Need for integrated management system:

Inflation has emerged as a worldwide problem due partly to a rise in the price of oil and food. Nepal is not an exception. The price of food and beverages, which accounts for about 55 per cent of consumer budget, has increased by 13.0 per cent compared to last year, with the price of rice rising by 25 per cent.

The impact of the recent rise in the price of oil has not been taken into account yet. This will push up the price further in the coming months. At the same time, very few have noticed that the Consumer Price Index in Nepal severely underestimates the rate of inflation, defined as continuous change in the price of goods. The main reason is that its base is almost twelve years old and the weight assigned by it on Consumer Price Index is out of date. The most important issue at present is to find a way to control inflation caused by both internal and external factors.

A delegation from the International Monetary Fund that visited Kathmandu recently for pre-budget consultation has, according to press reports, suggested maintaining the exchange rate of the Nepali currency peg to the Indian currency to keep inflation low and stable. I do not think that anybody will raise an objection to the recommendations of the IMF delegation, not because this is the best option but because the alternative may be worse. In particular, if the political authorities, given their irresponsible behaviour in recent weeks, have also the liberty to fix exchange rate too, it might lead to hyperinflation as in Zimbabwe where price is increasing at a monthly rate of 355, 000 per cent!

This will cause capital flight from the country leading to total collapse of the

economic system of the country. It is, therefore, pertinent for the IMF delegation to

argue that “pegged exchange rate system had not only helped to check inflation but also discouraged capital flight to India”. This is a million dollar argument that needs to be examined in detail.

Inflation under the pegged exchange rate system is determined by external factors, and domestic monetary policy has no role whatsoever in determining domestic rate of inflation or growth rate of the economy. Its only task is to maintain equilibrium in the country’s balance of payments. In Nepal’s case, domestic inflation, given fixed exchange rate with India, is determined by India and cannot exceed India’s inflation rate. That is the safest route that IMF has discovered for Nepal.

We must maintain a pegged exchange rate with India at least until we have an elected government. That does not, however, mean that we can peg exchange rate with India at any level at our pleasure for so-called national prestige. If we do follow such a practice, this will create unnecessary problems in the balance of payments, increase poverty level and even capital flight from the country. The IMF delegation has tried to avoid the question whether Nepali currency is pegged with Indian currency at the realistic level. If we are not sure about the cause itself, how can we evaluate the effect? As a result, the recommendations of the IMF delegation, as usual, can only be taken with a pinch of salt, and this time it has to be more than a pinch.

The current exchange rate of Nepali currency with Indian currency, as we have mentioned several times, is highly overvalued. It has been maintained by buying Indian currency from India by selling US dollars. In the first ten months of current fiscal year, Nepal bought Indian currency worth Rs.48 billion. It is expected to reach about Rs.60 billion in the current fiscal year, 50 per cent higher than that of last year. The total balance of payments deficit with India is expected to reach 90 billion in the current fiscal year. The question is: Is the current exchange rate between Indian currency and Nepali currency realistic?

It is surprising to note that IMF and other decision makers have not mentioned a single word about Nepal’s balance of payments with India which in normal circumstances is at a crisis stage. They are quiet because Nepal has US dollars received from remittances from labourers working abroad. On the contrary, Nepali currency has appreciated against the US dollar so that the family of workers who used to exchange, for example, one US dollar for Rs.71.69 in January 2007 now receive only Rs.64.45, a loss of Rs.7.24 per dollar. The current exchange rate with Indian currency has cost Rs.8-10 billion to the families of migrant labourers. It surely has increased their poverty level, the detailed information for which has yet to be collected.

There is a general feeling that current exchange rate cannot be maintained for long. The current undeclared instability in the exchange rate has increased the capital flight from the country, a problem realised by the IMF in the earlier staff report. Against this background, what we actually need is a detailed framework to manage inflation and exchange rate in an integrated manner.

Dr Pant is executive director, Institute for Development Studies