Relatively speaking, the document outlining the national monetary policy for the current fiscal year presented by the Nepal Rastra Bank governor on July 23 was truly impressive not because it contains well perceived monetary policy, and the detailed programmes for implementation, but because of the fact that it does not promise, like the budget of the current year, something for everybody.

Otherwise, the impressive document with its 10 chapters, 32 pages, and 115 paragraphs is like Franz Kafka’s novel with the double possibility of interpretation. It, therefore, necessitates two reading methods, an official reading and a not-so-official one. This article uses both the methods.

The aim of the monetary policy as outlined in the document is not controversial. It aims to help the government to achieve its declared annual growth rate in gross domestic product of five per cent, manage the liquidity in the country to confine the annual inflation rate to six per cent and maintain the surplus in the balance of payments in the current fiscal year at Rs. 16 billion with money supply, broadly defined, and credit to the private sector increasing at an annual rate of 16 per cent and 18 per cent, respectively. It, however, does not explain what the central bank will do to achieve the monetary targets indicated in its plan. Against this background, it is safe to state that the monetary targets, which are not even mathematically consistent, simply reflect the wish of the policymakers. For example, simple arithmetic (growth in money supply less the growth in GDP) will tell us that with an expected annual growth rate of five per cent in GDP and increase in money supply by 16 per cent will lead to 11 per cent inflation rate per annum.

The most important question has never been raised. It is: Can an open economy like Nepal that is maintaining a fixed exchange rate with its major trading partner follow an independent monetary policy and inflation rate? My routine answer is, no. Unfortunately, the policymakers will never learn, notwithstanding comments in the past from several institutions and individuals, myself included.

It may be recalled that the International Monetary Fund (IMF) has explained as early as January 2001 how monetary policy in Nepal should be conducted. It said, “The fixed exchange rate requires that domestic monetary conditions be consistent with the peg and monetary policy be broadly harmonised with that of India” The IMF team that visited Nepal in November, 2005, also suggested that the same procedures should be followed but requested the Nepal Rastra Bank to review the exchange rate with Indian currency regularly.

The exchange rate with the Indian currency, however, has never been taken seriously in Nepal, in spite of the rising trade deficit with India that is expected to have reached Rs. 61.3 billion or equivalent to 11.4 per cent of GDP in the last fiscal year. Nepal, in fact, is not in a position to maintain the free convertibility of Nepali currency to Indian currency at the prevailing exchange rate without active support from India. It has excess of income over expenditure in convertible currency due to increasing remittances from Nepalis working abroad as well as declining trade, in relative terms, with countries other than India.

Therefore, Nepal Rastra Bank has used its convertible currency reserve to support the exchange rate with Indian currency using several means. In that process, Nepal Rastra Bank purchased Indian currency worth Rs. 27 billion with the Reserve Bank of India in the last fiscal year by paying convertible currency. As this alone was not sufficient to meet public demand for Indian currency, it is estimated that about Rs. 13 billion worth of imports from India was paid in convertible currency. The demand for Indian currency is expected to increase at a rapid rate in the current fiscal year for several reasons.

Against this background, it is appropriate to question the sustainability of the current exchange rate of Nepali currency with Indian currency without external assistance. It is high time to review the exchange rate of Nepali currency to make it more realistic.

In particular, India is experiencing almost double-digit growth rate while in Nepal GDP in per capita terms between 2002/03 and 2005/06 increased, on average, at an annual rate of 0.3 per cent. As a result, the balance of payments deficit with India is expected to have reached almost a crisis stage clearly indicating over-valuation of Nepali currency vis-a-vis Indian currency.

It, however, appears that increasing receipts from remittances have given the policymakers a false sense of prosperity in the country and ample resources to support the overvalued exchange rate. That is why the governor mentions “remittances” eighteen times in his speech presenting the new monetary policy document.

Dr Pant, a monetary economist, is executive director, IfDS