It appears that the public are investing in Indian banks creating a problem of capital flight

Raghab D Pant

Capital flight and interest rate

There have been reports in the press that receipts from the remittances have declined by more than ten per cent in the first half of the current fiscal year compared to the same period last year. It is also reported that due to this — India’s share in income from the remittances amounts to 25 per cent of the total — the total income from remittances has shown a declining trend. The authorities have refused to identify the reasons. It is believed in the financial circle that the new financial problems are recently emerging partly due to lack of understanding among the policy makers of proper methods to implement the declared policy measures.

In November 2003, the IMF agreed in principle to provide US$73.9 million to the government under its Poverty Reduction Growth Facility(PRGF) to implement Nepal’s economic and financial policies for 2003/04-2005/06. In that process, Nepal has pledged (i) to maintain fixed exchange rate with the Indian currency and (ii) to maintain foreign currency reserve to cover about six months’ of imports of goods and services.

The government, however, has agreed to institutionalise the process that was in practice. This means that Nepal’s exchange rate with other currencies cannot be determined by the forces of demand and supply as in other countries following liberal economic policy; it has to be fixed by taking into account the exchange rate of that currency with the Indian currency. More importantly, Nepal has to formulate and implement monetary policy within the constraints imposed by the fixed exchange rate. The basic question is: What are these constraints?

It is now widely believed that the effect of the policy pursued by NRB will depend on the type of exchange rate system followed by the country. Because of the fixed exchange rate with India, its policy will have no effect in determining the growth rate of the economy, though it can create, as Nepal Rastra Bank Act 2058 also clearly stipulates, the type of environment needed to accelerate the development process.

The case would have been completely different had it been following the flexible, that is, market determined exchange rate policy. Similarly, Nepal cannot maintain, at least in the long run, an inflation rate different from India. In practice, the price of goods traded in the market is largely determined by the price prevailing in India, given the fixed exchange rate and open border. In that process, Nepal also cannot maintain an interest rate different from India without affecting the balance of payments.

What then should be the goal of our monetary policy? Monetary policy of Nepal should be used for no other purposes but to maintain its balance of payments position, specially with India, at a favourable level. The fixed exchange rate has provided a framework to pursue an integrated policy measure between Nepal and India. Any deviation from this framework will create problems in the financial sector and, subsequently, on overall development performances.

Recently, the interest rate structure followed by the banking systems of Nepal and India shows clear divergences. In particular, the interest rate offered by the commercial banks of Nepal has shown a declining trend so much so that real interest rate, that is, nominal interest rate provided by the banks adjusted for inflation, is negative. This means, in fact, the public are losing money by investing in fixed and savings deposit of the commercial banks. The interest rate in India is relatively high and, according to press reports, there is a possibility of its going up in the coming months. It is perhaps more profitable for the Nepali labour to invest in India than in Nepal. Thus, it is not surprising that the remittances from India are declining while those from other countries are following the past trend.

The problem is more serious than what it appears. Nepal has a convertible foreign exchange reserve sufficient to finance one year of merchandise imports, but its reserve of Indian currency is declining at a fast rate (by 75 per cent in the first five months of the current fiscal year). Though the information is sketchy, it appears that the public prefer, and are doing so, to invest in Indian banks creating a problem of what is popularly known as ‘capital flight”. The total Indian currency reserve of the banking system was slightly higher than Rs. 3 billion in February, 2005 which is not sufficient even to finance two weeks of imports.

How will then the government solve the problem if the demand for the Indian currency exceeds its supply? It can, of course, borrow but I don’t see any source who can lend. The IMF will provide loans at the time of crisis in the balance of payments. It, however, cannot provide loans in Indian currency because it is not an convertible currency. As far as convertible currency is concerned, NRB has more than Rs. 100 billion at its disposal. In the past, the NRB has maintained Stand-by Credit Arrangement with the Reserve Bank of India under which it was authorised to borrow an agreed amount in Indian currency at a nominal interest rate. Such arrangement, to the best of my knowledge, is not operational at present. It will not be surprising if a typical problem emerges in the financial sector involving exchange rate of Nepali currency vis-à-vis Indian currency. The monetary authorities should immediately work out the detailed strategy to deal with the emerging problem of balance of payments with India.

Dr Pant is with Institute for Development Studies