Real Effective Exchange Rate (REER)

based on a 24 currency basket of currencies

Exchange Rates

1. 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[1].  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 terms.

2.Two other widely used indicators to measure exchange rate changes are the Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER).

3.The 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. 

4.However, 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 price indicators.

5.Nevertheless 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 industries.

Publication of Indices

6.The 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.

7.Rather 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 international competitiveness.

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.

Calculation, 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 Central Bank.

 NEER

NEER is the weighted geometric average of the bilateral nominal exchange rates of the domestic currency in terms of foreign currencies. 

                where   e  :       Exchange rate of the Sri Lankan rupee against the US dollar

                                    (US dollars per rupee in index form)            

e_i :         Exchange rates of currency i against the US dollar 

(US dollars per currency i in index form)

w_i :        Weights attached to the country/ currency i in the index

            Weighting Scheme

10.The 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:

The 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   markets.

REER

 11.REER is inflation adjusted NEER.                                                      

            where   P  : Consumer Price Index (CPI) of Sri Lanka

P_i : 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 value. 

13. In order to ensure up to date information, the base year 1999 has been set and the index begins from January 2000.