Nepal | May 23, 2019

Exchange rate policy: The way forward

Guna Raj Bhatta

Unless a credible policy alternative is available, abandoning peg or adjusting level of peg may not sustain longer, requiring substantial intervention in the exchange market or frequent adjustments in the rate

Illustration: Ratna Sagar Shrestha/THT

Nepali currency (NC) has fallen to a record low—to 118 a dollar—as the US currency continues to gain strength. Nepali rupee was hovering around 102 a USD last year. Such an upsurge in the rate of exchange has been blamed to exchange rate policy of Nepal. Nepal’s exchange rate is fixed with Indian Currency (IC). When Nepal Rastra Bank (NRB) was established in 1956, stabilising NC vis-à-vis IC was one of the two objectives of the central bank due to wide divergence between market rate and official rate. IC was widely circulated throughout the country and it was a legal tender. Currently, exchange rate is Rs 160 for every INR 100.

The current regime and the level of peg are constant since 1992.

The rate of NC is set as per the exchange of IC and USD, thus, it depends upon at Indian economy as well as the behaviour of Reserve Bank of India to stabilise exchange rate. Licensed institutions are free to set their exchange rate observing the foreign currency market movements, except for IC. Citing the major trading partner, open porous border, better policy and economic stability and stability in investment flows, among others, Nepal’s fixed exchange rate policy has remained unchanged despite economic liberalisation initiated in Nepal in the early 1990s. This has, however, emerged as a major issue of late—both at the policy regime and level of peg—with the argument that Nepal is paying exchange dividend to foreigners. The deteriorating trade balance is also blamed for the exchange rate policy.

Theoretically, a pegged exchange rate is a monetary policy strategy such that the price stability objective could be achieved by anchoring it with another price variable known as “nominal anchor”. Thus, exchange rate is Nepal’s nominal anchor for containing inflation. This principle fully justifies the current fixed regime. This is because empirical evidences show very close tie of Nepal’s inflation with India and Indian inflation is relatively lower. Also, after the recent move of India towards inflation, it seems that Nepal can benefit further.

A significant number of countries still adopt fixed exchange rate. From resource-rich to the small or very big economies like China still follow some sort of fixed regime. About 48 per cent of the world economies fix their exchange rate. This shows that the regime itself cannot be the cause of poor economic performance.

A depreciating currency has couple of advantages. Weak currency means lots of money in domestic terms for foreigners. Thus, domestic goods and services would be cheaper for them. Likewise, a few dollars will mean a lot (in local currency) for the country that receives remittance, investment, grants and loans. But the problem arises at the time of payback—either in terms of import and loan repay or foreign investment and earnings’ repatriation. For a good economy, stability in the exchange rate—either through peg or other means—is desirable.

Revisiting exchange rate policy is a very serious tool globally. Once introduced, reversal would be costly. The East-Asian financial crisis was originated from Thailand in June 1997 after the Bank of Thailand floated its exchange rate. Currency crises quickly spread over many countries including Indonesia and South Korea.

Unless a credible policy alternative is available, abandoning peg or adjusting level of peg may not sustain longer, requiring substantial intervention in the exchange market or frequent adjustments in the rate. Furthermore, since exchange rate is considered a price variable, it should also be understood whether the country has a credible “alternative nominal anchor” for monetary policy. Otherwise, a rising inflation would be a serious macroeconomic problem like the one Argentina faced recently.

Nepal has very limited policy choices due to its geographical and economic conditions. Fairly speaking, it can either adjust the level of peg or introduce a flexible regime such that exchange rate is determined based on market factors. Adjusting the level of peg, however, would not be a piece of cake—both in terms of setting equilibrium level of peg as well as the requirement of frequent adjustments that may lose the trust at local currency.

On the other hand, a market-determined rate needs market factors prevalent in setting optimal prices. Even the prices of stocks and real estate are getting problematic in Nepal due to the price determination beyond market fundamentals. So it may not be fair to have an exchange rate priced in the market mechanism.

The existing exchange rate policy—both peg and its level—can be still a better policy choice. It is observed a no significant misalignment of real effective exchange rate from the fundamentals. Although an overvaluation of NC was observed against USD, the recent sharp depreciation helps correcting this disequilibrium.

Initiating any form of policy change needs extensive preparation. But it is the right time to ponder on way forward for the phased exchange rate liberalisation, synchronised with reforms in the monetary policy and capital accounts. Nepal is yet to be able to sustainably correct the trade balance through exchange rate policy and the available source of foreign currency reserve is also vulnerable.

Bhatta is deputy director of Nepal Rastra Bank

A version of this article appears in print on October 16, 2018 of The Himalayan Times.

Follow The Himalayan Times on Twitter and Facebook

Recommended Stories: