Recently, Nepali currency has depreciated substantially against convertible currencies, particularly against the US dollar. In the last two months alone, the Nepali currency has depreciated by about 12 percent against the dollar. Interestingly, such a heavy depreciation is not related to the overall state of Nepali economy, but to the position of Nepali currency vis-à-vis the Indian currency. Nepal has been maintaining more or less a pegged exchange-rate regime with the Indian currency since 1960. The current parity—one Indian rupee equals 1.6 Nepali rupees—was set in 1993, which is exactly the same parity that was first announced in 1960.
Until 1993, the exchange-rate parity with the Indian currency was changed several times—sometimes through revaluation and sometimes through devaluation. Since, it has been left unchanged, for nineteen long years. This is the longest time period in Nepal’s history that the country has maintained the same parity with the Indian currency, during which a lot of water has flowed in the Bagmati River. Perhaps, it is the longest time period in the world history of fixed exchange rate in the post-Bretton Wood era. Because of this rigid parity for a prolonged period, the Nepali currency has been swinging with the Indian currency, in tandem.
There have been endless debates on the pros and cons of fixed versus flexible exchange-rate systems. Although many advanced countries have flexible exchange rates, there are still some countries which have fixed exchange-rate regimes, of all kinds. Given the structure of the Nepali economy, its trade pattern, and its long, open border with India, Nepal may not be able to withstand the flexible exchange rate with the Indian currency, mainly due to the possibility of speculative attacks and the informal nature of trade in the border region. Yet, it does not mean that Nepal should maintain the same parity for such a long time.
After 1993, the divergence between the Indian and the Nepali economies has been steadily growing. India has become one of the fastest growing economies in the world, while the Nepali economy during this time period has remained sluggish, even stagnated, marred as it was by the prolonged political instability. Some argue, including the IMF, that it is the pegged exchange rate with the Indian currency that has helped Nepal to maintain macroeconomic stability amidst the 10-year-long internal conflict starting in 1996. But it seems to us it is the rigid pegged exchange rate which has made the Nepali economy sluggish, with widespread unemployment contributing to escalate the conflict in a short period of time. In fact, maintaining an over-valued exchange rate and pre-mature opening up trade account, among others, have resulted in moribund Nepali industrial-sector.
The consequence of maintaining the peg for years on end is evident in the many anomalies seen in the economy, for the simple reason that the peg does not seem to be obeying economic fundamentals. Nepal’s trade deficit has been widening, more seriously with India, tremendously increasing the demand for the Indian currency. In recent years, in order to manage its Indian currency reserves, the Nepal Rastra Bank has been buying a substantial amount of the Indian currency by selling the US dollars and has also imposed a quantity restriction on supply of the Indian currency. Clearly, there is a shortage of the Indian currency, creating a black market for it, where it is traded at a higher rate. This shortage has led to numerous cases of frauds, as revealed recently by the Department of Revenue Investigation. Black markets and frauds may be a natural response to a shortage in a market economy. But the important question is: can we sustain such anomalies?
Although the Nepali economy needs exchange-rate stability, it should look to expand its reserves in other currencies too. Despite having two-thirds of trade with India, no one can deny the important role of the US dollar in the Nepali economy. In this regard, the extreme volatility against the US dollar—both heavy appreciation and depreciation—has negative implications for the economy. One may think that a substantial depreciation may promote exports. But, if we look at the potential capacity of the Nepali economy and imports content of exportable goods, depreciation against the US dollar does not seem to promote exports in a real sense, but only increase inflation and external-debt liability. More importantly, no one knows how long this depreciation will last, which makes investment uncertain and vulnerable.
As a policy, central banks globally have primarily two goals—stability and economic growth. Our rigid focus on exchange-rate stability to maintain macroeconomic stability may have hurt economic growth and employment generation. For a sound health of the economy, experience around the world shows, monetary authorities should maintain an undervalued real effective exchange rate, not a stable nominal exchange rate with a single currency. Since the pegged exchange rate does not mean one is obliged to hold on to the same parity in perpetuity, the monetary authorities should be able to change the peg as and when necessary. Abandoning such policy rigidity will allow Nepal some economic independence in that it will not have to open up its umbrella when it rains in Delhi. Again, international evidence shows that maintaining a rigid pegged exchange rate for a long time will invite a crisis sooner or later, which will make a forceful exit necessary, causing a significant damage to the economy. Nepal may not be an exception to this rule.
Remittance has been helping the government to maintain a rigid pegged exchange rate for such a long time. Thus it is the remittance inflows, not the pegged exchange-rate with the Indian currency, that have helped maintain macroeconomic stability in the country in spite of protracted political instability and internal conflict. Sustainability of the current peg depends on the volume of remittance inflows. With its help, Nepal has had to sustain ever-increasing imports to meet the rising consumption. Hence it is about time Nepali policymakers seriously rethought the current exchange-rate regime.
Shrestha is a PhD Candidate at the New School for Social Research, New York and Panday is a PhD Candidate at American University, Washington DC
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