There is speculation in the press that both the deposit rate offered by the commercial banks and loan rate charged by them may go up soon. The reason is that some of the public enterprises, including Tamakoshi Project, Nepal Telecom and Nepal Oil Corporation, are expected to crowd out the market for the financial resources in the not too distant future. It is also reported that the bankers have already begun to feel a liquidity crunch. The basic question is: Will the deposit and loan rates go up? My answer is: Yes, but not for the reasons cited above but due to Nepal’s exchange rate system that maintains a fixed rate with the Indian Currency (IC) while the exchange rate with other currencies moves, pari passu, with IC.

Our experience at present is not different from the Canadian experiences after the Second World War when the International Monetary Fund (IMF) was established to stabilise the exchange rate of member countries. A fixed rate system was adopted at that time; and the member countries were obliged to buy and sell the foreign exchange at a fixed rate whose value can not be changed, after a certain limit, without the approval of IMF.

Canadians were surprised to observe the functioning of fixed exchange rate system because with big neighbour on the south it had neither the control over money supply nor over the interest rate. If interest rate in the United States goes up, there will be outflow of capital and money supply, that is, total currency and deposit held by the public will decline. Similarly, if interest rate in Canada is high — which was a rare case — there will be inflow of capital from the United States which helps to reduce interest rate in Canada. Canadians have no control over either interest rate or money supply, or over the rate of inflation. It was sometimes said that if the United States has influenza, Canada will have pneumonia. The Canadian authorities, therefore, decided to move to the flexible exchange rate system under which exchange rate is determined by supply and demand in the market.

Nepal’s case is not different from that of Canada or any other country that maintains fixed exchange rate. It cannot control all policy instruments, namely, exchange rate, money supply and interest rate. If it intends to control exchange rate with IC, both interest policy and other monetary variables will be determined by the rate prevailing in India, specially given the free convertibility of the Nepali currency into IC and vice versa. The only function that monetary policy can do under such exchange rate

system is straight in that, as suggested by IMF, it should remain geared to supporting peg to the Indian rupee. This is what Nepal Rastra Bank has been doing for the past

several years. But if monetary authorities want to control both money supply and

interest rate, Nepal should let exchange rate be determined by the market. The choice is ours.

Nepalis who save mostly either in real state or in cash have no incentive to hold cash due to several factors including (i) low interest rate in deposit; (ii) security situation in the country and (iii) high interest rate in India in both commercial banks and bonds. In Nepal, in particular, the interest rate in commercial banks’ deposit is barely 3-4 per cent while in India it is about 9-10. Suffice it to say that it is cheaper for the Nepali households and businessmen to borrow from the Nepali commercial banks and then deposit in Indian banks.

Against this background, we are lucky that we have still not witnessed massive outflow of capital from Nepal probably due to some other factors, the detailed information for which is not available. But in recent months, there have been press reports indicating outflow of capital for investment; and the momentum, as the experiences of other developing countries suggest, once started is difficult to check without taking some sensible policy measures by the government. The balance of payments position with India is deteriorating at a rapid rate. The rough estimates available to us shows that in the period July-December, 2007, Nepal Rastra Bank has purchased IC worth Rs. 50 billion from India by paying in US dollars. Still, people,

as of November 2007, are holding, in per capita terms, about two months of income whereas they used to hold only 45 days of income. Why they are holding this excess cash is difficult to guess. But sooner or later it will lead to the increase in demand for IC.

The good days in our balance of payments are perhaps over. In the first three months of the current fiscal year, the foreign exchange of the banking system declined at an annual rate of 15 per cent. If this trend continues, this will definitely lead to a decline in money supply followed by the rise in deposit rate offered by the commercial banks due to one reason or another, including capital flight which is the effect rather than cause of the problem.

Dr Pant is executive director, Institute for Development Studies (IfDS)