Currency peg with India
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.
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.