In recent years, India has experienced a very high growth rate in national income — 9.2 per cent in the current year, that is, almost equal to China’s growth rate of 10.4 per cent — and the Eleventh Five Year Plan (2007/08-2011/12) has a target of maintaining an annual growth of 9 per cent in gross domestic product. At this rate, India’s national income will double every nine years; the per capita income, at constant price, in the last two years only increased by 15 per cent, almost a world record. A recent indication is that the growth rate will exceed even that of China’s in the current year, and The Economist predicts that India will soon overtake Japan to become the world’s third largest economy.

Nepal has not been able to reap any benefit from such an incredible economic performance of its main trading partner for reasons that need little explanation. On the contrary, Nepal’s economic performance is the worst in the Asia Pacific region: the per capita income has declined or is barely positive since the past several years. However, the politicians and bureaucrats have never failed to present — almost in Don Quixote’s style — the need, and capability, of Nepal to match the economic performance of India. But these words alone seldom help to improve economic performances; the growth in national income in the current year is expected to be less than one-third of India’s. On the contrary, Nepal may soon face new problems due to its failure to maintain realistic exchange rate with Indian currency. This article aims to clarify this issue.

In India, too, there have recently been wide ranging discussions on the economic growth rate that India can sustain in the long-term without any undesirable symptom of overheating. The overall price index in recent months, however, has increased at a relatively higher rate, currently pushing 6.7 per cent largely due to supply constrain and buoyant domestic demand. Though the rate is lower than what Nepal has experienced (7.5 per cent), it is almost one percentage point higher than the upper limit set by the Reserve Bank of India. This has made the Indian policy-makers extremely nervous.

The government, as explained by the Finance Minister, is determined to take all steps to moderate the inflation rate. The Reserve Bank of India, for example, increased repo rate, that is, the interest rate at which it lends to commercial banks to 7.5 per cent. It also increased the cash reserve ratio or the amount of money the commercial banks need to keep with the Reserve Bank by 50 basic points. This has, no doubt, withdrawn the liquidity from the system. Similarly, the price of petrol and diesel has been reduced by Rs. 2 and Rs.1 per litre respectively.

What impact these developments will generate, if any, in Nepal? As far as price is concerned, the inflation rate of Nepal is higher than the current rate in India. So what we need to be careful about is not the rate of inflation per se in India, but the impact of policy measures initiated, or expected to be initiated, by India to control the domestic price rise on major macro variables here. For example, the Indian Prime Minister has indicated his preference to reduce the import duty to the level of ASEAN countries. Similarly, the government has reportedly indicated its preference to the Reserve Bank for a “stronger rupee”, that is, appreciation in the value of domestic currency vis-à-vis foreign currency.

In the latter case, the value of Nepali currency will also appreciate automatically as is the case until now, given Nepal’s commitment to maintain fixed exchange rate with Indian currency. True, Nepal has foreign currency reserve that is adequate for 10 months of merchandise import. This, however, will not justify to follow a policy of “stronger rupee”, given Nepal’s sluggish economic performance; the Nepali currency is already appreciated by about 5.0 per cent in the last one-and-half-months. The further appreciation of Nepali currency will virtually destroy our tourism and export, especially of garments and carpets, and reduce economic growth rate. At the same time, it will not be possible not to maintain fixed exchange rate with India.

This dilemma has arisen because we are not following the correct exchange rate with India. Notwithstanding high foreign reserve position, Nepal has high and rising deficit in the balance of payments position with India. This deficit has been maintained by selling convertible foreign currency to India. This fact has never been made public but the current process

cannot continue for long.

The conclusion is obvious: the exchange rate of Nepali currency with respect to Indian currency need to be maintained at realistic level, given the divergence in growth rate between Nepal and India. The realistic rate is expected to be around NRs.180=IRs.100. It is not good to wait for long to follow the correct policy.

Dr. Pant is executive director, Institute for Development Studies