With imports from India 3.7 times higher than exports to it and trade deficit with it shooting through the roof—widening by over 120 percent in the last five years—it is natural that we are unable to pay for all our imports from India, averaging 60 percent of our total imports, in IC. However, the deficit alone does not explain the extent of shortage of IC being experienced in paying for imports. Part of the explanation lies in the increasing circulation of IC in the economy. As IC competes with Nepali currency (NC) as a medium of exchange in various parts of the country, it is little surprise that not all the IC that Nepal earns from India, both formally and informally, enters its financial system. Hence, a greater scarcity of IC than would otherwise be the case.
When foreign currency circulates as a medium of exchange alongside domestic currency, bypassing the financial system, the central bank loses control of money supply to that extent. The goals of monetary policy are thus not achieved.
Just how much IC is in circulation is a matter of comprehensive research. The gravity of the problem appears to have dawned upon NRB, which, in its new monetary policy for 2009/10, has promised to conduct a study on the circulation of IC in the economy by mid-July 2010 and bring IC transactions within the formal fold.
It is critical that NRB succeeds in its mission. Failure would mean “new Nepal” reverting to the situation prevailing from 1835 to 1956, when a dual currency regime was in place, with both IC and NC serving as legal tender. Or, more accurately, the years from 1956 to 1960, when the use of IC in domestic transactions continued unabated even though it was officially illegal.
PAST EXPERIENCE
NC is the only legal tender in Nepal, plain and simple. It is instructive here to recall that high volatility in the NC-IC exchange rate from 1934 to 1956—to the extent of almost daily changes from 1951 to 1956—due to the use of IC and NC as substitutes led to the establishment of NRB in 1956. Currency speculators were having a field day, to the detriment of Nepal’s trade and commercial interests. The goal of a single unified currency was enshrined in the very preamble to the NRB Act 1955.
Unfortunately, NRB failed to live up to its raison d’etre in the first four years of its existence. In 1957, for example, about 73 percent of total deposits and about 81 percent of total credits in Nepal Bank Limited—the only bank at that time—were denominated in IC. Nepal’s foreign exchange income was pooled with India’s and no separate account was maintained till 1960 when efforts to end the use of dual currency began in earnest.
Beginning May 14, 1960, NRB started to quote the rate of foreign currencies in terms of NC. The years from 1960 to 1965 were monumental in the drive to establish a single currency. The 1956 payments policy, which required all government expenditures to be effected in NC throughout the country, was successfully implemented. Similarly, the Foreign Exchange Control Act-1960 was introduced and enforced, prohibiting the use of any currency other than NC in internal transactions. That was no mean feat. It was the same NRB. The key was political will.
ADVERSE EFFECTS
The growing use of a foreign currency in internal transactions has adverse impacts on the economy and, by extension, the nation state, some obvious and some not so obvious. It thwarts the implementation of monetary policy, which is basically the central bank’s exercise of its control over money supply, narrowly defined as the sum of total currency in circulation and demand deposits in banks. When foreign currency circulates as a medium of exchange alongside domestic currency, bypassing the financial system, the central bank loses control of money supply to that extent. The goals of monetary policy are thus not achieved. For example, considering inflation a phenomenon of too much money chasing too few goods, and assuming monetary tightening to be the answer, an attempt to reduce money supply becomes futile when not all the money chasing the few goods is domestic currency.
The national foreign exchange reserve is also affected. The amount of IC in circulation detracts from the reserve of the same. This artificially inflates the shortage of IC, as is being experienced, prompting NRB to increase the number of items that can be imported from India in convertible currencies—which stands at 135 against 91 three years ago. It is sheer inefficiency to be selling US dollars to buy IC in volumes more than necessary when the latter is circulating freely in the economy. The dollar, or for that matter any other hard currency, is an international means of payment that can be used to pay for imports from virtually any country in the world. The bulk of these hard currencies are earned by Nepalis toiling on foreign shores. They must be used in the most judicious manner, preferably towards the neglected goal of trade diversification.
If IC circulation in relative terms were to reach levels existing in the 1950s, the NC-IC fixed exchange rate regime may break down, bringing back the exchange rate volatility of that era.
The problem of fake IC is intimately linked with its growing circulation. In the absence of requisite human resources and equipment for identifying fake notes, financial institutions are loath to exchange even IC notes other than that of denominations of 500 and 1,000. This is leading people—say, migrant workers bringing home their earnings from India—to use IC for their daily purchases. As IC’s acceptance as a medium of exchange increases, the greater is the tendency to bypass the financial system, and, in turn, the more difficult it is to check the plague of counterfeit IC. This also makes it difficult to control IC-financed nefarious activities.
POLITICAL WILL
The nation witnessed a similar crisis, albeit a more severe one, several decades ago and managed to triumph over it. NRB’s original raison d’etre has again shot back to relevance. It is positive that the central bank has formally set out on the task. But for all the touted autonomy granted to it by NRB Act 2002, it would be naïve to think that the central bank is completely immune from political interference. Such meddling can throw a spanner in the works. Moreover, NRB needs the active cooperation of the home ministry to succeed.
It is fashionable to attribute the current problem almost exclusively to the 1,800-km open border. But then the open border existed in the 1960s and before as well. It must be borne in mind that the key to the success in achieving a unified currency in the 1960s was sheer political will.
Whether such political will exists today is an open question. There is an argument that the Rana regime promoted the dual currency system as its leaders had investments in India. Anecdotal evidence suggests that many movers and shakers of present-day Nepal are in the same league as the Rana rulers of yore they love to deride, at least in one respect—they too have substantial investments across the border. Does Noida Colony—but for one example—ring any bell?
kharelparas@yahoo.com
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