Views of a Nepali Economist

The Treaty of Peace and Friendship that Nepal signed with India in 1950 was a landmark moment for both nations. India had just gained independence in 1947 after centuries of British occupation. The treaty was a way for India to start building relations with its closest neighbor. The treaty resulted in the creation of an open border between the two nations. Labor, capital, goods and services, as well as all sorts of economic activities started to flow and be carried out freely between the two countries.

In addition to such forms of mobility, Nepalese were also free to convert the Nepali Rupee into Indian Rupee without any obstruction, and in unlimited quantity. However, when Nepal Rastra Bank (NRB) was established in 1956, one of the very first things it did was to promote the use of NRs within Nepal’s borders. The primary aim was to, effectively, get rid of the dual-currency system in place at that time in Nepal where both IRs and NRs were considered legal tenders. Despite NRB’s good efforts, dual-currency system persisted, and we used both IRs and NRs within Nepal’s borders until 1961.

Before the NRB entered the financial arena, the exchange rate between the two currencies would float, and was determined by private money changers. Although the ability to hold both currencies was helpful for Nepalese carrying out cross-border trade, the frequent swings in exchange rate due to availability or lack thereof of the Indian currency was getting problematic to the Nepalese. So, in order to help businesses and general public who conducted businesses and made everyday purchases across the border, the NRB pegged the Nepalese rupee to the Indian rupee at 1.6 to 1 ratio. So, NRs 1.6 became equal to IRe 1.

The exchange rate is, still, the same today even after the Foreign Exchange Regulation Act of 1962 initiated convertible exchange rates of NRs with currencies of other countries. There have been various attempts to get rid of this peg, but the enormous volume of every day cross-border trade has made the process impossible to implement. Also, frequent adjustments between IRs and NRs are impossible given the massive amount of trade and purchases that occur every minute. As a result, the IRs and NRs are still pegged today in the same ratio of 1:1.6.

Now, there is no doubt even among policymakers that the peg has been very popular for the citizenry of both countries who are involved in the increasing cross-border trade. However, this peg has resulted in some challenges, especially when it comes to monetary management and policies in Nepal. The mere existence of Indian currencies inside Nepal has been a hindrance while determining the demand and supply of money in the Nepalese market.

In addition, the easiness with which the two currencies can be substituted for one another has made it difficult to carry out effective monetary policy in Nepal. This easy substitutability dampens the monetary effect when NRB changes domestic money supply. To put it bluntly, effectiveness of monetary policies in Nepal has been hampered due to the ready supply of Indian currency in Nepalese market. The peg between the two currencies and the easy supply of IRs within Nepal’s borders has limited the extent to which the NRB can flex its muscles in carrying out its monetary policies.

The NRB has a set of tools to carry out its monetary policies. The most often used tool is the contraction or expansion of money supply. A contractionary policy reduces the amount of money available in the market, and expansionary policy increases the amount. However, NRB cannot simply gather money from the market and hide it if it wants to pursue contractionary policy. Nor can it spray money in the market if it wants to pursue expansionary policy. It has to do it using legitimate means, and the most common means is the changing of interest rates.

When NRB increases the interest rates in the market, it becomes expensive to borrow money from banks. On the other hand, if the NRB reduces the interest rates, individuals and businesses find it cheaper to borrow money. In today’s Nepal, people have been looking for cheaper loans to invest in a variety of economic activities. Every Economist as well as people in the NRB know that lowering the interest rates is the best way to help Nepalese businesses and individuals get cheaper loans to increase their investments. So, what, then, is the reason for historically high interest rates in Nepal? The culprit: the peg of NRs to IRs.

How? If NRB lowers the interest rates in Nepal to help improve the investment climate by making it cheaper for investors to borrow money in the Nepalese market, money from Nepal will simply move to India to take advantage of the comparatively higher interest rates in India. In order to avoid this from occurring even during normal times, NRB has always kept the interest rates in Nepal slightly higher than that in India. This has hurt the investment climate in Nepal because investors cannot get low interest loans.

To combat the effects in Nepal’s monetary climate, the NRB has used a host of sterilization techniques but all have failed in achieving the objectives. The failure of sterilization techniques result due to relatively inflexible exchange rate system in Nepal with regards to IRs. If we had a rather flexible exchange rate system with regards to IRs, we would not be experiencing high interest rates and excess monetary growth. If the pegging is removed, the variable exchange rate will help generate more capital within Nepal as well as bring in more FDI’s into Nepal. A variable exchange rate will also make our exports cheaper and thus Nepali exporters will also benefit.

The message from Nepal’s monetary policy experience is loud and clear: it is time to ditch the peg of NRs and IRs. And, we don’t have to go very far to learn the aftermath. Look at how well India has done after it ditched its peg of IRs with the US dollar. Its monetary policies have been much more effective, investment climate has improved and growth rate has been staggering. Ditching our pegging system will make the NRB much more independent and autonomous in its applications of monetary policies, the investment climate in Nepal will improve, and the economy will flourish. The end result justifies taking the risk.

This opinion piece was published in The Republica daily on 29 May 2011 under the title "Ditch the Peg".