Exchange Rate Issues in the Maldives Azeema Adam A thesis submitted for the degree of Doctor of Philosophy in Economics of The University of Canberra January 2012 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 Mal- dives. 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 use- ful for the policy makers of the Maldives, to monitor the behaviour of the ex- change 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 ex- change rate are examined. They are: (i) equilibrium real exchange rate (ERER) and exchange rate misalignments; (ii) inflation dynamics and exchange rate pass- through (ERPT); and (iii) partial dollarization in the Maldives. The econometric techniques of cointegration and error-correction modelling (ECM) were em- ployed 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 experi- enced varying levels of misalignments over the last two decades, and the RER has ii been substantially misaligned for a little over one-third of the period under analy- sis. 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 in- ternational standards. However, unlike most other countries in which dollariza- tion 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 Mal- dives 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 alterna- tive exchange rate regime for the Maldives. This was found not to be a viable op- tion 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. iii Acknowledgements This thesis would not have been possible without the support and encouragement of many individuals and organisations. I would like to thank, first, my primary supervisor, Dr Craig Applegate, for his advice, guidance and encouragement dur- ing the last four years. I am also thankful to Professor Anne Daly, Professor Phil Lewis and Dr Shuang Liu for their valuable advice. I would like to express my gratitude to AusAID for granting me the Australian Leadership Award to undertake this research. A very special thanks goes to the AusAid Officer at the University of Canberra, Ms Rozana Muir, whose help and support made my life as a student so much easier. I would also like to express my appreciation to Dr Lisa Lines of Elite Editing for her editorial assistance. I am deeply thankful to the Maldives Monetary Authority, especially my colleagues at the Monetary Policy and Research Division, for providing the data and informa- tion for my research. In particular, I would like to thank Mariyam Rashfa for her speedy responses to my numerous data requests. Most importantly, this thesis would not have been possible without the encour- agement, support and love of my husband, Aliny, who helped me stay motivated throughout the completion of my thesis. Finally, the inspiration and love that I have always received from my two beautiful children, Luha and Yanaal, and their patience in having both their parents doing full-time studies, is remarkable. My heartfelt thanks go to Luha, Yanaal and Aliny, and I dedicate this thesis to them. v Contents Abstract ........................................................................................................................ ii Certificate of Authorship of Thesis .............................................................................. iv Acknowledgements ....................................................................................................... v Contents ....................................................................................................................... vi List of Tables ................................................................................................................ x List of Figures ............................................................................................................. xi List of Acronyms ........................................................................................................ xiii Chapter 1: Introduction ............................................................................................. 1 1.1 Aims and Scope of the Research .................................................................... 3 1.2 Exchange Rate Regime in the Maldives ......................................................... 6 1.3 Structure of the Study ................................................................................... 8 Chapter 2: Literature Review on the Choice of Exchange Rate Regime ............ 13 2.1 Introduction ................................................................................................ 13 2.2 Classification of and Trends in Exchange Rate Regimes .............................. 14 2.2.1 Types of Exchange Rate Regimes ........................................................... 14 2.2.2 De jure Exchange Rate Regimes versus De facto Exchange Rate Regimes .. 16 2.2.3 Trends in Exchange Rate Arrangements ................................................ 19 2.3 Fixed versus Flexible Exchange Rate Regimes .............................................. 23 2.3.1 Advantages of Fixed Exchange Rate Regimes ......................................... 24 2.3.2 Disadvantages of Fixed Exchange Rate Regimes ..................................... 25 2.3.3 Advantages of Flexible Exchange Rate Regimes ...................................... 25 2.3.4 Disadvantages of Flexible Exchange Rate Regimes ................................. 26 2.4 Macroeconomic Performance under Alternative Exchange Rate Regimes .... 27 2.4.1 Inflation ............................................................................................. 27 2.4.2 Growth and Volatility ......................................................................... 29 2.4.3 Crisis Probabilities .............................................................................. 30 2.4.4 International Trade Flows ................................................................... 31 2.5 Determinants of the Choice of Exchange Rate Regime ................................ 32 2.5.1 The Optimal Currency Area Theory ..................................................... 32 2.5.2 The Financial View ............................................................................ 34 2.5.3 The Political View .............................................................................. 34 2.5.4 Determinants of the Exchange Rate Regime Choice................................ 34 vi 2.6 Conclusion .................................................................................................. 35 Chapter 3: Real and ominal Effective Exchange Rates in the Maldives .......... 38 3.1 Introduction ................................................................................................ 38 3.2 Concepts of Real Exchange Rates ................................................................ 40 3.3 Tradable and Non-Tradable Sectors in the Maldives ................................... 42 3.4 Methodological Issues ................................................................................. 46 3.4.1 Formulae ............................................................................................ 46 3.4.2 Choice of Nominal Exchange Rate