The impact of exchange rate on balance of payment: an econometric investigation on Sri Lanka

Abstract

The exchange rate and its direct and indirect impacts are widely addressed issue at present. Exchange rate is a fundamental macroeconomic variable that affects not only for economic performance of the particular country but also it has an impact of other countries throughout the world. The exchange rate is a key determinant of balance of payments (BOP) of the country. Thus, this study attempts to examine the impact of exchange rate on balance of payment by adopting Sri Lanka data over the period of 1978 to 2016. Johansen cointegration technique is used to identify the number of cointegrating relationship and long run relationship, Short run relationship and long run adjustment are examined by using error correction model. Johansen co-integration Trace test statistics and Maximum Eigen value both are identified two co-integrating relations in the system of equation. The results of Johansen co-integration identified exchange rate have a positive and significant long-run relationship with balance of payment. There is a positive and significant adjustment towards the long-run equilibrium between exchange rate and balance of payment in Sri Lanka. Error correction coefficient (0.003) of exchange rate reveals that 0.3% (less than 1%) disequilibrium is corrected by each year one period after the exogenous shocks which implies that exchange rate moves downward towards the long run equilibrium path. while error correction coefficient of balance of payment and lending interest rate move upward towards with long run equilibrium path in each year one period after the shocks. But other macroeconomic variables do not have adjustment towards longrun equilibrium. Finally, this study concludes either devaluation under fixed exchange rate regime or allowing depreciation under freely floating exchange rate regime of the domestic currency against foreign currencies can use as a short term and long term policy measurement to correct the balance of payment imbalance situation.