The Reserve Bank of India did not change the repo rate—5.5 per cent—for the second time in a row, despite inflation reaching a six-year low of 2.07 per cent. Governor Sanjay Malhotra attributed this decision to uncertainties surrounding tariffs and fresh GST reduction, sparking a debate—if inflation is so subdued, why hold back from adjusting the rate?
The answer extends beyond the dollar exchange rate. The rupee’s story is not just about its exchange rate with the United States, but about its Real Effective Exchange Rate (REER), and that is exactly where the story flips.
The REER, which examines the rupee against a basket of 40 trading-partner currencies adjusted for inflation, functions as a corrective lens. It is the sole indicator that demonstrates how the rupee-dollar exchange rate resembles a distorted funhouse mirror, exaggerating depreciation; it delves deeper into the actual cost of Indian goods on the global market.
Why the dollar isn’t the whole story
When media headlines highlight the rupee’s “weakening against the dollar”, it is easy to overlook that India engages in trade with numerous countries beyond the United States. The rupee’s true strength is determined by how it performs against the currencies of all its major trading partners. Economists quantify this through the rupee’s Effective Exchange Rate (EER), which functions as a weighted index, similar to how the Consumer Price Index (CPI) monitors the weighted average price of goods and services in a household basket.
The Reserve Bank of India constructs two versions of the Nominal Effective Exchange Rate (NEER): one against a basket of six key currencies—the dollar, euro, yuan, pound, yen, and Hong Kong dollar—and another against a broader basket of 40 currencies that collectively account for nearly 88 per cent of India’s trade. Both indices use 2015-2016 as a base year of 100. An index value exceeding 100 signals an appreciation, while a value below 100 indicates depreciation.
However, NEER only tells part of the story, as it does not consider inflation, and that is exactly where the Real Effective Exchange Rate (REER) becomes relevant. REER is simply NEER adjusted for inflation differentials between India and its trading partners. If the rupee depreciates against foreign currencies but inflation in India is higher than abroad, the rupee can actually appreciate in “real” terms. A REER above 100 denotes overvaluation, indicating that the rupee is more expensive compared to competitors, while a REER below 100 signals undervaluation.
This distinction has significant implications. An increasing REER suggests that Indian goods are becoming relatively more expensive globally, while imports look cheaper for India, leading to a gradual erosion of trade competitiveness. This is precisely why the November 2024 REER increase was such a red flag.
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The hidden story of the rupee
In November 2024, India’s REER reached a record high of 108.14. This indicated that our exports were about eight per cent pricier than they ideally should have been, not because factories suddenly became inefficient, but because of two main factors.
The first was inflation, with Indian prices climbing faster than those in the US, Europe, or East Asia, and the second was strong capital inflows. Foreign Direct Investment in India surged by 14 per cent year-on-year, reaching $81.04 billion in 2024-2025, driven by policies favourable to investors, a booming manufacturing sector, and a surging services industry. These inflows bolstered the nominal value of the rupee, preventing it from depreciating naturally.
The dual impact was severe. Inflation increased relative costs, while inflows kept the rupee artificially strong. The result was an overvalued currency, putting pressure on exporters and hindering competitiveness. By June 2025, the REER had corrected to 100.36, aligning more closely with its fair value and what might’ve seemed like a collapse on television was, in fact, a correction.
Why India looks worse than others
The optics, however, remain quite awkward. While the euro and yen have strengthened against the dollar in 2025, the rupee continues to depreciate. This disparity, however, is misleading. Europe and Japan were initially undervalued, with domestic inflation subsiding, allowing their currencies to appreciate. India, by contrast, started from an inflated position, characterised by higher domestic inflation. Hence, to restore balance, the rupee had to give more ground.
It is also important to note that the other emerging market currencies experienced a more pronounced depreciation against the dollar than the rupee in 2024, resulting in a relative appreciation effect. Therefore, even when the rupee appeared weak in headlines, it was relatively stronger, putting further pressure on Indian exporters.
The RBI’s proactive intervention in foreign exchange markets also played a key role. They sold a record $20.2 billion in November 2024 alone to prevent excessive depreciation, thereby maintaining the relative stability of the rupee compared to its peers.
This is exactly why focusing solely on the rupee-dollar exchange rate is deceiving. Against the global currency basket, the rupee is not in crisis; rather it is stepping away from a dangerous overvaluation.
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Repo rates, currencies, and the “impossible trinity”
The Reserve Bank’s decision in October exemplifies a strategic equilibrium. Although on paper, a rate cut might’ve looked tempting, the situation warranted caution. Inflation has been trending below four per cent since February, easing to a six-year low of 2.07 per cent in August, aided by lower food prices and a favourable base effect. Typically, such benign inflation would have ordinarily supported the argument for monetary easing. However, the RBI chose to resist.
The RBI Governor noted that the Monetary Policy Committee unanimously decided to maintain the current interest rates, citing tariff uncertainties and the recent reduction in the GST rates. These factors are expected to stimulate domestic demand without the need for any additional monetary boost.
Additional rate cuts on top of this would lead to an overstimulation of the economy, particularly given the current fragility of external balances. This decision highlights the necessity for monetary policy to consider the interconnections between fiscal measures, external risks and currency stability, rather than functioning in isolation.
By holding at 5.5 per cent interest rate, the RBI has opted for a strategy of patience rather than immediate intervention. It recognises that over easing could reignite pressures on the rupee and undo recent competitiveness gains. This restraint reflects its long-standing preference: using rates sparingly and leaning on the REER and selective interventions to guide the currency.
It is also a textbook case of the “impossible trinity”—no country can have free capital flows, a fixed exchange rate, and a monetary independence all at once. By prioritising competitiveness over cosmetic strength, the RBI made its choice crystal clear.
Inflation makes the REER crucial for assessing the rupee’s value. Despite low inflation, the RBI refrained from rate cuts due to GST-driven demand and tariff uncertainties. In 2024, high REER masked rupee overvaluation, prompting RBI to allow currency correction and sell $20.2 billion to prevent volatility. With the REER back near fair value, the competitiveness does improve, but the long-term goals include controlling inflation, enhancing export quality, and linking energy security to currency security.
A rupee that is aligned with competitiveness and increasingly utilised in trade is not depreciating; rather, it is demonstrating maturity. What may appear as weakness in market indicators is rather an indicator of strength in real economic terms. If India sustains this course, 2025 will not be remembered as the year of a falling rupee, but as the year of a sovereign one that was corrected at home and respected abroad.
Bidisha Bhattacharya is an Associate Fellow, Chintan Research Foundation. She tweets @Bidishabh. Views are personal.
(Edited by Saptak Datta)