Views of a Nepali Economist

I wrote on May 29, 2011 in Republica about the pegging of Nepali Rupee with the Indian Rupee. The article was titled "Time to Ditch the Peg". Click here to read that article. To paraphrase, some of my important points were:

.........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.

.....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 Nepali 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.

.....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.

 Then, sometime in June 2011 (I do not remember the exact date), Sukhdev Shah wrote in Republica an article, titled "Keep the Peg", that basically was a counter-argument to the points that I raise. Click here to read his article. Some of his counter-arguments were:

.......Offsetting disadvantages of devaluation would be the threat of inflation and economic destabilization, if the government fails to implement supportive measures to back up devaluation that includes mopping up of excess liquidity in the economy with the use of restrictive fiscal and monetary policies.Such policy tightening ordinarily requires sharp cutbacks in bank lending, tax increases, and reduction in government spending aimed at getting a balanced budget. In the absence of these restraining measures, domestic cost and prices would rise proportionally to the devaluation and competitive advantage gained from devaluation may quickly evaporate.   

The only thing I want to say with regards to the above comments from Shah is that it looks like, according to Shah, the Nepali policymakers and government would have to learn how to work the various policies related to monetary and fiscal policymaking. So, we are keeping the peg because we are lazy to learn the policies? If I understand his reasoning correctly, getting rid of the peg can teach us important lessons on fiscal, monetary and budgetary policymaking. Shah also says:

  ......With export and import volumes largely unchanged, trade outcome from devaluation would be a larger trade deficit and higher inflation due to rise in the prices of imported goods. Restrictive fiscal and monetary policies that would be needed to subdue inflation can cause recession and undermine growth.

 ........While the floating of exchange rate presents an easy way out of the present difficulties, it carries risks of its own and will pose difficult challenges never been faced before. The first issue to be faced would be to change the public mindset, which has come to view a fixed exchange rate with the Indian rupee as sacrosanct and inviolable.

From above excerpts, is Shah suggesting that we should not get rid of the peg  because it might bring more inflation? Recession? I say, bring it on if that is what we are going to get. Whatever the results may be, we will learn valuable lessons in monetary policy making. If the results do turn out to be very damaging, we always have the option to go back to the peg. And, I am willing to accept the blame for suggesting to ditch the peg. I'll take it in stride. But, my point is, let us see what happens. No risk, no gain.

Also, the reasoning that we should stick with the peg just because the public has come to identify with it in the last 50 years, and that getting rid of the peg would cause petty problems for the public, is not the right approach in terms of thinking about it policy wise. We also thought letting women burn in the pyres of husbands were okay, remember? But, we got used to the fact that women no longer burn in their husbands' pyres. Society changes according to the new set of rules. Let us make the new rules. People will adapt themselves according to them. It's a small issue.

Shah also says:

Many people would agree that much of the economic difficulties facing the nation today are political in nature and the situation would more likely get worse if the economy loses its exchange rate anchor. It would be inappropriate then to interfere with the exchange rate peg at this time as that devaluation would not provide a lasting relief. The best option would then be to reduce our consumption and increase productivity which, in turn, would require a large measure of fiscal discipline, political stability, and lowering of the risks faced by producers and investors.

You know what's the best way to reduce consumption and increase productivity? Getting rid of the peg! Because it is one of the main reasons why the Nepalese society today consumes so much. A devaluation of our currency would make our exports cheaper, and imports expensive. We would be making more money from exports. We would be consuming less from imports, which in turn, would help our domestic agricultural production. A devalued currency would make it enticing for our farmers to start producing again with an intent to supply to domestic as well as overseas markets. All gain.

And, again, today (July 4, 2011), another article was published in Republica by Hari Bansh Jha. Professor Jha's article is titled "To Peg or not to Peg". Click here to read it. Some of his major points are:

Under the floating exchange regime, exchange rate between the Nepali and Indian rupees would be determined each day on the basis of demand and supply of the respective currencies as it happens in relation to the exchange rate of Nepali currency with all other currencies, including Euro or US dollar. 

Prof. Jha has this fact wrong, as far as I know. The Nepali rupee does not float with Euro or US dollar. NRs is pegged with IRs, and IRs floats with Euro and US dollar. So, the rates for NRs to Euro or NRs to US dollar exchange are not determined by the floating system. It's an adjusted pegging by observing the float of IRs with Euro or US dollar. I just wanted to clear that up. Prof Jha goes on to say:

In the international market, the value of Indian rupees is increasing due to the growing strength of the economy. But in Nepal the Nepali currency has gradually been loosing its value on account of the poor economic growth of 3.4 percent. If there were floating exchange rate arrangement between the Nepali and Indian rupees in the place of fixed exchange rate, the value of the Nepali currency would have been far lower than what is it is today.

 This is actually what I have been saying all along. Since the IRs is getting stronger, the NRs is getting stronger. Since NRs is getting stronger, our exports have become expensive. This is why we should have a floating NRs which is not pegged with IRs that gets stronger every day. We want our NRs devalued so that we can export more and import less. I think the main mistake everyone has been making in this devaluation argument is that for some reason they think a devaluation is harmful. A devaluation can do a lot of good to Nepal's sagging export industry. Prof Jha further says:

Moreover, the floating exchange rate does not appear to be practical for Nepal as the central bank of the country is not fully equipped to run independent monetary policy for its own limitations. It can do very little to control inflation through its monetary policy. Until inflation is controlled in India, the central banking authority can do little about it in Nepal.

Again, this is exactly why we should get rid of the peg. The reason our inflation is tied with Indian inflation is because of the peg. The reason NRB's monetary policies are weaker is because the peg doesn't let it become effective. Once we get rid of the peg, NRB gains its muscles to control inflation the way it pleases in Nepal. Until then, we simply rely on Indian policies and follow suit. Prof Jha ends his articles with this:

It will promote capital flight from the country and thereby affect business, trade and other economic activities. Besides, it would also bring about hyper inflation in the country.

Yes, removing the peg might bring hyper inflation. But, it will not promote capital flight. Prof Jha has his theory mistaken somewhere. We will still have higher interest rates than India when we remove the peg. So, our higher interest rates will actually bring more capital into Nepal. Plus, inflation isn't bad if it is actually resulting in higher economic growth. We can easily tolerate an inflation as high as 10 percent if we are growing at around 7-8 percent.

In overall, I am happy to see that there are these discussions going on in our national dailies regarding this topic. Usually, nobody talks about removing or keeping the pegging. I am just happy to see at least a couple of people talking about it in Nepal.

Labels: IRs, monetary policy, NRB, NRs, peg