Nepal has adopted the conventional fixed-peg exchange rate arrangement with Indian currency (IC) and flexible exchange rate system with rest of the currencies. That is, the exchange rate of Nepali Rupee with other currencies is basically determined by supply-and-demand forces in the foreign exchange markets whereas the exchange rate with IC is officially determined by Nepal Rastra Bank (NRB). Currently, the exchange rate of NC with IC is Rs 1.60 per unit of IC, which was fixed in 1993. To maintain the pegged rate with IC, NRB is always ready to purchase/sell foreign exchange at the predetermined rate. Due to this, the pegged exchange has come to be the nominal anchor of the monetary policy in Nepal.
Although there is no dispute about the floating rate of NC with other currencies, questions are often raised about the pegged exchange rate with IC. Is the current pegged rate with IC economically viable? What are the costs and benefits of this peg? How long will NRB keep the current pegged value with IC fixed? Why does NRB continue defending the pegged rate fixed in 1993 despite changes in economic as well as political arenas? Now, Nepali rupee seems to be depreciating against the dollar because of its peg with IC. However, this is now the whole story. Whatever the real causes of depreciation, the decline makes exports cheaper, imports dearer and pushes up foreign debt denominated in US dollar. These issues need to be looked into while evaluating the peg with IC.
First, let us consider the benefits of the peg with IC. One, the peg has reduced business uncertainty and transaction costs resulting in smooth foreign trade and a stable investment climate. If we allow day-to-day fluctuations in the rate, speculation over the currency will be high, the natural flow of international investments will be hindered and fuel inflation will set in, all boosted by the 1,750-km long permeable border Nepal and India. Since India is our major trading partner covering around 60 percent of foreign trade, our macroeconomic policy goal of achieving external sector stability requires the stability in exchange rate with IC, currently made possible by the pegged system.
Two, exchange rate risk has been reduced with stabilization of speculation and prevention of exchange rate overshoot. Three, the fixed exchange rate with IC also acts as an anchor for the price level. By pegging our currency with IC, we are importing inflation from India which has been instrumental in anchoring inflation over the past few years. It imposes price discipline because if price level in Nepal is too high compared to India, we will fast lose our reserves. Since deficits in BOP and reserve loss cannot go forever, we need to restrain excessive inflation and thus be forced to discipline prices. In addition, the pegged arrangement is an important signal of policy commitment to achieving low inflation because the loss of monetary autonomy due to pegging of currency limits the ability of NRB to pursue excessive expansionary monetary policy.
Rather than changing the peg with Indian currency, NRB should think about ways to ensure the sustainability of the peg and work at restoring people’s confidence in financial institutions.
Talking about the demerits, the pegged rate with IC, at first, limits NRB’s ability to conduct an independent monetary policy and undermines its effectiveness in meeting its monetary policy goals. NRB, in that case, may not be very effective in relieving pressure on exchange rate beyond the short-term and completely ineffective in controlling high international capital mobility. Second, to maintain the fixed rate with IC, NRB needs high foreign exchange reserves, which also entails opportunity costs. NRB has been purchasing huge amount of IC by selling dollars to meet the chronic shortfall of IC that results from huge deficits with India. For example, NRB purchased IC amounting Rs.12,384 crores by selling equivalent amount of US $274 crores in FY 2067/68.
This represents not only the depletion of the precious foreign exchange reserves but also entails very high administrative costs. Third, it also limits the shock absorption capacity of Nepali economy. Due to the fixed rate, the shocks are largely absorbed by changes in economic activity and employment conditions instead of through changes in nominal exchange rate, a painful and protracted process. For example, if the Indian economy suffers adverse shocks, it will be quickly transmitted to the Nepali economy. In addition, wage and price flexibility are essential to moderate the impact of adverse shocks in pegged regimes. These situations are absent in Nepal.
It is very difficult to accurately quantify the merits and demerits of the existing pegged rate with IC, and work out the best policy option by comparing marginal costs and benefits. Although currency adjustment, especially pegged rate with IC, has become a major concern because of the growing economic disparities between Nepal and India, it is not the right time to change the rate or the regime. Given the current environment of political and economic transition along with institutional and operational constraints, the incurred costs will outweigh the marginal gains of such a change.
Despite the advantages of a floating rate, its success calls for extensive institutional and operational foundations and frameworks, which are difficult to develop and maintain in the country’s current context.
Since Nepal is a small economy depending highly on India for trade, pegged rate with IC serves best to maintain stability in external sector. Thus, it will be better for NRB to think about the ways to ensure the sustainability of pegged rate with IC as well as about restoring people’s confidence in the banking and financial institutions in order to ensure economic stability. Sustainability of the pegged rate with IC calls for astute management of domestic absorption, enhancement of the productivity and ensuring the competitiveness of the economy through reduced transaction costs and infrastructure development.
The writer is Assistant Director, Nepal Rastra Bank
bcbirendra@nrb.org.np
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