THE EFFECT OF MACRO ECONOMIC FACTORS ON

DETERMINING EXCHANGE RATES IN SRI LANKA

RESEARCH PROPOSAL
TITLE
The effect of macro economic factors on determining exchange rates in Sri Lanka.

BACKGROUND
Trade and financial transactions within a country are generally carried out in local
currencies i.e. Rupees and Cents in Sri Lanka, unless otherwise permitted in a foreign
currency for a specific reason. When such transactions take place between
persons/entities of two different countries that use different currencies, it is necessary to
convert local currencies into foreign currencies or vice versa. These are known as foreign
exchange transaction. The rate at which the currencies are converted is the exchange rate.
In many countries, the exchange between a local currency and foreign currencies takes
place freely through the banking system. However, half a century ago, a majority of
countries in the world had restrictions on such conversions, which have come to be
known as exchange controls. The exchange control function in Sri Lanka is performed
and exercised by the Central Bank of Sri Lanka as an agent on behalf of the Government
through the Department of Exchange Control. The powers of exchange control are
derived from the Exchange Control Act (ECA) No. 24 of 1953.The ECA continues to be
in force, but the freeing of foreign exchange transactions from control is effected by
delegating the powers of the Central Bank to commercial banks that have been appointed
to act as Authorized Dealers in foreign exchange and granting general permission under
the Act.

There were four main exchange regimes that have been adopted by Sri Lanka, fixed
exchange rate, duel exchange rate, managed float with crawling band and free floating
regimes. Before the liberalization in 1977, Sri Lanka adopted fixed exchange rate regime
and later that is from 1977 it was the managed float regime. Turning a great milestone in
Sri Lankan history, in 23rd January Sri Lanka has adopted the free float regime which is
still we are experiencing.

The Balance of Payments and exchange rates are more related because the settlement of
Balance of Payments is done using these exchange rates. Under the fixed exchange rate
regime, the govt. (monetary authority) is obliged to buy and sell foreign exchange with its
own currency to maintain the exchange rate at a fixed parity and as a result the
adjustment occurs through the Official Reserve Transactions (ORT) account
accumulating or de-cumulating the foreign exchange reserves. The result is the BOP
deficit or surplus. In the case of floating exchange rate regime, an adjustment occurs
through changes in exchange rate and not through the reserve flow or BOP. Finally,
under the regime of managed floating, crawling peg or crawling band, adjustment occurs
both through the foreign reserves (BOP) and exchange rate changes. (Humphrey and
Keleher, 1982) Under this situation, the authorities intervene time to time in the foreign
exchange market to control the fluctuations in the exchange rates and to keep the rate in
the equilibrium level. Also they have to decide the proportionate amount of exchange rate
pressure, originated through disequilibria in the money market, should be relieved
through the exchange rate movement and through the reserve flows. In this case, both the
variables will change and contribute to the restoration of monetary equilibrium.

Since BOP is considered as an important element of external price stability it is very

significant to identify the exchange rate behavior and the determinants of it.

In a free market exchange rates are determined by the interaction of currency supplies
and demands. The supply and demand schedules in turn are influenced by price level
changes, interest rate differentials, and economic growth. Ultimately these factors;
interest rate differentials, inflation rates, economic growth, money supply, foreign direct
investments, foreign currency deposits would affect the exchange rate. In situations
where there is a high inflationary or interest rate or even a economic depress, it is
worthwhile to know what is the effect on determining exchange rate. Since these are
macroeconomic factors, it is can say that macro economic factors are having a greater
influence on exchange rate.
RESEARCH QUESTION AND OBJECTIVES

The exchange rate is the price of national currency in terms of foreign currency. The
close linkage of the exchange rate to the general price levels of the economies as wells to
the other macroeconomic factors and produce an economy with wide importance of
policy making since it affects the real income and wealth of those economies.

Therefore the research question of this research is “what are the macro economic factors
that influence exchange rate”

The objectives of this research can be stated as;

 Aims at identifying and analyzing the significance of macro economic factors that
influence the exchange rate.

 Aims at identifying and understanding the relationship between the

macroeconomic factors and the exchange rate.

RESEARCH METHODOLOGY (DATA n DESIGN)

THE DATA
The study wishes to focus on secondary data available in Central Bank annual reports and
other certain publications. The data relating to different macroeconomic variables that
affecting the exchange rate such as inflation rates, interest rates, and economic growth
rates, foreign direct investments, money supply are to be concerned together with
exchange rates. This study analyze the effect of macroeconomic factors on exchange
rates from 1996-2006. Yearly data (time series data) are to be extracted from Central
Bank annual reports and other publications.
RESEARCH DESIGN
This research is concentrated in analyzing the macroeconomic factors that determining
the exchange rates in Sri Lanka. The study will focus both periods that is before the free
float and after the free float exchange rate regime. (For the Managed Float and Free Float
systems.) The economic factors are comparing with five major currencies which are US
Dollar, Sterling Pound, Japanese Yen, Euro, Australian dollar. The factors considered for
the analysis are inflation rate, interest rate, money supply, import cost, export income,
trade balance, foreign direct investments, foreign reserves, foreign currency deposits and
foreign participation in the stock market. These relationships will be identified under
literary survey. To examine the relationships, the correlation coefficient between each
economic factor and all five exchange rates will be computed. Correlation coefficient,
the statistical method, identifies the direction of the relationships as well as the strength
of the relationship between two variables.

LIMITATIONS OF THE STUDY

 The study being carried out for a total of 12 years, 6 year period for each of the
two exchange regimes.(under free float there are only 6 years)

 In order to have an effective analysis, five major currencies were chosen

(US dollar, UK pound, Euro, Japanese yen, Australian dollar)

 This study was carried out in partial fulfillment of B.Sc (Finance) degree
program. The limited time span available also restricted the deep analyzing the
data of study.
TIMESCALE
Activity Time
Preparation of the research proposal 2 weeks
Research design 2 weeks
Collecting data 4 weeks
Preparation to analyze the data 3 weeks
Analyzing data 4 weeks
Draw conclusions 3 weeks
Preparation and submit the report 3 weeks
Total 21 weeks

RESOURCES
 Central Bank annual reports and other publications
 Lecture guidance
 Computer equipments and internet facility
 Previous articles and journals

REFERENCES
 Annual Reports of Central Bank of Sri Lanka from 1996 to 200c
 BEC 2301: Macro Economics Course manual 2003, University of Sri
Jayewardenepura
 Shapiro, A.C., Multinational Financial Management, seventh edition
 Weerasekara, Y.M.W.B and D.S. Wijesinghe (2001), Exchange Rate
Management of SriLanka, Unpublished paper presented in the Central Bank of Sri
Lanka.
 Athukorala, P., (1998), Trade Policy Issues in Asian Development, Routledge
Studies in the growth economies in Asia, Routledge, London, England.
 Athukorala, P. and S. Jayasooria, (1994), Macro Economic Policies, Crises and
Growth in Sri Lanka,1969-1990The World Bank, Washington D.C.

 White, H. and Wignaraja, G. ( 1992 ) “ Exchange Rates, Trade Liberalization and

Aid: The Sri Lankan Experience” World Development, Vol-20, pp 1471-1479
 Abhayankar, A. , Sarno, L. and Valente, G. ( 2005 ) “ Exchange Rates and
Fundamentals: evidence on the economic value of predictability” Journal Of
 International Economics, Vol- 66, pp 325-348
 Broda, C. ( 2004 ) “ Terms of trade and exchange rate regimes in developing
countries” Journal of International Economics, Vol- 63, pp 31-58