Money Matters 1 - Peg or No Peg ?

Raju Nepal

Nepali currency was pegged with Indian currency in 1992. Pegging rate is not reviewed even as economic reforms have taken place in both countries

Different countries adopt different exchange rate policy: fixed exchange rate system, floating exchange rate system or pegged exchange rate system. Nepal follows the pegged exchange rate system with Indian currency at NPR 1.6 for INR 1. 

Pegging system is adopted mainly to avoid unnecessary volatility of currency. As currency is directly related with welfare of the society, government gives top most priority of its stability. We have seen huge volatility in currency during the end period of communism in USSR, and at the high inflation time in Brazil. Likewise Eurozone experienced huge economic crisis due to Greece in the recent times. Some countries, in the past, have pegged their currency against gold as well. Being the strongest currency of the world, as well as the universal currency, most countries prefer their currency being pegged with US$. China still follows some kind of pegging with US$ in the name of fixed exchange rate policy. Due to its very strong economic data if China follows a floating exchange rate system with its currency and US$, the Chinese currency would now be trading at less than 1 per US$, which is still above 6 due to the control mechanism adopted by China's central bank. Otherwise, most of the countries peg their currency due to the weak financial data of the country, rising interest rate and huge trade and current account deficit.

There are several models of pegging. Fixed pegging and range pegging are two main types in use these days. Nepal has pegged its currency with Indian currency as a fixed pegging for long. The main reason of this was to have stable trade relation, long open border and free use of both currencies in border towns and lack of timely decision making at our end. NPR 1.6 for INR 1 was fixed in 1992. Before 1.6 it was 1.45 for long. Since then, it has not been reviewed. In the past 24 years so many economic reforms have taken place on both countries. Financial indicators have moved to different directions, we have adopted policy of sending labor to other countries, but currency pegging and the pegged exchange rate has remained unchanged. By keeping our currency at the same exchange rate with India for almost quarter of a century, we have indirectly accepted the dependency of our economy on India economy. This is the reason other big countries see Nepal from Indian lens. It has impacted not only our business but the politics as well. In whichever direction the Indian economy and their currency moves, we are also moving in the same direction by completely ignoring our financial indicators. Changing the pegging system is still not among our government's top priorities. But is NPR1.6 to INR 1 pegging right? No.

The currencies of any two countries cannot have the same value for more than 25 years. The main factors determining exchange rates are economic growth, import/export, current account balance, and interest rate. During the 25 years period, all of the above indicators have moved in different directions for India and Nepal. The pegging must have been reviewed several times by now.

In 1992 India's GDP was only US$ 325 billion. It is US$ 2.1 trillion now. Nepal's GDP then was US$ 3.4 billion, now it has reached US$ 20 billion. Nepal's trade deficit, most of it with India, is increasing day-by-day and stands at US$ 75 billion in 2015. This is the only factor, economists argue, that has devalued our currency. But this is wrong concept. There are much more than trade data which determines exchange rate of currency between two countries. Regarding interest rate, our exchange rate system is always better than that of India. They still follow regulated interest rate system and we have deregulated our interest rate system long back. If we talk about 91 days Treasury Bills yield India is still at 7.23 percent, and in Nepal TreasuryBills yield has been less than one percent for long. Thus our economy is doing better in terms of liquidity in the market. Our savings account interest rate is much more competitive than India's. Regarding inflation, both the countries have almost the same inflation rate. However, Indian economy is growing much faster than Nepali economy in the last 15 years.

Another major factor that determines exchange rate is current account balance. When we adopted the policy of sending Nepalis to foreign countries as labor force, our current account balance was in red. After about one million people left to other countries for work our current account became green. Now there are more than 2.5 million people working as laborers in other countries. The remittance sent by them has made our current account balance positive. If we include the figure of remittance coming from India in this, the current account balance with India will also be positive. Large number of domestic help and other people are sending huge amount of money to Nepal from India every year through informal channels.

As of 2014, India's current account deficit is 1.5 percent GDP, and Nepal's current account surplus 4.7 percent GDP. This clearly shows our economic indicators are strong enough to revalue our currency. Likewise, India's foreign currency reserve is sufficient to import only 4 month's goods and services, but Nepal's foreign currency reserve is sufficient to import about 11 months goods and services. Clearly, all financial indicators show the currency exchange rate between Nepal and India should be much below 1.6. So what should be done?

Now that we have had the constitution, we need to first decide whether to continue with this system or change it to some other possible methods like making it free from Indian domain. May be it is difficult for our political leaders to take such a drastic step in this bad time, but we must start the process of reviewing the exchange rate every two years or as and when big changes take place in economy.

On the one hand, our financials say our numbers are good enough to revalue our currency, but on the other hand, if we need some Indian currency we need to buy from grey market at higher price. The main reason is flourishing black market in border area. Likewise, Nepal's central bank, Nepal Rastra Bank, has not been providing Indian currency notes to public as per their demand in order to stop black marketing. Short supply always leads to higher price. As regime of currency note is changing towards plastic money, that problem will go down in near future. Till then our central bank should focus on matching real demand of Indian currency notes. Due to the earthquake and Indian blockade, inflow of Indian currency from tourist has gone down sharply. Let's hope it will increase in near future. Likewise blackmarketing of fuel also became major reason of short supply of Indian currency, which resulted in the rate movement to the upper side. All these problems can be addressed by a single decision of changing the pegging system.

The government should at first decide whether the Nepali currency should be pegged with Indian currency or not. And if they decide to continue with pegging (since going from pegged to floating at once can have more negative effects than the positive effects in the short run), the government should form an expert committee to review the rates. Then they should decide on the new exchange rate, which should be the actual rate of pegging between Nepali currency and Indian currency.

Published in Republica on 30th January 2016