Friday, August 26, 2011
Ditching the peg can do wonders
.
The following opinion piece was published in the Republica on August 21, 2011. The direct link to Republica is here. A more detailed version of this article was posted in my blog here.
On May 29, I wrote an op-ed piece in Republica titled “Time to ditch the peg”. It was about the pegging of Nepali Rupee with the Indian Rupee, and I presented my opinions on why I think it should be abolished.
I wrote that the easy substitutability of the two currencies makes it harder for the Nepal Rastra Bank to carry out effective monetary policies to combat inflation in Nepal. 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. NRB has always kept the interest rates in Nepal slightly higher than that in India to avoid this from happening. This has hurt the investment climate in Nepal because investors cannot get low interest loans.
I concluded that if the pegging is removed, our higher interest rates would attract more capital into Nepal. Also, our devalued currency would mean that our export industry would gather momentum while our imports would reduce. All in all, I suggested that getting rid of the peg would benefit the economic climate in Nepal.
Then, a week or so later, in June, Sukhdev Shah wrote an op-ed piece in Republica titled "Keep the Peg" as a counter-argument to the points I had raised earlier. I wish to provide a rebuttal.
Shah wrote that “trade outcome from devaluation would be a larger trade deficit and higher inflation due to rise in the prices of imported goods” and that “restrictive fiscal and monetary policies that would be needed to subdue inflation can cause recession and undermine growth”. Is Shah suggesting that we should not get rid of the peg because it might bring more inflation or a recession? I disagree with such avoidance tactic. We will not learn how to slay the beast if we never face the beast.
If the results of abolishing the peg do turn out to be as damaging as Shah suggests, we always have the option to go back to the peg. Whatever the results may be, we will learn valuable lessons in monetary policy making.
Shah also mentions that while floating exchange rate might seem like an easy way out, it has elements of risks and that we will have to face dire challenges if we get rid of the peg. He says that “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”. This 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 minor discomfort to 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 their dead husbands was okay, remember? But, we abolished that system, and we have got used to the fact that women no longer burn in their husbands' pyres. Of course, this is only an example. I am not implying that the issues of pegging and women burning in their husbands’ pyres are of equal importance. The important point is: society evolves according to the new set of rules. Let us make the new rules. People will adapt themselves according to them.
While linking the issue of pegging with that of inflation, Shah says that getting rid of the peg would not provide lasting relief. He mentions that “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”. If you ask me, one of the best ways to reduce consumption and increase productivity is getting rid of the peg.
A devaluation of our currency would make our exports cheaper, and imports expensive. We would be making more money from exports, and consuming less from imports. Also, a devalued currency would make it enticing for our farmers to start producing again with intent to supply to domestic as well as overseas markets. One of the main reasons why we have become so gluttonous is because of the fixed peg which enables us to import too much food from India and produce too less in domestic farms.
On July 4, another op-ed piece titled “To peg or not to peg” appeared in Republica by Hari Bansh Jha. Professor Jha mentioned towards the beginning of his article that if we adopted the floating exchange rate, our exchange rate with IRs would be determined by market demand and supply just like “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. 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 exchange rates for NRs to Euro or NRs to US dollar are actually adjusted rates calculated directly via the peg of NRs with IRs. I just wanted to clear up that misunderstanding.
Prof Jha goes on to say that “the value of Indian rupees is increasing due to the growing strength of the economy”, and that if the NRs would float with IRs, “the value of the Nepali currency would have been far lower than what it is today”. I do not understand why Prof Jha, an Economics professor, should have any objections with this. I, as an Economist, actually like the sound of that argument.
Here’s why. Since the IRs is getting stronger, the NRs is getting stronger. Since NRs is getting stronger, our exports have become expensive. 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 pegging argument is that, for some reason both Shah and Prof Jha think devaluation is harmful. Devaluation can do a lot of good to Nepal's sagging export industry.
Prof Jha further writes that a floating exchange rate is impractical because “the central bank of the country is not fully equipped to run independent monetary policy for its own limitations”. He then mentions the limitation being the NRB’s inability to “do very little to control inflation through its monetary policy” because “until inflation is controlled in India, the central banking authority can do little about it in Nepal”.
Nepalese inflation is always 1 to 2 percent higher than Indian inflation due to transportation cost and customs duty for bringing goods into Nepal. Therefore, our inflation is directly tied with Indian inflation because of the peg. The reason NRB's policies are weaker is because the peg dampens any monetary policy. Once we get rid of the peg, NRB will gain its muscles to control inflation the way it pleases in Nepal.
Prof Jha ends his article writing that abolishing the peg will “promote capital flight from the country and thereby affect business, trade and other economic activities” and that “it would also bring about hyper inflation in the country”. I agree about inflation but not about capital flight. Prof Jha has his theory wrong on capital flight. Higher inflation would mean that we will have higher interest rates than in India. So, our higher interest rates will actually attract more capital into Nepal. Also, inflation isn't bad if it is actually resulting in higher economic growth. We can tolerate inflation as high as 10 percent if we are growing at around 7-8 percent. If you don’t believe me, ask India.
Despite my disagreements with both Shah and Prof Jha, I am very happy to see these discussions getting highlighted in Republica. Usually, nobody talks about removing or keeping the peg. I am just happy to see at least a couple of people talking about it in Nepal.
The following opinion piece was published in the Republica on August 21, 2011. The direct link to Republica is here. A more detailed version of this article was posted in my blog here.
On May 29, I wrote an op-ed piece in Republica titled “Time to ditch the peg”. It was about the pegging of Nepali Rupee with the Indian Rupee, and I presented my opinions on why I think it should be abolished.
I wrote that the easy substitutability of the two currencies makes it harder for the Nepal Rastra Bank to carry out effective monetary policies to combat inflation in Nepal. 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. NRB has always kept the interest rates in Nepal slightly higher than that in India to avoid this from happening. This has hurt the investment climate in Nepal because investors cannot get low interest loans.
I concluded that if the pegging is removed, our higher interest rates would attract more capital into Nepal. Also, our devalued currency would mean that our export industry would gather momentum while our imports would reduce. All in all, I suggested that getting rid of the peg would benefit the economic climate in Nepal.
Then, a week or so later, in June, Sukhdev Shah wrote an op-ed piece in Republica titled "Keep the Peg" as a counter-argument to the points I had raised earlier. I wish to provide a rebuttal.
Shah wrote that “trade outcome from devaluation would be a larger trade deficit and higher inflation due to rise in the prices of imported goods” and that “restrictive fiscal and monetary policies that would be needed to subdue inflation can cause recession and undermine growth”. Is Shah suggesting that we should not get rid of the peg because it might bring more inflation or a recession? I disagree with such avoidance tactic. We will not learn how to slay the beast if we never face the beast.
If the results of abolishing the peg do turn out to be as damaging as Shah suggests, we always have the option to go back to the peg. Whatever the results may be, we will learn valuable lessons in monetary policy making.
Shah also mentions that while floating exchange rate might seem like an easy way out, it has elements of risks and that we will have to face dire challenges if we get rid of the peg. He says that “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”. This 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 minor discomfort to 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 their dead husbands was okay, remember? But, we abolished that system, and we have got used to the fact that women no longer burn in their husbands' pyres. Of course, this is only an example. I am not implying that the issues of pegging and women burning in their husbands’ pyres are of equal importance. The important point is: society evolves according to the new set of rules. Let us make the new rules. People will adapt themselves according to them.
While linking the issue of pegging with that of inflation, Shah says that getting rid of the peg would not provide lasting relief. He mentions that “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”. If you ask me, one of the best ways to reduce consumption and increase productivity is getting rid of the peg.
A devaluation of our currency would make our exports cheaper, and imports expensive. We would be making more money from exports, and consuming less from imports. Also, a devalued currency would make it enticing for our farmers to start producing again with intent to supply to domestic as well as overseas markets. One of the main reasons why we have become so gluttonous is because of the fixed peg which enables us to import too much food from India and produce too less in domestic farms.
On July 4, another op-ed piece titled “To peg or not to peg” appeared in Republica by Hari Bansh Jha. Professor Jha mentioned towards the beginning of his article that if we adopted the floating exchange rate, our exchange rate with IRs would be determined by market demand and supply just like “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. 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 exchange rates for NRs to Euro or NRs to US dollar are actually adjusted rates calculated directly via the peg of NRs with IRs. I just wanted to clear up that misunderstanding.
Prof Jha goes on to say that “the value of Indian rupees is increasing due to the growing strength of the economy”, and that if the NRs would float with IRs, “the value of the Nepali currency would have been far lower than what it is today”. I do not understand why Prof Jha, an Economics professor, should have any objections with this. I, as an Economist, actually like the sound of that argument.
Here’s why. Since the IRs is getting stronger, the NRs is getting stronger. Since NRs is getting stronger, our exports have become expensive. 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 pegging argument is that, for some reason both Shah and Prof Jha think devaluation is harmful. Devaluation can do a lot of good to Nepal's sagging export industry.
Prof Jha further writes that a floating exchange rate is impractical because “the central bank of the country is not fully equipped to run independent monetary policy for its own limitations”. He then mentions the limitation being the NRB’s inability to “do very little to control inflation through its monetary policy” because “until inflation is controlled in India, the central banking authority can do little about it in Nepal”.
Nepalese inflation is always 1 to 2 percent higher than Indian inflation due to transportation cost and customs duty for bringing goods into Nepal. Therefore, our inflation is directly tied with Indian inflation because of the peg. The reason NRB's policies are weaker is because the peg dampens any monetary policy. Once we get rid of the peg, NRB will gain its muscles to control inflation the way it pleases in Nepal.
Prof Jha ends his article writing that abolishing the peg will “promote capital flight from the country and thereby affect business, trade and other economic activities” and that “it would also bring about hyper inflation in the country”. I agree about inflation but not about capital flight. Prof Jha has his theory wrong on capital flight. Higher inflation would mean that we will have higher interest rates than in India. So, our higher interest rates will actually attract more capital into Nepal. Also, inflation isn't bad if it is actually resulting in higher economic growth. We can tolerate inflation as high as 10 percent if we are growing at around 7-8 percent. If you don’t believe me, ask India.
Despite my disagreements with both Shah and Prof Jha, I am very happy to see these discussions getting highlighted in Republica. Usually, nobody talks about removing or keeping the peg. I am just happy to see at least a couple of people talking about it in Nepal.
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