The Exchange rate system: Should Nepal revisit the Peg with Indian Currency?

BY NITISH SHRESTHA

JULY 03, 2020

Recently, few questions have emerged on the pegging of Nepali currency to Indian
currency.

Questions like: Is it a correct policy to peg with the Indian currency?

Whether the Nepali currency should adopt a floating currency exchange? Or should
Nepali currency be pegged with another currency and other related questions? These
are important and serious issues and require serious thinking and analysis.

Hope these questions are NOT (repeat NOT) raised at this time when there are both
diplomatic and political issues with India.

Right at the outset, we feel that to raise such a serious issue that requires
wisdom and knowledge from professionals and experts in monetary policy, with any
political mindset is WRONG and should not be done.

Having said this, let us look at this issue with some analytical thinking and by
asking a few questions.

What makes a currency strong?

Generally, a currency is said to be strong by considering the demand of the

currency along with the gold deposit of the country’s central bank.

A currency is classified as strong when it is worth more than other country’s

currency. In other words, for illustration, if the Indian currency is worth half
the US dollar, the dollar would be considerably stronger than the Indian currency.

If the inflow of foreign currency in a country is greater than the outflow, then
the said country’s currency will be stronger and vise-versa.

Similarly, most people hold myths related to the strong currency that if a country
produces more cash the currency gets stronger.

Fixed versus Floating Currency: What is better for Nepal?

Many countries follow either a fixed exchange rate or floating exchange rate or
both. In fact, various methods of interest rates are determined by merging fixed
and floating exchange rates.

Under the international monetary system, the Gold Reserve System was accepted in
1816-1914 as gold parity. Breton Woods System accepted Pegged Exchange Rate from
1944 to 1971.

And, Dollar System with a flexible exchange rate was introduced in 1971.

A fixed exchange rate or a floating exchange rate determines the value of a

currency. A floating exchange rate is determined by the open market and the demand
and supply on the global currency market.

Usually, developing countries, for stability, opt for a fixed exchange rate as the
floating exchange rate can decrease the value of the currency.
Therefore, in a floating exchange rate regime, if the demand for the currency is
high, the value will increase. On the contrary, if the demand is low, the value of
the currency will decrease.

In a floating exchange rate regime, the ideal situation is when the inflow and
outflow of foreign currency are somewhat equal.

If the inflow of foreign currency in a country is greater than the outflow, then
the said country’s currency will be stronger and vise-versa.

A fixed exchange rate or pegged rate, on the other hand, is set against another
major currency. A fixed exchange rate is set by the central bank.

In other words, a fixed exchange rate is known as a regime where a country ties the
value of its currency to some other widely-used commodity or currency.

Usually, developing countries, for stability, opt for a fixed exchange rate as the
floating exchange rate can decrease the value of the currency.

Countries, opting for a fixed rate, often peg their currency against the country’s
currency with which most of the trade occurs.

Nepal’s history regarding exchange rates has seen a few interesting changes. Until
1957, Nepal’s currency was under the floating exchange rate system.

After the establishment of Nepal Rastra Bank in 1956, the currency was pegged with
Indian Rupees at the rate of 100 NPR = 154.5 INR. Exchange rates between Nepali
currency and Indian currency have gone through a few changes after that (Table 1).

There have been many changes in the last 25 years and “the debate on whether the
peg is needed for Nepal “has been raised on many occasions. While most of the
economists argue that peg is the reason for stability in the trade and stability of
the Nepalese currency, some other economists here believe that Nepali currency
shouldn’t remain pegged with Indian currency.  Their argument is to make the
country independent but at the same time, they suggest Nepali Rupee be pegged to
the US dollar.

Pegging with US Dollar is not practical, even not possible at the current situation
when Nepal’s largest trading partner is India (Table 2); hence until now, Nepal’s
currency has been pegged with Indian currency.

Nepal does not have large exportable goods and Nepal’s leading trade partner is
still India. As Nepal’s largest trading partner is India, and the Nepali currency
is pegged with Indian currency, some Nepali citizens make a blanket statement that
Nepal is highly dependent on India on all aspects.Nepal receives most of its
imports from India. Keeping this rate of exchange stable removes all uncertainty,
and provides a useful market indicator for the country.

These citizens also loosely mention that Not pegging with the Indian currency means
reducing Nepal’s dependency on India — thinking if based on the political bias will
be unfortunate.
So the next logical question is:

What could be the impact of removing the Peg with Indian Currency?

One of the most common views is to reduce imports from India, and/or change the
exchange rate between Nepal and India from fixed to floating.

However, neither might be the best course of action for Nepal given the present
situation of the country.

If the peg with Indian rupees is removed, Nepali rupees will face a severe decline
because, in the case of Nepal, the outflow of foreign currency is higher than the
inflow.

This means that all imports including from the rest of the world will become more
expensive in Nepali rupees.

If the peg was not continued with India the value of 1 INR would be equal to 3.9
NPR (based on the same growth rate of 143.83%). However, this scenario is merely a
hypothesis with assumptions.

If the exchange rate is changed from fixed to floating, given Nepal’s terms of
trade in the international market, the exchange rate between Nepali currency and
foreign currencies, could drastically increase, to Nepal’s disadvantage.

Hence a floating trade rate does not appear to be viable for Nepal at this moment.

In 1993 as mentioned above, Nepali Rupees were pegged with Indian currency at the
rate of 1 INR = 1.6 NPR.

During the same period, 1 USD = 49.59 NPR. The current value of 1 USD is equal to
120.89 NPR (exchange rate between Nepal and the USA on June 28, 2020).

Let us assume that Nepal did not continue the peg with India in 1993, but instead
opted for a floating exchange rate system. The growth rate of NPR to USD from 1993
to the present is 143.82%.

If the peg was not continued with India the value of 1 INR would be equal to 3.9
NPR (based on the same growth rate of 143.83%). However, this scenario is merely a
hypothesis with assumptions.

Through this, we can observe that if Nepal removes the peg with India, then the
value of Nepali currency would depreciate substantially.

As for reducing import dependency with India, Nepal’s production and manufacturing
sectors have not been able to boom, therefore before reducing imports, increasing
production and manufacturing in Nepal is of utmost importance.

Given Nepal’s poor and unfavorable policies to revitalize the industrial base and
the agriculture sector, domestic production may not increase.

Some vital elements such as relaxation in taxes and customs duties, market
guarantee, and subsidies for agriculture are still not granted by the government of
Nepal and have not created an environment for removing the peg possible.

Alongside, businesses are facing difficulty to flourish as the shortest distance to

the seaport from Kathmandu on average is 11 days (to and from) (Kolkata seaport).

So if the pegging is revised, then imports would be more expensive causing the
burden to fall on the consumers. Additionally, Nepal’s number one import item is
petroleum products which is a necessity.