REER (Real Effective Exchange Rate) is frequently misunderstood in Pakistan as an indicator of currency undervaluation or overvaluation. Critically, it functions as a lagging rather than leading indicator of currency valuation relative to trading partners.
“100 should not be misinterpreted as denoting the equilibrium value of the currency. 100 merely represents the value of the currency at a chosen point in time (in this case the average value of the currency in 2010).”
The March 2023 Misconception
One year prior, REER dropped to 85 in March 2023 when PKR depreciated to approximately 280 against the USD. Many investors incorrectly interpreted this REER of 85 as signaling 15% currency undervaluation, expecting subsequent appreciation.
The December 2023 Reality Check
By December 2023, while PKR remained around 280 versus the USD, REER had climbed to nearly 99. This occurred because REER incorporates inflation differentials between domestic and basket currencies. The hyperinflation following the previous devaluation widened the currency gap, pushing REER back toward 99.
Practical Market Dynamics
Beyond its theoretical limitations, REER remains largely academic. Market realities, specifically current account and financial account supply-demand dynamics, ultimately determine actual currency equilibrium levels.