The International Monetary Fund (IMF) in its 2012 report makes an explicit remark that the exchange rate peg of Nepali rupee (NRs) with Indian rupee (IRs) has served as a pillar of macroeconomic stability in Nepal. India is the largest trading partner of Nepal, a small open economy.
The current freefall of IRs has made us contemplate whether we should terminate or revalue the currency peg with India. In 2003, IMF had issued a study paper stating that Nepal may want to rethink the currency peg, but that would not be a good idea given the impact of Indian economy on Nepal and the open border. Moreover, some pragmatic economic factors should be borne in mind while revisiting Nepal’s currency peg with India. [break]
The historical background of the peg is one factor we need to take into account. There was a floating exchange rate system between the two countries from 1932 to 1960. This created a lot of uncertainty, which had negative effect on our economy. There were several money exchangers in different parts of the country. Speculation and hoarding of currencies was rampant, while the market was not operating as expected since money changers made people’s lives difficult.
Since early Shah Period, Nepal has relied heavily on India for its foreign trade—more than two-third of its foreign trade is with India now. Prior to 1932, the metallic currency of Nepal was valued at NRs 128 NRs for IRs 100. The rate was fixed in 1877 by the then Rana Prime Minister Ranoddip Singh. The exchange rate had remained constant until 1932. It had been quite stable from 1960 to 2002 when the rate saw seven adjustments, the last one in February 1993. That adjustment of NRs 1.60 equaling IRs 1.00 prevails to this day.
At that time, one US dollar was equivalent to NRs 49. Both the Nepali and Indian economies, including the global economy, have witnessed massive changes in the last two decades, mostly owing to the 2008 global financial crisis. But the exchange rate between the two currencies has stayed the same. The Indian economy started progressing after sweeping liberalization by the minority government of P V Narasimha Rao in 1991. The Nepali economy started falling after a record growth rate of 7.5 percent during the fiscal 1993/94.
The question of whether to revalue or end the pegged exchange rate regime is not new. It had surfaced a couple of years ago as well. The then Finance Minister, Surendra Pandey, and Finance Secretary had to make a statement that the exchange rate would not be changed immediately. Today, voices are rising that the country should gradually prepare to end the pegged exchange rate regime with India by consolidating its domestic economy. That could be an option, if we could strengthen our economy.
But before jumping to end the pegged exchange rate, we need to look at how the two economies have evolved in the last couple of decades. Now, the pessimism over the sluggish growth of the Indian economy has compelled foreign investors to pack up, resulting in the fall of IRs. However, the Nepali economy that was struggling to maintain a mere four percent economic growth must remember that the Indian economy grew at five percent even at its lowest.
Meanwhile, our economy faces two-way pressures, one from the trade that we do in IRs, and another from the trade in convertible currency (US dollar). Here, we have to think about our import basket, which is mostly full of Indian goods, mainly petroleum products and automobiles. Due to the freefalling currency, Nepal Oil Corporation (NOC) has already asked for a loan worth NRs 4 billion for petroleum imports.
A statement from the governor of the Central Bank that the exchange rate should not be tampered with at the moment is understandable. The peg with IRs is good for the economy; it forestalls the possibility of currency speculation of the kind witnessed during 1932-1960. Nonetheless, we do not have the luxury to sit back and do nothing as the currency continues to fall without a foreseeable end.
The governor is floating the option of import substation, but that would be a dangerous step, maybe even suicidal in the long run. Import substitution mechanism, which had been adopted by Jawaharlal Nehru in India after Independence in 1947, had taken Indian economy to a deadend. Nepal government, rather, needs to work on reducing the size of informal economic activities, which constitutes around 40 percent of total economy today.
Some government officials and economists are in favor of increasing the export basket, which is not a viable option either. Our goods and services cannot be competitive in the global market unless we have smooth electricity supply to our industries. And this we cannot do for the next four to five years.
The government has to work with the Central Bank to identify measures needed to take advantage of this situation. There are several steps that the government can take, such as streamlining remittance flow into productive sector, launching different programs to lure foreign tourists, and even asking Non-Resident Nepalis to invest in productive sectors while the US Dollar is appreciating.
There are several steps that the Central Bank can take to make the situation favorable for the country, though it cannot do anything directly to accelerate growth. The double digit inflation hitting people’s lives hard can be tackled by the Central Bank through different measures. Neither readjustment of the exchange rate, nor termination of currency peg will favor domestic economy. People’s sentimental reasons for terminating the currency peg with India should be countered with sound economic reasoning.
The author is a graduate student at Tsinghua University in Beijing, China
bhoju.poudel1@gmail.com
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