Friday September 27, 2019 07:23:47
ECONOMYNEXT – Sri Lanka’s rupee is undervalued based on a real effective exchange rate index which is good for owners of export and import substituting businesses, Central Bank Governor Indrajit Coomaraswamy has said.
“Right now the real effective exchange rate is below 100 and so the rupee is undervalued, which is favorable for exporters, and producers of import substitutes.” Governor Coomaraswamy said, at a forum on International Trade Agreements: Policy Options for Sri Lanka.
According to central bank data Sri Lanka’s REER index number was 92 in February.
A real effective exchange rate index is calculated by measuring the (nominal) changes in exchange rates of a basket of currencies (usually trading partners) against a domestic currency and adjusting it for inflation.
REER calculations make no distinction whether the currencies in the basket are true floating rates, or are pegged strongly with complementary money and exchange policies, or are unstable soft-pegs with contradictory policy that depreciate permanently.
A genuinely floating currency like Australia or Canada may temporarily fall against another currency like the US dollar, based on their credit cycle.
Critics have also said that if a large weight goes to currency produced by a bad central bank like that of India, which has a history of depreciation, the domestic currency will be hostage to the monetary policy of that agency, when the REER is targeted.
When currencies collapse due to central bank policy errors (printing money to target interest rates, while targeting the exchange rate to create ‘reserve buffer’), in Sri Lanka and elsewhere claims are made that a currency is ‘undervalued’.
The collapse of the US dollar in 1971-73 along wth the Bretton Woods soft-peg system, which was due to printing money to target an output gap among other policy errors during the administration of President Richard Nixon, was later blamed on an ‘overvalued’ US dollar by Mercantilists.
If the basket is changed, or inflation is re-based, the REER index will change, raising questions about past claims. A REER index is usually based on historical trading patterns.