Keep the peg

Keep the peg

On the top of seemingly endless political problems, Nepal is facing new challenges in the management of its economy ensuing from the continued loss of foreign exchange reserve resulting from deficits in its foreign operations. According to Nepal Rastra Bank’s data, country’s foreign reserve declined during the fiscal year that ended in July 2010 by 18 billion rupees to 269 billion rupees, 6 percent lower than the level at the beginning of the year.

This decline, although small, is significant in two ways. First, this decline is the first in many years, especially compared to the period since 2006 when political peace in the country was restored. Total reserve held by NRB more than doubled to 287 billion rupees over the three-year period until July 2009. Second, and more significantly, the decline in reserve was mainly due to a sharp run-up in imports that increased by a whopping 100 billion rupees or by about a third. The large import growth, along with a declining level of reserve, reduced the reserve backing of imports from one year to less than nine months.

Data for the current fiscal year ending in mid-July 2011 will not be available for another six months but indications are for a much larger trade gap and reserve loss than experienced during 2009/10. Foreign reserve declined further to 253 billion rupees by mid-April 2011, with further decline expected during the remainder of this year through July, to 240 billion rupees, equivalent to eight months of imports, the lowest level of import coverage in a decade. The outlook is for a continued decline in reserve unless the economy goes into a recession that will reduce imports, and/or reserve is supplemented from outside loans, such as from International Monetary Fund(IMF).

Role of fixed exchange rate

Ordinarily, decline in the level of foreign exchange reserve should not be worrisome if there is no commitment to hold on to a certain exchange rate—value of domestic currency in terms of foreign currency—like the Indian rupee or US dollar. A rise in the demand for foreign goods relative to foreigners’ demand for our exports would create a shortage of foreign currencies in the exchange market, which will push up their prices, meaning a depreciation of the exchange rate. Such deprecation will continue until trade balance has been restored through a decline in imports or a rise in exports or combination of both. Also, the service and capital account balance respond positively to exchange rate depreciation but the relationship is not as strong and direct.

The automatic adjustment mechanism is hindered if the country maintains a fixed exchange rate—fixed value of foreign currency in terms of domestic currency. This is the exchange rate system that Nepal currently maintains—a fixed rate of rupee with the Indian rupee at 160 rupees to 100 Indian rupees. All other exchange rates of NRs are expressed using the cross rates, of IRs with those currencies.

If the rate is fixed in this way, all adjustments to imbalances in the country’s foreign accounts get channeled through change in the level of reserve held at NRB. With the balance of payments generally in surplus, NRB’s foreign reserves increased from less than 71 billion rupees early in the decade to nearly 272 billion rupees toward the end of fiscal year 2009. As noted above, the trend has now been reversed, with the prospects of reserve level declining to 244 billion rupees by the end of current fiscal year in July 2011.

Devaluation option

A quick fix to the problem of reserve loss—and its repercussions on the broader economy—would be devaluation: Fixing a higher rupee rate for Indian currency—for example, 200 rupees per 100 Indian rupees. By making exports cheaper and imports more expensive, devaluation helps reduce the trade gap and also has a positive effect on other foreign transactions, like travel and remittance receipts and a more subdued demand for foreign services, like education and health.

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.

However, a much larger concern about the success of devaluation would be whether we can cut back on imports and increase exports, both of which are very difficult propositions. This is so because most of our imports from India—our largest import source—are essential items that cannot be reduced even when their prices rise after the devaluation, while most of our exports face inelastic supply that would mean a largely unchanged volume. 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.

Floating exchange rate

The other policy option is to float the exchange rate which, in the context of current situation, would mean an immediate fall-off in the exchange value of the rupee, paralleling devaluation. However, the difference would be that after the exchange rate settles down to a lower and trade-balancing level, its future course would be uncertain. This would mean that speculators would have to take a risk making a profit as well as loss if they engage in speculative activities. Unless the government policy happens to be reckless and lacks credibility, speculation under a floating rate regime tends to be stabilizing and helps bring about orderly changes in the exchange rate consistent with underlying market forces.
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.

The prevailing view, at least outside of Kathmandu Valley, is that Nepali rupee is an accepted medium of exchange only because it can be converted into Indian rupee at a fixed exchange rate. What this means is that floating of the rate would risk bring back the dual currency system—practiced until the mid-1960s—with Indian rupee gaining an advantage over Nepali rupee as a medium of exchange.

Nepal experimented with the floating rate system during the 1950s but that proved to be disastrous when the rate could change as much as 10 percent in a single day! Upheavals in the exchange market—and implicitly in the larger economy—did not stop until the newly established central bank took command of the exchange rate in 1960 by fixing the rate at 160 rupees per 100 Indian rupees, and by guaranteeing unlimited convertibility. Government has changed this rate on many occasions but never dared to float it and, finally, has to return to the original rate of 160 rupees in 1991— in part to maintain confidence in the rupee.

Floating the exchange rate looks to be a sensible option to help stabilize the economy and create favorable conditions for growth but this does not seem practical. 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.

SUKHDEV SHAH ,Writer is an economist and can be reached at sshah1983@hotmail.com


Published on 2011-06-27 01:00:16