Assignment of International Business

On
Currency Pegging: NPR with INR

Submitted By: Nozal Laudari

Trimester: IV
Section: B

Submitted To: Pradeep Pandey

Faculty, Ace Institute of Management

Date: March 22, 2022

India is responsible for three-fifths of Nepal's trade imbalance. Nepal pegs its currency, the
Nepalese rupee (NPR), to the Indian rupee because of this dependency (INR). The peg has been
fixed at one INR to 1.60 NPR since 1993. In the previous 25 years, a lot has changed. This has
sparked debate about whether the peg represents current realities or if Nepal really requires one.
The NPR's huge depreciation versus the US dollar has brought this problem to the fore this year.
The rupee rose from Rs.102.12 on December 29 last year to Rs.119 on October 11 this year,
before reversing some of its gains. The Nepalese rupee was merely following the Indian rupee's
downward trend. This year, the Indian rupee isn't the first emerging-market currency to suffer a
beating. The Indonesian rupiah, the South African rand, and the Turkish lira all sank strongly
against the dollar.
The value of one country's currency is linked to the value of another country's currency under a
pegged exchange rate. Market factors have no bearing. Most major currencies, such as the US
dollar, euro, and Japanese yen, are free to trade. There existed a global fixed exchange rate from
1870 and 1914, when World War I began, in which all currencies were tied to gold. The gold
standard was referred to as such. Countries assembled in Bretton Woods, New Hampshire, in
1944, while World War II was still raging, to agree to peg their currencies to the US dollar,
which was anchored to the price of gold at $35 per ounce.
This method lasted until 1971, when US President Richard Nixon abolished the dollar's gold
convertibility. The rupee was first used in Nepal in 1932. Both the Nepali and Indian rupees were
legal money until 1956, when the Nepal Rastra Bank, the country's national bank, was created.
The Nepal Currency Circulation and Expansion Act of 1957 ended the dual currency system.
Pegging offers both benefits and drawbacks. Stability is the most frequently mentioned rationale
for a country's decision to peg. Foreign investors may be hesitant to bring money in if a currency
is too volatile. Countries that are focused on export and commerce would wish to maintain the
exchange rate low to increase their competitiveness.
Both profit if a nation with lower production costs pegs its currency to that of a richer country
with a stronger currency and the latter shifts output to the former, assuming all other factors stay
constant. In addition, the wealthier country has no currency risk, resulting in certainty. Profit is
increased in a country with lower manufacturing costs as it is converted into its currency.
Imports become more expensive as a result of this. Maintaining the peg might also be costly.
Once upon a time, the Thai baht was tied to the US dollar. The administration was unable to
preserve the peg during the Asian currency crisis of 1996-1997. The baht was launched in July
1997, right before an IMF bailout.
A central bank's monetary policy may also become uncontrollable. Hong Kong's currency is
pegged to the US dollar. The Federal Reserve slashed its benchmark interest rates dramatically
after the financial crisis a decade ago. Hong Kong followed suit, igniting a – probably
unsustainable – fire in the city's real estate market.
Importantly, if a country is in the process of investing in infrastructure but lacks the necessary
finances, a strong currency can help. China, on the other hand, has been accused for years of
intentionally keeping the yuan's exchange rate low in order to wield it as a mercantilist weapon.
Each day, China sets a rate for the yuan to trade in a band against the greenback.
China is now attempting to shift its economy away from reliance on exports and toward domestic
consumption. Because of continued trade tensions with the United States, the yuan's near-term
outlook is hazy, but a stronger yuan will help Chinese consumers in the long run. The argument
is that there is no such thing as a "one-size-fits-all" currency. The variables are always shifting.
When the Indian rupee rises or falls in reaction to a change in the Reserve Bank of India's
monetary policy, it's like saying "when India coughs, Nepal coughs." So, why are you still bound
to this? It's simple to ask that question. Generating an answer, on the other hand, is more
difficult, especially when the two countries share an open border.
A country's and its markets being completely convertible is an indication that they have matured.
Things will remain tumultuous in the immediate aftermath. Nigeria's currency, the naira, was
pegged to the US dollar until 2016. Saudi Arabia's riyal is still pegged to the US dollar, and the
country's main export, oil, is priced in dollars. It's difficult to say if Nepal has the necessary
infrastructure in place for a free float at the moment.
At the same time, one way to know if the peg is benefiting Nepal is if Indian manufacturing
moves north, which hasn't occurred yet. While there are a variety of reasons why this may not
have happened, ranging from regulatory obstacles to a shortage of energy, the reality remains
that a low NPR may operate as an export subsidy for Indian businesses. Is the exchange rate not
low enough then?
Nepal's dependency on India has risen since the pegging was last revised in 1993. India's
proportion in Nepal's overall trade fell to 28 percent in the 1992/93 fiscal year. This was over
two-thirds in 2017-2018. India's living standards rose at a quicker rate throughout this time.
Nepal's GDP per capita was $180 during the time. In 2017, the price was $835. They were $298
and $1,940 in India, respectively.
In the meanwhile, the Nepalese economy has undergone a transformation. Remittances now
account for more than a quarter of GDP, whereas they were non-existent in 1993. A weak
currency is advantageous since these monies are converted into more rupees. However, Nepal is
entering an investment phase in which the country's infrastructure must be built. It might be
expensive to have a weak currency. This is when things become a little complicated.
Macro variables aren't set in stone. Sectors that were given the most emphasis/weight by
policymakers may no longer be so as the economy changes. This necessitates a continuous
examination of the country's monetary policies. For far too long, the peg has remained
unchanged. The INR moved from 1.60 NPR in FY1964/65 to 1.01 in 1965/66 to 1.35 in 1967/68
to 1.39 in 1971/72 to 1.45 in 1977/78 to 1.68 in 1985/86 to 1.65 in 1990/91 until the 1993
devaluation.
What could be the impact of removing the Peg with Indian Currency?
One of the most popular ideas is to limit imports from India and/or adjust the fixed-to-floating
exchange rate between Nepal and India.
However, considering Nepal's current position, neither of these options may be the best option.
If the peg with Indian rupees is lifted, the value of Nepali rupees will plummet because the
outflow of foreign cash is greater than the influx in Nepal.
This implies that all imports, even those from other countries, will cost higher in Nepali rupees.
“If the peg with India were not maintained, 1 INR would be worth 3.9 NPR (based on the same
growth rate of 143.83 percent). This scenario, however, is merely a hypothesis based on
assumptions.”
Given Nepal's conditions of commerce in the international market, if the exchange rate is
changed from fixed to floating, the exchange rate between Nepali currency and other currencies
might skyrocket, to Nepal's detriment.
As a result, a floating exchange rate does not appear to be a feasible option for Nepal at this time.
In terms of lowering import reliance on India, Nepal's production and manufacturing sectors
have not been able to grow, therefore expanding production and manufacturing in Nepal is
critical before reducing imports.
Domestic output may not improve as a result of Nepal's inadequate and unfriendly policies to
reinvigorate the industrial base and agriculture sector.
Some critical aspects, like as tax and customs duty relief, market guarantees, and agricultural
subsidies, have still to be approved by the Nepalese government, preventing the peg from being
removed.
In addition, companies are finding it difficult to grow since the shortest trip from Kathmandu to
the ports is on average 11 days (to and from - Kolkata seaport).
If the pegging is changed, imports will become more costly, putting the burden on consumers.
Petroleum goods are also Nepal's most important import, as they are a requirement.
References:
Jha, H., 2011. Benefits of the Pegging Arrangement Between Nepali and Indian Currencies |
Manohar Parrikar Institute for Defence Studies and Analyses. Idsa.in. Available at:
https://idsa.in/idsacomments/BenefitsofthePeggingArrangementBetweenNepaliandIndianCurren
cies_hbjha_210711
Pandey, P., 2018. Should Nepal remain pegged to Indian rupee? - The Statesman. The
Statesman. Available at: https://www.thestatesman.com/opinion/should-nepal-remain-pegged-to-
indian-rupee-1502710788.html
Shrestha, N., 2020. The Exchange rate system: Should Nepal revisit the Peg with Indian
Currency? Khabarhub. Available at: https://english.khabarhub.com/2020/03/108994/