Identifying the factors affecting real LKR/USD exchange rate

Abstract

This study has investigated the macroeconomic factors affecting real LKR/USD exchange rate by using monthly data from January 2013 to July 2019. The explanatory variables of this study are net foreign assets, domestic Treasury Bonds yields and Treasury Bonds yields in United States (US). Vector Error Correction Model (VECM) is used to estimate the model. Long run equation without surprisingly indicates that the yield rates in US has the most significant influence over real LKR/USD exchange rate determination negatively. Recently, US have increased its interest rates (latter part of 2018) and that event may have significantly contributed to the recent nominal LKR/USD exchange rate depreciation. Second most significant explanatory variable is the interest rates in Sri Lanka and it influences negatively to the real LKR/USD exchange rate determination. Hence, we can draw a finding that foreign investment is a significant determination of the real LKR/USD exchange rate as relative interest rates of the both countries determine the investment flows to the Sri Lankan economy. Net foreign assets negatively relate with the real LKR/USD exchange rate and it highlights the fact that accumulation of foreign assets strengthens the domestic currency. Previous month’s deviation from long run equilibrium is corrected in the current month as an adjustment speed of 91 percent. Significant variable for the real LKR/USD exchange rate determination in the short run is the net foreign asset.