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Sri Lanka to target real effective exchange rate (REER) index

ECONOMYNEXT – Sri Lanka will target an inflation adjusted exchange rate index relative to competitors to keep the rupee competitive, while also targeting inflation through a flexible framework, Central Bank Governor Indrajit Coomaraswamy said.

"The framework is over time – gradually – to get to the point where the Real Effective Exchange Rate (REER) is 100," Governor Coomaraswamy said.

"But that will be a gradual process."

A REER is as statistical construct which attempts to show an effective or nominal exchange rate (EFF or NEER) index by measuring the appreciation or depreciation of one currency against a basket of currencies of trade partner currencies.

When a currency strengthens, the nominal exchange rate index can go up.

The real effective exchange rate adjusts the nominal rate to the inflation generated by the central banks of each country.

If Sri Lanka’s central bank generates more inflation than other central banks in the basket, the index will go up. If it gets far above 100, the rupee is said to be ‘overvalued’ or uncompetitive.

Sri Lanka has to weaken the rupee against other currencies to get the REER index down to around 100.

"Once we get the REER to a 100, it will take some time, [the framework is] to manage the exchange to keep the REER around there," Coomaraswamy said.

"We are not going to let the currency go suddenly and things like that."





He said the movements of the rupee over the last two months was an example.

The REER index movements depend on the basket of currencies in the index chosen (it is possible to create an export REER and an import REER). It also depends on the way the inflation index is computed either in Sri Lanka or in any of the competitor countries.

Sri Lanka has just re-based its main inflation index to include items dropped during the Rajapaksa regime.

"After the re-basing of the price index – it has put us back a bit – it is about 107," Coomaraswamy said.

If a competitor currency in the basket collapses due to monetary policy errors (like China’s Yuan now) the NEER and REER can go up until monetary policy is tightened in that country to halt the currency slide.

Coomaraswamy says the framework of targeting the exchange rate can help avert sudden falls in the currency.

He said in the 2011/2012 currency crises, Sri Lanka spent 4.0 billion US dollars to defend the rupee and then it depreciated 14 percent.

In the 2015/2016 balance of payments crisis, the rupee fell about 10 percent after spending two billion US dollars to defend the currency.

"I cannot see any sense in it. It is difficult to collect reserves," he said, explaining in Sinhalese. "If by spending reserves the currency is held, then it is alright. But if it is allowed to fall, what is the point?"

Other analysts who accurately predicts balance of payments crises generated by the central bank has pointed to delayed tightening of monetary policy by the central bank as the reason for frequent currency crises.

After printing money to stop rates from going up, unsettling foreign investors, then defending the currency, then sterilizing interventions (printing money to offset the tightening effect of dollars sales on the domestic monetary base) the central bank is then forced to hike rates.

Analysts say this is a classic problem with so-called soft pegged central banks which try to defend the exchange rate and interest rate at the same time, destroying the credibility of the peg and making foreign investors flee and making exporters to hold back dollars.

Meanwhile the central bank is also hoping to target consumer prices through a ‘flexible inflation targeting’ framework. (Colombo/Feb09/2017)

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