August 2005
Economy & Policy

Debate about NC - IC Peg

The Nepali rupee (NR) has remained pegged to the Indian rupee (IR) for long and nobody felt uncomfortable about that. But recently some quarters have started raising questions (particularly the exporters who export in dollars) about the practice.

The prime reason is the gradual strengthening of NR against the US dollar (USD) which is causing erosion in the competitiveness of Nepali products in the overseas market. Textbook theories of economics say, as country A's currency gains strength against foreign currencies, country A's exports will be expensive and the demand for country A's products in foreign countries will diminish. As most of Nepal's exports to overseas is invoiced in USD, NR's continuous appreciation over the last several years against the dollar is badly hampering Nepal's exports.

The exchange rate of one USD was NR 78 on December 13, 2002. It gradually reduced to NR 70.35 on July 1, 2005. The exporter who bills his exports in USD was getting Rs. 78 for every dollar worth of export in 2002. Now he is getting only Rs. 70.35 for the same export.

This reduction in the earning is not due to any reason internal to the Nepali economy. It is entirely due to the gradual strengthening of the IR to which the NR is pegged. As IR goes down, so does NR and as IR goes up so does NR. This has made the job of the Central Bank easy, but it has been causing difficulty to overseas exporters.

However, in principle, NR is not pegged to IR. The NR-IR rate is as floating as NR rate with the other international currencies. That is why the Nepal Rastra Bank announces the NR-IR rate every day as it does for other currencies. But in practice, the NR-IR rate is maintained every day at NR 160 for IR 100. With this rate fixed, NRB officials have to only do some calculations to announce the foreign exchange rate for other currencies for the next day after they receive the information about the rates being fixed by the commercial banks who in turn base their rates on what the Reserve Bank of India (RBI) is going to fix for the next day . The rate fixed by NRB for the next day is an average of what the banks are going to fix.

The Nepal Rastra Bank, in January 2005 in its mid-term review of last fiscal year's monetary policy, accepted that NR was overvalued by about 5 percent against the USD (thus requiring NR devaluation against USD) while it was undervalued by about 1.5 percent against IR (thus requiring revaluation against IR). In the annual review of last year's monetary policy, NRB in July 2005 stated that the NR is overvalued against the USD by 5.4 percent. One year ago, it was overvalued by only 0.8 percent, according to NRB. Floating NR by removing the peg will mean automatic devaluation of NR against USD and revaluation against IR. Alternatively, such devaluation and revaluation can be done also by issuing an order without unpegging.

One strong case in the past to oppose the devaluation of NR against USD was that such a move would increase the price of petroleum and various other essentials in the local market as they were then imported on payment of USD. But these days, petroleum is imported from India by paying Indian rupees. Therefore, revaluation of NR against IR now will make petroleum cheaper in the local market. However, as many industrial raw materials are now being imported from India against the payment of USD, such raw materials will be more expensive if NR is devalued against the dollar.

One point raised while opposing the devaluation of NR against IR is the current shortage of IR in Nepal. But Binod Bahadur Shrestha, outgoing President of FNCCI, calls it an artificial shortage "because the banks are refusing to accept IR when someone goes to them with a large amount of IR." Another aspect to be considered is the issue of increasing concentration of Nepal's foreign trade in India. In the late 1980s, India's share in Nepal's total foreign trade was about 22 percent but now it has crossed 60 percent. Undervalued NR has contributed to this. Such excessive concentration of the foreign trade on a single country is undoubtedly very risky.

When Nubiz asked a select group of prominent economists, bankers and businessmen about their opinion about whether to unpeg the NR from IR, a significant number of them were not prepared for the question. Even after they were given some weeks to contemplate on it, they were still undecided. However, nine out of 13 economists interviewed were clearly against the idea of unpegging NR from IR. Among the 13 bankers interviewed, 10 were against it while only two were undecided. Among the 17 finance company CEOs interviewed, eight were against and six were in favour of unpegging with three others undecided. Among the businessmen too the majority were in favour of retaining the peg.

However, a significant number of respondents from all groups were in favour of reviewing the current exchange rate of NR 160 for IR 100.

Should NR be Unpegged from IR ?

Prof. Dr. Bishwambher Pyakuryal

My answer to your question would be "no". To switch over to a flexible exchange rate system under the current political regime is not advisable. Any conclusion about it needs to be supplemented by the analysis of emerging issues in this regard. Outcomes of such an analysis support the continuation of a fixed exchange rate regime. First let me give you a brief background of the exchange system prevalent in Nepal and secondly, the reasons for advocating a fixed exchange rate system at least for the time being.

In short, Nepal's economy at present is very much influenced by external factors and hence it is prone to a higher degree of vulnerability. The weakening of the state machinery has made macroeconomic policy ineffective. While there is an excessive dependence on external aid, it is becoming difficult to comply with stringent conditionalities imposed by development partners. Against this background, despite the fact that Nepal's currency is overvalued against the Indian currency, I would prefer advocating the fixed exchange rate system to balance the country's fragile economic foundation. It is in our interest, not India's, to be at status quo. Further details about why pegged system should be preferred are explained in the following paragraphs. I would first like to give you the background.

Prior to the creation of the Nepal Rastra Bank as the Central Bank in 1956, the government had little control over the country's foreign currency holdings. Nepali currency was used only in the Kathmandu Valley and the surrounding hilly areas. The country's real medium of exchange was the Indian currency (IC). As Nepal practised a dual currency system, it was difficult to find out the actual holdings of IC in the country. Historically, the exchange rate between these two currencies was determined by an open market. The value of a 100 Indian rupees varied between Rs 71 and Rs 177 between 1932 and 1955. The fixed rate regime was first practised in 1958. The Nepali currency became the medium of exchange after the Foreign Exchange Act was passed in 1960. The full access to foreign currency other than IR was possible only after the Trade and Transit Treaty was signed with India in 1960. Prior to that India kept Nepal's foreign currency in their bank and the Indian government fulfilled Nepal's foreign currency needs. This was the reason why Nepal separated the Indian currency that was freely convertible from other currencies that were non-convertible.

One of the conditionalities of international financial institutions is the maintenance of a fixed exchange rate regime. For example, a loan agreement on Poverty Reduction Growth Facility with the IMF requires such an arrangement. Maintaining a fixed exchange rate means Nepal's monetary policy is fully dependent on India especially while determining Nepal's growth rate.

It has been almost three decades that many developing countries have shifted away from fixed exchange rates and moved toward more flexible exchange rates. Flexible exchange rate system helps determine the external value of a currency on the basis of the market supply and demand. Until 1975, about 87 percent of the developing countries had some type of pegged exchange rate. By 1996, a flexible exchange rate regime dominated and the number of countries with pegged exchange system fell to 50 percent. This can increase again depending upon the country's economic policy and priorities.

Secondly, countries with a higher inflation rate than their trading partner often depreciate their currency to prevent severe loss of competitiveness. But countries like Nepal with relatively thin financial markets, where a few large transactions can cause extreme volatility, cannot be well placed to allow exchange rate to totally free float for several practical reasons.

Theoretically, a fixed exchange rate has worked in small and more open economies that are dependent on exports and imports. Therefore, the structural characteristics of the economy should be considered before determining an appropriate exchange rate policy. The policy should be to stabilise macroeconomic performance, to minimise fluctuations in output, consumption and the domestic price level. A flexible exchange rate is preferred if disturbances are predominantly real (i.e. due to changes in tastes or technology that affect the relative prices of domestic goods) or originate abroad. However, Nepal is justified with a fixed exchange rate at the moment since disturbances impinging on the economy are predominantly monetary (i.e. changes in the demand for money), which affects the general level of prices. Therefore, Nepal should be safe to abstain from radical policy change as long as a 'no conflict' regime is restored and an elected people's government assumes power.

Now let me sum up my observation. The Nepali currency against IC was revalued by 3.0 percent on February 12, 1993 when IC significantly weakened against USD. At a time when IC is strengthened and appreciated against the dollar, NC also appreciates against the USD since it is pegged with IC as said before. The nominal devaluation of NC against IC can theoretically promote competitiveness of tradable goods but conflict has created ineffective and unpredictable macroeconomic policy regime in Nepal with declining export competitiveness and weakening employment opportunities. If this did not happen, the sliding currency would bolster export and create jobs.

We know that the inflation rate in Nepal is slightly higher than in India, which creates a situation of marginal overvaluation of the NC. It is therefore, a question of tracking the trend in price differentials in the local Nepali and Indian markets. If the difference were of a temporary nature there would be an automatic correction of marginal real appreciation of NC against IC. The message is to keep the real exchange rate constant and be careful not to jump over to appreciate or depreciate the currency on the basis of temporary market behaviour.

The execution of a realistic monetary policy should not, however, mean accepting the continuation of the artificially revalued or undervalued currency for a long period. The experience after globalisation shows that capital flows brought in by strong currency is more fruitful than the increased trade through devaluation. The example is Hong Kong. The thrust to maintain stability has encouraged pegging their currency against the dollar. But the growth in Hong Kong is suffering since the economy is being held back by their overvalued currency. Therefore, Nepal should stick to the present arrangement and strengthen institutions to carefully track macroeconomic behaviour. This may help in determining an appropriate exchange rate policy in the future.

Dr. Dilli Raj Khanal
Chairman, IPRAD and Former Member, NPC

Yes, I am in favour of abandoning the fixed exchange rate between the Nepali and the Indian rupee.

The exchange rate is a price of foreign exchange and hence a rate is the reflection of its supply and demand. In most circumstances it responds to domestic inflation and hence an increase in domestic prices above the prices of the trading partner makes exports less competitive. This means that under a fixed exchange rate system, increase in the domestic costs/prices are transmitted to the prices of exports expressed in foreign currencies and hence they erode export competitiveness. In such a situation, imports upsurge and domestic production is adversely affected. Conversely, when the exchange rate depreciates by less than the difference between the domestic and external inflation rates, in effect the exchange rate appreciates. Such an exchange rate policy brings distortions and works as a tax on exports and subsidy in imports. This was the policy very common up to the mid-1990s. Experience shows that overvalued exchange rate (through pegged system or otherwise) lowers returns to agriculture, penalises exports, induces capital flight, depresses foreign exchange earnings, discourages domestic savings, crowds out productive investment and encourages resource allocation in unproductive rent seeking activities. It, thus, retards the overall growth and development and hence the pegged exchange rate system is incompatible with the ongoing economic reform and liberalisation policies world-wide. The exchange rate is the most powerful policy tool in influencing relative changes in the prices and therefore an appropriate exchange rate policy is a must in a liberal economic regime.

Nepal has liberalised the exchange rate on the same grounds, with hard currencies. But exchange rate between the Nepali and the Indian currency is still pegged. This arrangement is, indeed, indirectly dictating Nepal’s exchange rate policy and therefore this has been one of the areas of policy debates in Nepal since long. Although Nepal despite the pegged exchange rate system with India has tried to correct mismatch by adjusting the exchange rates of hard currencies on the basis of cross-examination of the rate between the Indian currency and the hard currencies, the gap is widening especially after 2000. This is happening at a time when the rate of price rise and inflation in Nepal has been high compared to India. A comparison of trends in the real exchange rate movement since 1985 indicates that the Nepali currency has appreciated by almost 200 percent. This has eroded export competitiveness with a more damaging impact on the agriculture sector. It has also attracted workers from India to some extent. Above all, we are subsidising imports from India and at the same time hurting Nepali exports. Such an exchange rate system is detrimental from the country’s industrialisation, sustained growth and poverty reduction points of view. Similar findings were made by an exhaustive study carried out in the Institute for Policy Research and Development (IPRAD) which has also been recently published in a book form.

In view of the highly appreciated Nepali currency, a big devaluation followed by the adoption of a flexible exchange rate instantly will be devastating because that will have severe adverse near-term effects on the poor and other fixed income groups. Therefore, with some specific medium-term targets, the Nepali currency has to be depreciated gradually up to a period when we are in a position to absorb price-induced or other shocks that may come after introducing a flexible exchange rate system.

Binod Karmacharya
Economist, now associated with Asian
Development Bank

I say both yes and no to your question. If you mean to do it immediately, my answer would be no. This means that the time to do it is not now.

However, the present pegging arrangement of the Nepali Rupee (NR) to the Indian Rupee (IR) and its level require continuous monitoring and review: we may have to look for an alternative arrangement to the present one at a stage when we exhaust all the measures to enhance Nepal’s export competitiveness.

Currently Nepal appears to be reasonably well off with its choice to peg NR to IR. The main reasons for this are as follows:

1. Currently the prices of imported goods in Nepal are solely influenced by India, suggesting that with a peg to IR, Nepal can completely isolate the import side of its economy from external shocks. This means that any fluctuation between third country currencies (USD/NR, Euro/NR) will not lead to inflationary or deflationary pressures in the Nepali import prices (thereby not disturbing  the smooth supply of essential commodities from India).

2. It avoids likely disturbances in the intensive border trade.

3. It avoids IR hoarding practices through exchange rate speculation.

4. It provides a stable environment for foreign investors, particularly from India, by removing exchange rate risks and facilitates trade and capital transactions with India.

But we will have to undertake significant trade policy and behind-the-border reforms to enhance Nepal’s competitiveness and improve investment climate. These measures would include:

1. Reducing the anti-export bias by adjusting tariffs away from their present cascading structure;

2. Improvement in customs, duty drawbacks, trade facilitation, standards and quality, infrastructure and transport, and business support service;

3. Undertaking regulatory reforms in labour markets, and removing price or entry restrictions in specific sectors such as garments, carpets and agriculture. 

Nepal may look for a better policy option compared to the present pegging to IR when the following situation arises:

1. Measures suggested above are not adequate to improve Nepal’s export competitiveness;

2. There is an unreasonably poor monetary and exchange rate record in India; and

3. Nepal substantially increases its exports.

The alternative policy options would include among others:

1. pegging to a currency basket with a positive weight for the USD; and

2. a flexible exchange rate regime.

Anil Shah
Chief Executive Officer, Nabil

No. I think that we need to re- examine the fixed parity of the Nepali rupee and the Indian rupee from time to time but at this juncture it is not advisable for us to do away with the fixed exchange rate system. The abandoning of the system now will have the possibility of leading to an unsustainable rate of inflation keeping in mind the macro economic situation prevalent in Nepal. Continuing with the existing system gives us the benefit of ‘cushioning’ some of the effects of a turbulent economic scenario through a larger and more stable Indian economy.

 Another pitfall of moving away from the fixed parity is that once we abandon the fixed exchange rate system trying to move back to it at a future date would be an extremely difficult task. I think those considering the same should look at what happened to the Sri Lankan economy when the fixed parity of the Indian and Sri Lankan rupees was removed.

 If ever we need to consider removing the fixed parity at a time when Nepal is well on the path to a sustainable stable economic growth, that decision has to be taken only after some in-depth analysis on the benefits and disadvantages of the same on a national level.

Suman Joshi
CEO, Laxmi Bank Ltd.

The principles of a free market economy dictate that the Nepali currency be allowed to float freely. However, we cannot ignore the practical aspects of our economy just to fall in line with the market principles. At this juncture, the Nepali economy is, at best, fragile. On the other hand, our dependence on the Indian economy continues to be overwhelming. Until we become stronger economically and reduce our dependence on the Indian economy, it would be foolhardy to remove the safety net of pegged currency mechanism. We could, however, be open to discussions on the peg rate: If 1.60 is not reasonable, should it be 1.50 or 1.70 or something else? But don’t take away the peg altogether just yet and expose our economy to the full throttle of the market forces. China recently made a symbolic attempt to adjust its currency after years of substantial growth. In case of Nepal, we are struggling to maintain a position for the past several years, forget growth. We need all the support there is to bring our economy back on the growth path. De-pegging the currency is something we can do without at this point in time.

Prithivi Bahadur Panday
CEO, Nepal Investment Bank

In the 1980s the central bank had tried to float NR, but it did not work. Logically, it should work, but practically it does not. Officially, it is a floating system even today. If NR is left to float freely against the IR, the rate will be changing several times within a day. This will cause wide price fluctuation causing difficulties in the day-to-day life.

Shovan Dev Pant
CEO, Nepal Bangladesh Bank

I am apprehensive about whether the Nepali authorities would be able to manage the impact of NR-IR unpegging.

J Craig McAllister
CEO, Nepal Bank Ltd.

Yes, I support the idea of cutting the Nepali rupee free from the Indian rupee.

I am in favour of free markets and the economic efficiency and discipline they impose.  Pegging an economy with the problems of Nepal to an economy with the growth potential of India is inherently unworkable over the medium to long term.

sanjiv puri
CEO, Surya Nepal (P) Ltd.

Though the floating may help to increase exports, the benefit will be marginal as value retention from Nepal's exports is about 15 percent only.

Dr. Mohan Man Sainju
Chairman, Poverty Alleviation Fund

No. What you need is a periodic review of the fixed exchange rate and a revision as and when needed. Abandoning the fixed exchange rate system between the Nepali and the Indian rupee will  create more problems than solutions. The open border and the high proportion of trade and transportation between Nepal and India would open up problems about the stability and confidence in the Nepali rupees as the Indian economy in relatively stronger.

Hulas Chand Golchha
Chairman, Golchha Organisation

If NR is floated against IR, a lot of ordinary Nepalis will be cheated at the Nepal-India border. Revaluation or devaluation should, however, be done more frequently to suit the changing situation.

Dr. Yuva Raj Khatiwada
Executive Director, Nepal Rastra Bank and Former Member, NPC

I think that the peg is serving well for the time being but it doesn’t mean that we should take it as sacrosanct. We should be reviewing it. So far as Nepal and India are facing similar types of external shocks, there should be no problem in pegging. But should Nepal and India face non-synchronising shocks/differential shocks, then we probably need to think of de-linking the peg. Whether 1.6 is right or not is a different issue. The level of peg should be under review depending upon the trade relationships, trade flows and the strength of the economy.

Pegging is necessary for some time till our economies are moving in the same direction. That could mean one year or two years or even five years. But should you like to move faster than India you should de-link yourself. If you want capital liberalisation, you should be moving faster. Then you should de-link.

(Views expressed are personal of the individuals and do not necessarily reflect those of the organizations they are associated with)