

     SOFT CURRENCIES:

• Currencies whose value fluctuates in the Exchange rate markets.
• Fluctuation is on account of Country's political and economic instability.
• Countries avoid holding these currencies for trade purposes.
• Developing countries usually hold these currencies.

EXCHANGE RATE REGIME, FIXED EXCHANGE RATE /PEGGED FLOAT, FLOATING / FLEXIBLE EXCHANGE RATE, MANAGED EXCHANGE RATE, EXCHANGE RATE SYSTEM IN INDIA

EXCHANGE RATE REGIME: 

• An Exchange-Rate Regime is the manner in which an authority manages the Exchange Rate of its domestic currency in relation to other currencies in the foreign exchange market.
• Exchange-Rate Regime is closely related to Monetary Policy and both affects each other.

There are three main types of Exchange rate regimes:

●        Floating / Flexible Exchange Rate

●        Fixed Exchange Rate

●        Managed Exchange Rate 

FIXED EXCHANGE RATE /PEGGED FLOAT:

In Fixed Exchange Rate regime:

• Currency's value remains fix 
• Currency does not respond to Foreign-Exchange market fluctuations.
• The regime helps control inflation, and a stable environment for facilitating international trade. 
• Qatar is following Fixed Exchange Rate regime where 1 USD=3.64 Qatari Rial.

FLOATING / FLEXIBLE EXCHANGE RATE:

In Floating Exchange Rate regime:

• Currency's value fluctuates in response to Foreign-Exchange market mechanisms
• Market Mechanisms include speculation and supply and demand forces in the market.
• Currency is known as floating currency. 

Most of the countries have adopted Floating exchange rates after the failure of the Gold Standard and the Bretton Woods agreement.

MANAGED EXCHANGE RATE:

• Halfway between Floating Exchange Rate regime and Fixed Exchange Rate regime system.

In normal times, Currency's value fluctuates in response to Foreign-Exchange market mechanisms

                                                                 but 

The government or the country’s central bank may occasionally intervene to direct the country’s currency value into a certain direction. 

DIRTY FLOAT EXCHANGE RATE:

• When a country / the central bank manipulates the exchange rate without following rules and regulations.

EXCHANGE RATE SYSTEM IN INDIA:

Since independence------------Fixed Exchange Rate in the form of sterling parity & world currencies.

                                ⇓

Post independence “Fixed and Adjustable” regime. Exchange Rate $1=Rs 1 (1947)

                     ⇓

Economic crises associated with Balance of Payment crisis since independence led to devaluation of INR to 1 $ =31 Rs by 1993.

                     ⇓

                              Post 1993, Floating Exchange Rate Regime

 

EXCHANGE RATE, Devaluation vs Depreciation, Revaluation vs Appreciation

 

EXCHANGE RATE: 

• An Exchange rate / Foreign-exchange rate / Forex rate between two currencies is the rate at which one currency will be exchanged for another foreign currency. 
• It is also regarded as the value of one country’s currency in terms of another currency.
• Movement in Exchange rates affect the trade between two countries.

It can be written as:

                                                    1 USD =86 INR 

                                                              OR

                                                    1 INR =1/86 USD

Movements of currency’s Exchange Rates:

Currency’s exchange rates are regulated either by:

                                                         Market 

                                                            or 

                                              The Government /Central Bank 

Depending upon the mode of regulation, it can be either Devaluation, Revaluation, Depreciation and Appreciation.

DEVALUATION: 

• is downward adjustment of the currency with relation to other foreign currency
• is regulated by deliberate action of the government.
• takes place in a pegged / Fixed exchange rate system
• is just opposite of Revaluation.

So, If the value 1 USD =86 INR goes to:

1 USD =90 INR by the order of Government, then the value of INR devalue wrt Dollar.

Depreciation:

• is the fall in the value of currency.
• takes place in a floating Exchange rate regime.
• is controlled by market factors like economic fundamentals, political stability and other related factors.
• is just opposite of Appreciation. 

So, If the value 1 USD =86 INR goes to:

1 USD =90 INR under the influence of market forces, then the value of INR depreciates  wrt Dollar.         

Devaluation vs Depreciation:

• The devaluation and depreciation similar in the sense of their after-effects as the value of currency is decreasing /falling.
• They only differ in the sense of how value of currency is falling if it is through market then it is depreciation and if it is by government order then devaluation.   
• Devaluation takes place in pegged / Fixed exchange rate system while depreciation takes place in floating Exchange rate regime.              

REVALUATION:

• is Upward adjustment of the currency with relation to other foreign currency
• is regulated by deliberate action of the government.
• takes place in a pegged / Fixed exchange rate system
• is just opposite of Devaluation.

So, If the value 1 USD =86 INR goes to:

1 USD =80 INR by the order of Government, then the value of INR Revalue wrt Dollar.

 Appreciation:  

• is the increase in the value of currency
• takes place in a floating Exchange rate regime.
• is controlled by market factors like economic fundamentals, political stability and other related factors.
• is just opposite of depreciation.

 So, If the value 1 USD =86 INR goes to:

1 USD =80 INR under the influence of market forces, then the value of INR appreciates  wrt Dollar. 

Revaluation vs Appreciation:

• The revaluation and appreciation similar in the sense of their after-effects as the value of currency is increasing.
• They only differ in the sense of how value of currency is increasing if it is through market then it is appreciation and if it is by government order then revaluation.   
• Revaluation takes place in pegged / Fixed exchange rate system while appreciation takes place in floating Exchange rate regime.   

Tax Buoyancy in Pre and Post GST Era, Challenges Of GST

 

Tax Collection Pre and Post GST Era:

• The aggregate state and central taxes exhibited a CAGR of 11.53 per cent in the pre-GST period (FY13 to FY17) while the nominal GDP grew at a CAGR of 11.54 per cent during this period. 
• CAGR of the aggregate state and central taxes was marginally less than the growth of GDP, the  Tax Buoyancy was just below one .
• The Post-GST period experienced  the shock of the Covid pandemic. During this period,the nominal GDP grew at a slower CAGR of 9.6 % (FY19 to FY23) while GST collections grew at a CAGR of 10.9 per cent, implying Tax Buoyancy of around 1.1.
• Improved tax collection efficiency has resulted in increased Tax Buoyancy and it is  the main arguments in favor of GST. 

Speaking at the GST Day 2023, The Finance Minister stated that Tax Buoyancy of states has improved to 1.22 post-GST rollout from 0.72 in the pre-GST period. 

FY 2018-19---11.77 Lac Crores

FY 2019-20---12.22 Lac Crores 

FY 2020-21---11.36 Lac Crores 

FY 2021-22---14.76 Lac Crores 

FY 2022-23---18 Lac Crores

FY 2023-24 ---20.18 Lac Crores

In the first year of GST implementation Collection was less than 1 lac crore per month while it has reached to approx. 1.7 Lac Crore in FY 24. 

Challenges Of GST:

• Manufacturing states lose revenue on a bigger scale as GST is destination-based taxation .
• Input Tax Credit has certain limitations as conditions for availing ITC are stringent, leading many taxpayers to lose out on ITC. 
• Taxpayers also lose their Input Tax Credit (ITC) due to non-reporting or mistakes by their suppliers.
• Wrongful or fake Input Tax Credit (ITC) claims has emerged as a major cause of concern for GST authorities.
• GST regime has the complex four tier Tax structure as ranging from 0%,5%,12%,18% and 28% along with lesser used GST Rates (.25 % and 3 %) apart from GST Compensation Cess .
• The GST regime has increased the compliance burden for taxpayers, especially for small and medium-sized enterprises (SMEs). 
• GST requires taxpayers to file returns every month, which is time-consuming and complicated for SMEs.
• Despite Technological advances and compliances, still there is Tax Evasion.
• Goods and Services Tax (GST) authorities are learnt to have detected evasion of around Rs 2.01 lakh crore in 2023-24 — an amount equal to almost 10% of the total GST collected during the financial year. It is found that the majority of the alleged tax evasion was in sectors such as online gaming and casinos (Rs 83,588 crore), co-insurance/re-insurance (Rs 16,305 crore) and secondment (Rs 1,064 crore).

Duty Draw Back vs Remission of Duties and Taxes on Exported Products (RoDTEP)

 

Definition of Imports Under GST:

• As per IGST (Integrated Goods and Services) Act, 2017, Import is defined as bringing commodities /services from overseas into India. 
• Under GST regime, all imports are considered as inter-state supplies.
• As imports are considered at par with inter-state supplies, IGST is applicable to all imported goods and services  along with custom duties as applicable.

Duty Draw Back vs Remission of Duties and Taxes on Exported Products (RoDTEP):

• In order to have competitive trade, Exports needs to be zero-rated exports.
• To ensure competitive trade, GOI has multiple schemes
• In Pre-GST era, Duty drawback scheme was in place to ensure refund of taxation by Governments.
• Post-GST, Remission of Duties and Taxes on Exported Products (RoDTEP) is the prominent scheme.

Duty Draw Back:

• The duty drawback scheme allows exporters to get a refund when the customs duties are paid on imported items .
• These imported items are used in manufacturing of the items that are to be exported as illustrated:

Remission of Duties and Taxes on Exported Products (RoDTEP):

• In GST regime, the export industry in India remains internationally competitive prices due to the claiming of Input Tax Credit (ITC).
• But there are certain taxes which are out of GST regime e.g. Taxes on fuel used in transportation, Mandi tax, taxes on electricity, petroleum products etc 
• These taxes which are not covered under GST are not refundable under Input Tax Credit (ITC) in case of exports even in the GST regime.
• The objective of Remission of Duties and Taxes on Exported Products (RoDTEP) is to neutralise the impact of these non -GST taxes upon exported goods by providing rebates on all these non-GST taxes which are not refunded through Input Tax Credit (ITC). 
• Remission of Duties and Taxes on Exported Products (RoDTEP) ensures that Exports remain zero-rated exports by reimbursing the non-GST taxes upon submitting a proof that the items have been exported.
• All exporters of goods - merchant exporters and manufacturer exporters and SEZ  are eligible to claim the benefits of the RoDTEP scheme as long as the country of origin is India. 

Goods and Services Tax Identification Number (GSTIN),REVENUE NEUTRAL RATE (RNR),GST Compensation Cess, Anti-Profiteering Rules

 

                    

Goods and Services Tax Identification Number (GSTIN):

• Goods and Services Tax Identification Number (GSTIN) is a 15 alphanumeric character, PAN based distinctive number, assigned to every GST registered entity.
• Goods and Services Tax Identification Number (GSTIN) provides unique identity to the business entity in the GST regime. 

REVENUE NEUTRAL RATE (RNR):  

• GST rate at which the amount of taxes collected by the government in pre-GST regime and the amount expected to be collected post- GST remains the same.
• In Pre-GST era, state governments were having various taxation powers while post GST states lose taxation powers.
• So, REVENUE NEUTRAL RATE (RNR) ensures that the states don’t loose their revenue in the wake of GST regime.

GST Compensation Cess :

• GST Compensation Cess is levied on inter- and intra-State supply of notified goods such as aerated drinks, coal, tobacco, automobiles.
• The objective of GST Compensation Cess  proceeds is to distribute the Cess proceed to loss-incurring States on the basis of a prescribed formula so as to compensate the loss making states. 
• GST Compensation Cess was introduced through the GST (Compensation to States) Act, 2017 for initial 5 years
  
  . 
• The tenure of GST Compensation Cess has been extended to 31 March ,2026.

Composition Levy:

• The composition levy is taxation imposed upon small , small, micro and informal units taxpayers whose turnover is up to Rs. 1.5 Cr ( Rs. 75 lakhs in case of few States).
• The objective of Composition Levy is to bring simplicity and to reduce the compliance cost for the small taxpayers.   
• Composition Levy is to be levied upon the turn over and it is optional. 
• Eligible person opting to pay tax under Composition scheme can pay tax at a prescribed percentage of his turnover every quarter, instead of paying tax at normal rate. 
• Entities opting for composition levy can do their business activities within the state as restricted to do Inter- state business.

Anti-Profiteering Rules : 

• As per Anti-profiteering rules, the suppliers of goods and services have necessarily pass on the benefit of any reduction in the rate of tax or the benefit of input tax credit to the recipients by way of commensurate reduction in prices.
• The willful action of not passing the benefits on account of change in the rates and Input Tax Credit (Understanding Economy from basics to an expert perspective from a Guide ,Teacher and Practitioner: INPUT TAX, Input Tax Credit) to the recipients is known as “Profiteering”.
• National Anti-profiteering Authority (NAA) was set up  as statutory body under Section 171 of the Central Goods and Services Tax Act ,2017 to deal with  Anti-profiteering rules
• The objective  of  NAA was to ensure the implementation of Anti-Profiteering Rules 
• After the end of the tenure of this body on dec 2022,all powers are vested in Competition Commission of India .