Effective Exchange Rate (REER)
based on a 24 currency basket of currencies
An exchange rate can be expressed either in terms of the national currency
value of a unit of foreign currency (price quotation system) or foreign
currency value of a unit of the national currency (volume quotation
system). While it is
customary to express the exchange rate in the former, the latter is a more
appropriate indicator to assess the extent of appreciation and
depreciation of the national currency.
For example, the annual average exchange rate of the rupee against
the US dollar moved from Rs. 95.66 in 2002 to Rs. 96.52 in 2003, and hence
the US dollar value of the rupee dropped from 1.05 US cents to 1.04 US
cents per rupee during this period. Accordingly, the average nominal exchange rate (NER) of the
rupee against the US dollar depreciated by 1 per cent in 2003, in nominal
other widely used indicators to measure exchange rate changes are the
Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER).
NEER is a weighted average of major bilateral nominal exchange rates, with
weights based on the trade shares reflecting the relative importance of
each currency in the effective exchange rate basket2.
The REER is obtained by adjusting the NEER for inflation
differentials with the countries whose currencies are included in the
basket. As the inflation rate
in each country is assumed to broadly indicate the trends in domestic
costs of production, the REER is expected to reflect foreign
competitiveness of domestic products.
one cannot solely rely on the REER indicator to gauge the variations in
competitiveness, as it does not adequately capture the impact of a host of
other factors such as the changes in macro-economic policies, changes in
the trade and exchange system including the changes in the regulatory and
institutional environment and productivity changes.
In addition, there could be data deficiencies, particularly in the
effective exchange rate indicators are widely used to assess
competitiveness. The main
focus of the NEER and the REER is on the trade balance, particularly the
exchange rate induced changes in trade flows.
A trend appreciation of the real effective exchange rate is
considered unfavourable for the growth of export and import competing
Publication of Indices
Central Bank has, for many years, computed several NEER and REER indices
for its own internal policy purposes, the details of which were not made
available to the public, in the past. As Sri Lanka has moved to an independently floating exchange
rate regime, and consequently, bilateral exchange rates being determined
by the market, it is felt the publishing these indices would provide
useful information to the market.
than concentrating on the movements of the exchange rate against one
foreign currency only, this would enable market participants to track the
movement of the Sri Lanka rupee against an average basket of currencies.
In particular, the movements in the REER, which takes into account
both the effect of cross currency movements and the difference in
inflation rates, would provide some information on the Sri Lanka’s
8.In addition to providing the NEER and REER indices, the computational methods, the currencies in the basket and the trade weights used in the computations are also published. This would enable interested parties to carry out their own analyses. The indices will be updated on a monthly basis in the future.
Sources and Methodology
9.The NEER and REER based on trade composition with
24 trading partner countries are computed on a regular basis by the
is the weighted geometric average of the bilateral nominal exchange rates
of the domestic currency in terms of foreign currencies.
Exchange rate of the Sri Lankan rupee against the US dollar
(US dollars per rupee in index form)
Exchange rates of currency i against the US dollar
dollars per currency i in index form)
: Weights attached to the
country/ currency i in the index
weights are constructed on the basis of geometric average of Sri Lanka's
bilateral trade with each of the 24 countries.
The proportion of each country's bilateral trade to Sri Lanka's
total trade is then normalised to arrive at the following weights:
selection of the countries in the basket is based on bilateral trade
shares and the importance in terms of competitiveness of those countries
exports with Sri Lankan exports in international markets. For example,
even though Kenya’s bilateral trade share with Sri Lanka is not within
the largest 24 trade shares, Kenya has been included in the basket as it
is a major competitor of Sri Lankan tea in the international
is inflation adjusted NEER.
: Consumer Price Index (CPI)
of Sri Lanka
: Consumer price index of country i
Consumer price indices are updated on a monthly
basis. However, the time lag
with which the CPI data is available varies from country to country.
Therefore, the REER index based on actual data is published with a
six week time lag.
12. The exchange rates have been defined in terms of
indices so that the appreciation / depreciation of the rupee relative to
other currencies is directly reflected by a rise / fall in the REER index
13. In order to ensure up to date information, the base year 1999 has been set and the index begins from January 2000.
The British use the ‘volume quotation system’ where the exchange rate for the Sterling Pound is generally expressed in terms of foreign currency per Sterling Pound.
2 The notion of Nominal Effective Exchange Rate was developed by Hirsch and Higgins (1970) and later extended by others. See ‘A Revised Weighting Scheme for indicators of Real Effective Exchange Rate’, IMF/Working Paper WP/87/87 for details.
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