Debate Rages Over Reviewing Nepal's Pegged Exchange Rate with Indian Rupee Post-Election

Discussions in Nepal frequently commence after elections focusing on development, employment, price hikes, investment, and good governance. Correspondingly, conversations about various dimensions and possibilities of the economy are being heard now. A novel topic is also included in these discussions.

The question of whether it is appropriate or not to review the fixed exchange rate system of the Nepali Rupee against the Indian Rupee, which has been in place for three decades, from an economic perspective, has now become a widespread debate. Serious interest and discussion among the general public are growing regarding what positive or negative impact such a decision would have on Nepal's economy.

This issue has resurfaced after the Rastriya Swatantra Party (RSP), which secured nearly a two-thirds majority in the recently concluded general elections, included the review of the fixed exchange rate system with the Indian Rupee in its manifesto. In this article, we will discuss various aspects of this context.

• What is the Fixed Exchange Rate System?

Generally, a 'currency peg' or fixed exchange rate system refers to an arrangement where a country's currency is fixed at a stable rate against another country's currency or a specific value. In such a system, the central bank attempts to maintain its currency's value at a set rate.

In simple terms, if a country keeps its currency fixed at a certain ratio against another country's currency, it is called a 'currency peg'. Its main objectives are to keep the exchange rate stable, facilitate international trade, help control inflation, and attract foreign investment.

There are many examples of currency peg systems in world history. After World War II, the 'Bretton Woods' system was implemented in the global financial structure in 1944. Under this system, the currencies of many countries were pegged to the US Dollar. The arrangement made by Bretton Woods helped bring stability to the world economy for several decades.

Hong Kong has pegged its currency to the US Dollar since 1983. The peg to the dollar is considered to have played a significant role in stabilizing its financial system. However, the fixed exchange rate policy has not been successful for all countries. Argentina pegged its currency to the US Dollar at a 1-to-1 rate in 1991.

Although it initially seemed to help control inflation, economic problems gradually increased, leading to a major economic crisis there in 2012. Eventually, the peg system had to be ended. Thus, if the currency peg policy is used correctly, it brings economic stability, but it can be risky for countries with weak economies.

• History of Currency Peg in Nepal

Until seven decades ago, trade transactions in Nepal were conducted openly using the Indian Rupee (INR). Since exchange rates varied in different parts of the country, there was no uniformity in the INR exchange rate. To bring that situation under control and systematize the exchange rate, the policy of fixing a stable exchange rate between the Nepali Rupee and the Indian Rupee was implemented for the first time through the initiative of then Finance Minister Subarna Shamsher, four years after the establishment of Nepal Rastra Bank.

The government issued the Foreign Exchange Control Act in Chaitra 2016 BS. That Act was implemented from 1 Baisakh 2016 BS. According to the Act, only banks were given the authority to exchange Indian Rupees. The responsibility of determining the exchange rate was assigned to Nepal Rastra Bank.

In the initial years, the exchange rate was not stable. It kept changing according to the economic situation over time. A stable exchange rate between Nepal and India has been set nine times to date. The most changes, seven times, occurred during the Panchayat era. Since the advent of the multi-party system, the rate has been set only twice.

In B.S. 2023, the rate of the Indian Rupee was 100 Nepali Rupees to 1 Indian Rupee, and the exchange ratio was changed again in B.S. 2042. The highest exchange rate reached up to 170 Rupees for 1 Indian Rupee. Finally, on 1st Fagun B.S. 2049, the exchange rate was fixed at 1 Indian Rupee to 1 Rupee and 60 Paisa Nepali Rupee. Since then, despite many changes in government in Nepal, this exchange rate remains in effect to date.

• Potential Impacts of Changing the Peg

Since most of Nepal's imports come from India, the country's economy is deeply dependent on India. Due to the open border, daily trade activities operate smoothly and extensively. Many Nepali workers are engaged in employment in India. Tourism and financial transactions are also closely related to both countries.

For this reason, the fixed exchange rate maintained with the Indian Rupee has helped reduce trade risk, maintain price stability, and facilitate economic activities. According to studies conducted by Nepal Rastra Bank at various times, Nepali inflation generally appears to be similar to Indian inflation.

Currently, Nepal's economy is in a mixed state. Foreign exchange reserves are adequate, inflation is decreasing, hydropower generation is increasing, and the current account balance appears to have improved. However, challenges also persist, such as weak private sector investment, rising non-performing loans in the banking sector, and poor execution of capital expenditure. In Nepal's context, we can examine whether a currency depreciation (devaluation) reduces the trade deficit using the 'Marshall-Lerner Condition.'

According to this principle, a trade deficit can only be reduced if the currency weakens, making exports cheaper and increasing their demand abroad sufficiently, and making imports expensive, thereby reducing their consumption domestically. This is known as 'Price Elasticity.'

If people buy much more when exports become cheaper and buy less domestically when imports become expensive, currency devaluation can improve the trade balance. But if that does not happen, a change in the exchange rate alone will not make much difference.

In Nepal's context, essential items like petroleum products, medicines, machinery, and raw materials must be imported. Therefore, even if these items become expensive, the import volume is unlikely to decrease significantly. Similarly, Nepal's exports are neither very large nor diversified. Therefore, even if the currency becomes cheaper, there is no immediate prospect of a large increase in exports.

Therefore, some economists suggest that changing the currency peg with the Indian Rupee alone is unlikely to solve the trade deficit. Long-term economic reforms such as increasing exports, expanding industries, and reducing import dependency are also necessary for that. Nepal imports many goods from India.

If the exchange rate changes, fuel, medicine, food items, industrial raw materials, and machinery may become more expensive. Expensive imports can lead to increased market prices for goods and a rise in inflation. Since many of Nepal's industries depend on imported raw materials, a weaker currency can increase production costs. This also carries the risk of reducing profits for small businesses, increasing the cost of living for consumers, and heightening business uncertainty.

However, there may be some potential benefits to changing the peg. A weaker currency makes exports cheaper, potentially increasing export competitiveness. Furthermore, Nepal Rastra Bank might gain some independence in interest rates and monetary policy. A flexible exchange rate can also aid in adjustment during economic crises. But given Nepal's still weak export structure, such benefits are unlikely to be realized immediately.

In reality, Nepal's actual economic problem is not the currency peg. The main issues are low productivity, a weak industrial structure, low exports, lack of infrastructure, poor execution of capital expenditure, and excessive dependence on remittances. According to a World Bank study, Nepal needs improvements in exports, private sector development, hydropower, tourism, and the digital economy to achieve long-term economic growth. Therefore, a change in the exchange rate alone cannot reform the economic structure.

• Responsibilities of the New Government

The government formed after the election needs to focus on some key areas of economic reform. First and foremost, hydropower production must be made the basis of economic transformation to increase output, expand exports, and ensure energy security by increasing its use in the industrial sector. Additionally, it is necessary to create an investment-friendly environment by reducing regulatory hassles to encourage the private sector.

Export growth must be achieved by focusing on sectors like tourism, agro-processing, information technology, and hydropower exports. It is essential to strengthen the banking system by reforming the financial sector, making the economy production-oriented, reducing dependence on remittances, and expanding industries to create domestic employment.

It does not appear economically appropriate for Nepal to change its currency peg with the Indian Rupee immediately. This peg has played a significant role in maintaining Nepal's trade, price stability, and economic confidence. In the current situation, changing the exchange rate is more likely to increase inflation, raise industrial costs, and create economic uncertainty.

Nepal's real challenge is not the exchange rate, but rather increasing productivity, developing industries, expanding exports, and improving good governance. Therefore, the government formed after the election needs to focus on stable economic policies, production-oriented development, energy exports, private sector confidence, and long-term industrial development.

Only when the economic structure is strong can a situation be created where monetary policy regarding exchange rates can be reconsidered in the future.

(The author is studying at the Central Department of Economics, Tribhuvan University.)