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To peg or not to peg
JUL 25 -
Any country having a great portion of its trade with a particular country and high inclination in every economic aspect pegs its currency to that country’s to save itself the tension of fluctuating exchange rates. India is Nepal’s major trade partner. Most social, political and economic aspects of life are also closely interlinked with India. Historical friendship, Nepal’s trade dependency on India due to its being landlocked, open border, family connections between the two countries and various traditions ranging from religious to cultural have resulted in Nepal and India having good ties. One aspect of this friendship can be seen in the Nepali rupee’s being pegged with the Indian rupee.
Before the establishment of Nepal Rastra Bank, there was widespread circulation of Indian currency as a medium of exchange in many parts of Nepal. The exchange rate was determined by a few money changers. They used to fix the rate on the basis of demand and supply in the market. Nepal had faced the challenge of a dual currency system, i.e., prevalence of the Indian rupee and issuance of the Nepali rupee. The government was trying to abolish the dual currency system. Thus, a fixed exchange regime was introduced by (a) Fixing the exchange rate (Nepali Rs. 160 for Indian Rs. 100) on April 13, 1960; (b) Nepal Rastra Bank pledging to buy and sell any amount of Indian rupees at the exchange rate fixed by it and (c) Establishing a large number of exchange counters throughout Nepal.
Nepal did not devalue its currency even when the Indian rupee was devalued substantially on June 6, 1966. Consequently, the exchange rate of the Nepali rupee to the Indian rupee appreciated remarkably. Accordingly, the exchange rate moved to Nepali Rs. 101 per Indian Rs. 100 from the existing rate of 160 per 100, with Indian rupee holders losing unexpectedly. In March 1992, Nepal started an economic liberalisation policy through the introduction of partial convertibility of the Nepali rupee and subsequently full convertibility in February 1993. Then, except for the Indian rupee, the exchange rates of convertible currencies started to be determined on the basis of demand and supply in the market.
At present, Nepal has been following two sets of policies regarding the exchange rate—one for the Indian rupee and another for convertible currencies. Now India is under the managed floating rate system. However, Nepal’s competitiveness is being affected because of a long fixed exchange rate and indirect appreciation of the Indian currency. India’s fast growth has pushed up the Indian rupee while at the same time the Nepali rupee is facing devaluation. Devaluation makes exports cheaper and imports costlier, which can be considered good for exports.
At present, currency adjustment has become a major concern for the country’s economic policy makers. Disparities between the two countries are affecting Nepal’s monetary policy and competitiveness. The Indian economy is growing at more than eight percent while Nepal’s growth rate is a mere four percent. The reason the Indian rupee has been increasing in value is India’s economic strength and greater capital flow. The Nepali rupee seems to be strengthening because it is pegged to the Indian rupee. However, this does not show the real economic scenario.
To some extent, a pegged exchange rate controls inflation within the country. However, as the reference value rises and falls, so does the currency pegged to it. According to the Mundell-Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Thus, it is very difficult for the government of Nepal to use its monetary policy effectively without the help of the Indian government.
Likewise, price stability is one of the concerns of the monetary policy. Pegging the currency makes it easy to understand prices and their stability in the market. For a developing country like Nepal, it is a necessity to maintain the peg as it is, although the rate may be corrected. The currency peg is directly related with political stability, lower inflation and higher foreign reserves in the country. On the other hand, the country’s competitiveness with the outer world, its governance, easy mobility of capital and other economic indicators cannot be seen very clearly. The economy cannot be predicted independently as pegging leads to dependence on the pegged currency.
Nepal is at a structural disadvantage in terms of technology, transport facility, trade union tensions and energy crisis. These factors heavily affect fixing the exchange rate between the two countries. A fixed exchange rate system leads to loss of monetary autonomy of the country. This is necessary whenever the central bank has been independently unable to maintain a prudent monetary policy leading to a reasonably low inflation rate. When inflation cannot be controlled, adopting a fixed exchange rate system will tie the hands of the central bank and help force a reduction in inflation. Although Nepal is in a better position as it has two types of exchange rates, the pegging with the Indian currency needs to be revised very soon.
In recent years, a decline in production, poor distribution and supply channels, transport syndication, political crisis, salary and wage increases and cartelling have created pressure on the overall price level. All these factors have posed challenges to Nepal Rastra Bank to achieve the primary objective of maintaining price stability and a fixed exchange rate at par with the Indian currency.
It is obvious that monetary autonomy and the ability to control the economy are lost by choosing a pegged exchange rate. Although pegging can be a solution to the volatile exchange rate with other currencies, it is very difficult for a small country like Nepal which is dependent on India in many aspects of the economy to maintain a floating rate of exchange. A fixed exchange rate makes trade and investment between the countries easier
and more predictable, but regular adjustment gives a small economy better opportunities.
(The author is pursuing a Master’s in public policy at the KDI School of Public Policy and Management, Seoul, Republic of Korea)
Pradyumna Prasad Upadhyay
pradyumna7@gmail.com
Posted on: 2010-07-26 08:35
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