Analysing the relationship between FIIs and REER

Abstract

Since the 1991 liberalization, India had taken various initiatives by way of deregulating markets, lowering tariff rates on imports and taxes, which are all take the lead to encourage foreign investment and spur the higher economic growth during the 1990s and 2000s. Foreign Investment increased from US$132 million in 1991–92 to $5.3 billion in 1995–96, besides supplemented by an increase in literacy rates, food security, and life expectancy. Later foreign Investment raised by 316.9% from 1992 to 2005, and GDP grew from $266 billion in 1991 to $2.3 trillion in 2018; during this period, international trade flourished across countries in terms of exports and imports that created a demand for foreign currency and volatility in exchange rates. Considering the high growth potential of the Indian economy, foreign institutional investors started investing in India that created volatility in the capital market and exchange rates. Hence Effective Exchange Rate (EER) is used as a statistic to understand the international competitiveness of home currency’s in terms of a group of foreign exchange rates. Economists and policy analysts use EER for international trade to study the underlying factors such as trade-weighted index, competition, and technological changes in the country that helps to compare the domestic country’s performance against its most important trading partners. Foreign exchange traders also use EER to make arbitrage in the currency market. RBI publishes NEER and REER in RBI monthly bulletin. “The indices of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are used as indicators of external competitiveness. 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 fluctuation in NEER accounts only for the variation in the nominal exchange rate of the domestic currency against a basket of foreign currencies; the REER also accounts for the variations in the inflation differential in relation to the foreign countries.