Exchange rate issues in the Maldives

Abstract

The Maldives has maintained an exchange rate policy since 1994 that pegs the Maldivian currency, the rufiyaa, to the United States (US) dollar. In small and open economies like the Maldives, the role of exchange rate is even more crucial as changes in exchange rates have a quick and a direct impact on the economic activities and the cost of living in the country. Yet no empirical studies exist on the exchange rate regime of the Maldives. Further, the Maldives lacks the basic tools to analyse the exchange rate of the country; for example, information on the real exchange rates (RERs) and effective exchange rates (EERs). Therefore, this study aims to develop a set of key indicators for exchange rate analysis; examine the main issues related to the exchange rate; and evaluate the appropriateness of the current exchange rate regime of the Maldives. It provides policy makers for the first time estimates of the main indicators of the exchange rate for the Maldives. Since the basic indicators of exchange rate analysis do not exist for the Maldives, this study constructs indices for the nominal effective exchange rates (NEER), real effective exchange rate (REER) and the terms of trade (TOT). These indices facilitate the empirical analyses undertaken in this study. They would also be useful for the policy makers of the Maldives, to monitor the behaviour of the exchange rate in the country. To evaluate the performance and the appropriateness of the exchange rate peg in the Maldives, three specific issues related to the exchange rate are examined. They are: (i) equilibrium real exchange rate (ERER) and exchange rate misalignments; (ii) inflation dynamics and exchange rate passthrough (ERPT); and (iii) partial dollarization in the Maldives. The econometric techniques of cointegration and error-correction modelling (ECM) were employed to analyse these issues. The period of analysis was 1990–2010 and monthly data was used. The estimation of the RER misalignments showed that the Maldives has experienced varying levels of misalignments over the last two decades, and the RER has been substantially misaligned for a little over one-third of the period under analysis. The analysis of inflation demonstrated the importance of foreign prices, nominal exchange rates (NER) and monetary growth in explaining inflation in the Maldives. The ERPT in the Maldives was estimated to be very high and rapid, as expected, given the small and open economy. With regards to the partial dollarization in the Maldives, the economy remains highly dollarized even by international standards. However, unlike most other countries in which dollarization has been an outcome of macroeconomic instability, in the Maldives, dollarization is driven both institutional factors and the rapid development of the tourism sector. The high dollarization ratios also contribute towards the high ERPT estimated for the Maldives. The current exchange rate regime of the Maldives was assessed based on the empirical results from these three issues and the other determinants of exchange rate regime. The results from the quantitative framework and the exchange rate analysis of the issues examined in this study provided a compelling case for a pegged exchange rate regime for the Maldives. This study also assessed the option of adopting official dollarization as an alternative exchange rate regime for the Maldives. This was found not to be a viable option for the Maldives currently. The present study provides for the first time a comprehensive investigation of the exchange rate regime in the Maldives and would be a useful resource for policy makers in managing the country’s exchange rate policy.

Date of Award	2012
Original language	English
Supervisor	Craig APPLEGATE (Supervisor), Shuangzhe LIU (Supervisor) & Anne Daly (Supervisor)