Historically, developing nations have preferred a pegged exchange-rate regime. Like many other central bankers, our authorities are correct to point out that by pegging the exchange rate to a bigger, better managed economy, we are implicitly benefitting from better economic management. Leaving aside short-term nationalistic feelings, an objective view of ground realities of the Nepali economy would lend support to this argument.
From better economic numbers to better resources needed to manage the economy, it should not be too hard to see that India is a better managed economy than ours. Notice also that we are not the only nation with such a relationship with its neighbor. A larger economic relationship justifies a stable exchange-rate arrangement. Or else, why would there be Euro? A currency union is after all an extension of a pegged exchange-rate regime. [break]
A crucial aspect of our current exchange-rate system is that it protects us from paying more if our imports are denominated in the Indian Rupee. On the other hand, if we are buying goods by paying in US dollar, it is going to hurt our pockets whenever our currency loses value against the dollar. Most of what we buy is basic, essential goods from India. It is in our interest to avoid price rise of goods that most of our citizens need. Yet we also have to be mindful that depreciation of the Indian Rupee is going to increase the price of petroleum products in both countries and may translate into higher prices of other goods.
Obviously, there are challenges in a pegged exchange-rate regime. The biggest is that our policy (monetary) has very little chance to successfully respond to changes in domestic economy. To keep things simple, just consider inflation, which is a primary concerns of ordinary citizens. Under this system, our inflation is closely tied to India’s. So if prices rise in India, we will see a similar effect in Nepal. Moreover, if our economy enters a period of recession, there is not much that our central bank can independently do.
Better alternatives?
Can we contemplate better alternatives to the current system? This question has policy significance. The author’s research has tried to delve into this topic.
At the outset, it must be said that the current parity with the Indian Rupee is not sustainable in the long run. This may come as a surprise, but data suggests that the current parity (1.6 NPR/INR) has been artificially sustained for long.
Our economic performance justifies a fall in the value of Nepali Rupee vis-à-vis India Rupee. Those anecdotal stories of how people in the border region of Nepal are forced to convert at 1.7 NPR/INR is not very different from what economic numbers suggest.
Now, consider a counter-factual scenario where a similar devaluation would occur. Our exchange rate with the US dollar will fall further. Immediately, prices of all imports will rise. But why are we not devaluing our currency, as suggested by data? The answer is that our authorities are committed to preventing a general rise in prices until the country has adequate foreign-exchange reserves. Again, the impact of economic performance under a pegged exchange-rate system is reflected through changes in the stock of these reserves. Unless the reserves are significantly depleted, we can avoid any serious crisis. One can’t, however, deny how lucky we have been in this regard and how precariously we are placed going forward.
Some have also argued in favor of a floating regime with India. Can we reasonably contemplate pursuing a free-floating exchange rate with all currencies, including India? We could if we are willing to suffer the consequences. Notice how our exchange rate would fluctuate daily in response to economic performance and speculative behavior. Since our economy is not in a better standing than India’s, our currency is likely to see volatile swings in its value. Sometimes volatility in exchange-rate movements is much more consequential than straight-forward devaluation.
A relatively less damaging alternative could be a currency basket. We have tried this type of system in the past but without much success. Consider how this system works. There would be a few currencies that will be targeted to create a reference unit. For example, some candidate currencies can be the Indian Rupee (INR), US dollar (USD), Euro (EUR), and Chinese Yuan (CNY).
These currencies are selected based on their importance in our economic relationships with different countries. The four currencies form a basket, where they will be assigned some weight, again depending on the significance of relationship. A simple calculation goes this way. Reference exchange rate = 0.5 x INR/USD + 0.3 x INR/EUR + 0.2 x INR/CNY. Using exchange rates of August 25, 2013, the reference unit is 60.16 (0.5 x 64.49 + 0.3 x 85.87 + 0.2 x 10.5). We will then derive our exchange rate with the US dollar and other currencies using this reference rate and our peg rate with the Indian Rupee. For example, NPR/USD exchange rate = Reference unit x NPR/INR exchange rate = 60.16 x 1.6 = 96.2.
Notice a few points. First, the current exchange rate with the US dollar is over 105. Under the basket system, we would reduce the impact of the INR/USD exchange rate on our exchange rate with the dollar to some extent. Second, assigning the weights (summing to one) is a debatable proposition. Third and perhaps the most important consideration is that there is a strong possibility of funds (remittances, exports income, etc.) being diverted, i.e., funds that would normally come in US dollars could come as Indian Rupees.
At normal times, this arrangement can be a reasonable alternative because the US dollar and Indian Rupee are equivalent foreign-exchange units for us. Nonetheless there are other practical issues involved under such an arrangement. The bottom line is that we do not have any easy alternative. And this brief discussion indicates difficulty with other alternatives.
Remittance
This brings to the core of our problem. We all know that Nepal’s economic performance has been sub-par for a long time. The exodus of workforce is a testament to that. Yet it is even more unsettling to note that economic agendas and logical discourses are nowhere to be found. We all are shown rosy pictures about the future, but when it comes to serious policy issues, either there is no consensus at all or in most cases the ideas and debates are superficial.
Ironically, the exodus of workforce has created some sort of equilibrium, with remittances contributing about a quarter to our economy. The sustainability of our exchange rate system and macroeconomic stability are all contingent on remittance, since it has been the only viable source of foreign-exchange reserves for a long time. While remittance has created a buffer zone against passivity, our vulnerabilities are the making of our own neglect and degrading of economic issues. Our socio-political achievements, as towering as they may be, are not likely to have meaningful impact in ordinary lives if we lose sight of the economy.
This is the second of a two-part article. The first part was published yesterday (August 31)
The author has a doctorate in economics from American University, Washington D.C. His
doctoral dissertation analyses the exchange rate and monetary policy in Nepal
680anand@gmail.com
Related story
To peg or not to peg