The recent reports from the banking sector indicate Nepal’s alarming balance of payments position with India in that the continuation of the current trends may lead to foreseen problems soon. The reason is that the demand for Indian currency in Nepal has increased at a very unusual rate. As a result, whatever surplus Nepal has generated in its balance of payments with other countries, the available convertible foreign reserve is used to buy Indian currency from India to meet the local demand. As a result, the foreign reserve position of the country has not only stagnated but even started to decline. In the current year up to now, Nepal Rastra Bank — according to Mr. Ramji Regmi, Director of the Foreign Exchange Department — has purchased US$ 1.30 billion, or fifty percent of the current foreign reserve of the country, from the market, out of which all but Rs. 0.09 billion was used to buy Indian currency. This clearly indicates the over valuation of the exchange rate of Nepali currency vis-à-vis Indian currency, an issue that we have been raising for the past two years. The authorities until now have refused to listen. But for the new government it is not possible to follow the same approach because, according to Nepal Rastra Bank’s own account, chickens are slowly coming home for roost.

There are several reasons for the emergence of such unwanted situation, apart from the overvaluation of exchange rate of NC. The most important of them are: (i) rising deficit in merchandise trade account and, presumably, (ii) capital flight due partly to political disturbances and due partly to difference in the productivity of the capital. The authorities are expected to be aware of the situation but they are maintaining silence until now due largely to two reasons. They are: (i) constituent assembly election; and (ii) favourable impact of rising trade deficit with India on government revenue.

The change in the exchange rate of the Nepali currency (NC) vis-à-vis Indian currency (IC), and, therefore, other currencies as well would have generated negative impact on the domestic price level which is already rising at a relatively high rate. As the receipts from remittances, pension and grants were high — these three items together account for more than twenty percent of Gross Domestic Product (GDP) — and rising, the government followed the unrealistic exchange rate with Indian currency. It, however, increased the demand of IC due partly to the increase in demand for imports as domestic production was more or less stagnant. In particular, the increase in imports led to the rise in trade deficit as export started to decline due partly to the rise in domestic demand. As expected, trade deficits with India accelerated at a rate higher than the growth in domestic output; it is expected to reach Rs. 124.4 billion, 15.7 percent of GDP, in the current year compared with Rs 117.7 a

year before. The total import in the current year is expected to reach Rs. 193 billion, or 24.5 percent of GDP.

The incumbent government, however, not only tolerated but even encouraged the rise in imports, though implicitly. The rise in import of goods, particularly from India, led to a rise in government receipts from taxes on consumption which alone are expected to contribute 45 percent of government revenue. This helped the government to maintain fiscal position in a not too unsatisfactory situation relative to growth in income. It, however, gave the false impression to the general public that government fiscal position is well managed. The government was also relatively active in making transparent the revenue from import duties month in and month out.

It is, however, not possible to fool all of the people all of the time. Unfortunately, the decision makers of the Nepal Government now will not be able to fool even themselves, a practice that had been in operation since the past two years. As indicated above, and the information provided by the decision makers of the Nepal Rastra Bank too, the present practice of supporting exchange rate with IC by receipts from remittances can not continue for long. But because of political uncertainty that now prevails in the country, the current decision makers will naturally try to avoid unpopular but necessary decisions, however costly it may be. In our case, the Finance Minister is not expected to continue in his position for long and we still don’t have full time Governor in the central bank.

The first task of the new Minister of Finance will, therefore, be to maintain realistic exchange rate, a problem that the incumbent government has avoided for the past two years. This will be the most unpopular decision for few months though after that it will generate most favourable impact in the country. The other option will be to maintain flexible exchange rate system that will be most helpful to insulate the domestic economy from undesirable external influence. It is, however, not easy to manage the flexible exchange rate system.

Dr Pant is executive director, Institute for Development Studies