It is official: the Nepal Rastra Bank, the central bank of the country, has invested Rs. 33 billion in Indian Treasury Bills due to high interest rate in India- 5.25 percent- compared to 0.25 percent in the United States. It is a controversial decision. The question is simple. Is it legitimate for the central bank of the country to run after profit in utilizing the country’s reserve which consists largely of convertible currency or gold and, only to some extent, Indian currency?

It is argued that if the interest rate in India declines and that of US rises, Nepal Rastra Bank can not switch its investment to the United States as the Indian currency is not a convertible currency. Central bank should not involve itself in commercial activities to make profit as its main task is to formulate and implement monetary policy primarily to maintain stability in the price level of goods and services and to maintain exchange rate at the proper level. Therefore, it is not inappropriate to claim that investing the country’s reserves in inconvertible currency for profit is not a legitimate task for a central bank.

This is a correct conclusion with respect to investment of reserve in other inconvertible currencies than Indian currency. The reason is simple: the need of Indian currency in Nepal to meet the deficit in the country’s balance of payments with India to maintain Indian Currency/ Nepalese Currency exchange rate at the current level of Rs.160=IRs. 100, a rate fixed in the Panchayat period, totaling Rs. 106 .5 billion in 2008/09, up from Rs. 31.7 billion in 2004/05, an increase of about 240 percent within a span of four years.

The demand for Indian currency will increase further in the coming days if there is no major change in the economic performances of the country with output stagnating, price increasing and balance of payments with India deteriorating. The total trade deficit with India in the fiscal year 2007/08 totaled Rs.103. 8 billion, or 13.5 percent of total production of goods and services in the country in that year, popularly known as Gross Domestic Product (GDP). This deficit in trade account in that year with India was financed from two sources: by buying Indian currency from the Reserve Bank of India with dollar or by paying exporters in India in convertible currency.

The need of Indian currency will increase further in the coming days. The reason is simple: the prospect of satisfactory growth in real output is not promising due partly to continuous political problems in the country while the receipt from

remittances is expected to increase at a satisfactory rate. As a result, the growth of money income in the country will, as usual, far exceed the growth in the production of goods and services which, at present, is barely positive.

It may be noted that 85 percent of receipts from remittances is used by the family for consumption purposes. Thus, as the receipts from remittances have increased, it will also increase the demand for goods and services in the country creating a problem of excess demand which will lead to a rise either in price or in imports or both.

The current experiences of Nepal are not different from the above observation. While the rate of inflation

in 2008/09 reached 12.1 percent, substantially higher than the prevailing rate of inflation in India, total imports increased by 28.2 percent.

Most of the countries of the developed and emerging countries of the world, at present, are suffering from the problem of low domestic demand but Nepal is suffering from excess demand but slow growth in domestic output.

Nepal’s income of foreign exchange is largely in convertible currencies, but a large part of

expenditure is in Indian currency due to rising trade deficit attributed to various structural factors, including the exchange rate system maintained by Nepal. It is well known

that Nepal maintains fixed exchange rate with India and floats, parri passu, with Indian currency with respect to other currencies.

It is now more expensive to import from countries other than India due to devaluation of the dollar and, as a result, import from India will increase further in the coming years if there is no substantial change in the structure of the domestic economy. Exports can not increase in real terms due to stagnant output, and the trade deficit will further widen.

Nepal’s demand for Indian currency may reach Rs. 200 billion by the end of 2012/13, and its reserve of Indian currency should be maintained at least at that level. At the end of last fiscal year, Nepal’s reserve of Indian currency was just Rs. 26 billion. It used to buy Indian currency from the Reserve Bank of India as and when needed. This can not be accepted as a correct approach. It can now diversify its reserve- India itself, for example, has changed the composition of its reserves by buying 200 tons of gold from the IMF- by investing in Treasury bills and bond of India to meet its annual demand of Indian Currency. The high interest rate will be an added benefit.

Dr. Pant is former Vice- Chairman of the National Planning Commission