Impact of Key Macroeconomic Variables on Exchange Rate under Political Instability: Evidence from A GMM Analysis in Sri Lanka

While there have been many explorations on the determining factors of foreign exchange rates, hardly any literature has been carried out to explore the moderating role of political stability in these relationships.  This study explores the most influential macroeconomic drivers of the foreign exchange rate in Sri Lanka explicitly examining the role of political stability in the macro fundamentals-exchange rate nexus. Employing monthly data of foreign reserves, workers' remittances, trade deficit and tourism earnings from 2013–2022 and applying Generalized Method of Moments (GMM), the study tests the exchange rate dynamics within a crisis economy context. The findings show that foreign reserves, workers' remittances, and trade deficit are good predictors of foreign exchange rate in the short run, whereas the tourism earnings has no statistically significant impact in the Sri Lankan context. Further, findings reveal that political stability directly affects the exchange rate, and more interestingly, moderating the effects of other macro variables on exchange rate, by reducing the pass-through from foreign reserves, strengthening the effect of remittances, and buffering the effect of trade deficit in the short term. These findings highlight the significance of structural imbalances and institutional fragility in determining exchange rates behaviour in emerging economies in ways that are less common in stable economies. In conclusion, conducive macro environment together with credible political governance helps strengthen the currency. From policy perspective, the efforts contributing to institutional credibility, external financing strategy, remittance channels, and minimizing temporary foreign reserves accumulation are suggestive.