Determinants of Foreign Exchange Rate in Sri Lanka

Abstract

The exchange rate is a crucial economic indicator reflecting a country’s international economic health and competitiveness. Following the COVID-19 pandemic and subsequent economic instability, the Sri Lankan rupee has experienced significant depreciation. This study examines the determinants of the foreign exchange rate in Sri Lanka using secondary macroeconomic annual time series data from 1990 to 2023. Data were obtained from the World Bank and the Central Bank of Sri Lanka, with the exchange rate considered the dependent variable. Independent variables include the GDP growth rate, foreign direct investment (FDI), inflation, interest rate, balance of payments, and trade openness. The Augmented Dickey-Fuller and Phillips-Perron tests were used to assess the stationarity of the data, while the Autoregressive Distributed Lag (ARDL) model was employed to determine long-run relationships among variables. The ARDL bounds test confirmed a co-integration relationship, and the error correction model revealed the significant impacts of these variables on the exchange rate. The findings indicate that the exchange rate has a positive relationship with the balance of payments and inflation and a negative relationship with GDP growth and FDI. Interest rates and trade openness exhibit mixed effects in the long run, with interest rates showing a positive relationship and trade openness a negative one. Overall, the results confirm that all the examined variables significantly impact the exchange rate in both the short and long run, providing insights for policymakers aiming to stabilize Sri Lanka’s currency and macroeconomic environment.