KATHMANDU, June 30

Greater flow of foreign aid in the coming days should not be a major cause of concern, as such transfers would replenish foreign exchange reserve, providing the country much needed cushion to finance imports, former central bank governor Yubaraj Khatiwada said today.

His comment comes at a time when many are criticising the government for holding the donors’ conference to mobilise resources from abroad, rather than tapping internal sources to finance recovery and reconstruction works in the aftermath of earthquakes of April and May.

“My eyes were always focused on the (foreign exchange) reserve floor when I was the governor,” said Khatiwada, who stepped down from the driving seat of Nepal Rastra Bank (NRB) in March upon completion of his five-year tenure. “This is because a declining reserve does not bode well for a country which is dependent on imports.”

The International Monetary Fund requires countries to maintain a foreign exchange reserve enough to finance merchandise imports of eight months.

“But many countries cannot afford to keep such a huge reserve unless high-yielding investment tools are offered to them to cover the cost of holding such currencies. So, I’d say foreign exchange reserve should be able to finance imports of at least six months,” Khatiwada told a seminar organised by the Society of Economic Journalists here today.

Nepal’s foreign exchange reserve stood at $7.65 billion (Rs 781.33 billion) as of mid-May, up 10.2 per cent than in same period last year. These funds are enough to finance merchandise imports of a whopping 12.6 months.

Nepal’s foreign exchange reserve has lately been growing because of money sent by Nepalis working abroad. This inflow of remittance, in turn, is helping the country maintain current account and balance of payments surplus, despite widening trade deficit.

Since the flow of workers’ remittance is unlikely to taper anytime soon, Nepal does not need to worry about facing a major foreign exchange crisis in the near future. But things could gradually change as imports start going up to fulfil various recovery and reconstruction needs.

“Already, the portion of imports in the country’s capital spending stands at around 50 per cent. Now, people are thinking of abandoning the use of traditional domestically-manufactured building materials that are not quake-resilient. This means, we’ll be importing more of steel and other building materials, which will continue to exert pressure on foreign exchange reserve,” Khatiwada said.

This means the country will need greater stock of foreign currency because payments related to imports should be made in convertible currencies, such as the US dollar. And even if a majority of goods are brought from India, with which Nepal has maintained a currency peg, the country still needs to offload the greenback to purchase Indian currency.

So, there seems to be no alternative to maintaining a sound foreign exchange reserve.

And if such a precaution is not taken, the country may even face severe shortage of foreign currencies like three decades ago, which triggered a financial crisis.

On December 1, 1985, Nepal’s foreign exchange reserve dropped to a rock bottom of around $40 million. “This was barely enough to finance merchandise imports of a week,” said former acting central bank governor Krishna Bahadur Manandhar.

Nepal faced foreign exchange crisis at that time because of a narrow-sighted assumption that rise in money supply does not build inflationary pressure here, because inflation in the country is ‘derived’, or passed through imports from India.

While the central bank was blinded by this misconception, public spending started rising to levels never seen before, widening the fiscal deficit. “The soaring public spending — which raised money supply — then gave a boost to people’s purchasing power, which amplified demand for goods, especially those imported from India,” Manandhar said.

This exerted pressure on the foreign exchange reserve. Gradually, the NRB got trapped in vicious circle of offloading US dollars to purchase Indian currency.

“In the end, the country had to brace for a financial crisis,” Manandhar said, adding, “It is essential to adhere to macroprudential norms to prevent the financial sector and economy from facing a disaster.”

Yet, many frown upon the idea of mobilising financial resources from abroad, citing it builds inflationary pressure.

But Khatiwada said: “Foreign aid itself is not inflationary. In fact, the inflationary pressure is exerted by monetary channel. And since the central bank has control over the monetary channel, it should use money market tools to absorb excess funds as soon as inflationary waves are detected.”

Another reason why foreign resources are needed, according to Khatiwada, is because the country may not be able to borrow huge sums from the domestic market every year.

“We may borrow Rs 100 billion next year and another Rs 100 billion a year after that, but we cannot continue repeating this cycle, because this will ultimately crowd out private investment, which is not good for sustainable growth of the economy,” Khatiwada added.