A recent news report entitled "Nepal foreign exchange reserves cross US$ 3 billion mark" (July 26) caught my attention. Despite a widening trade deficit (17.3 percent of Gross Domestic Product in
the fiscal year 2006-07), Nepal Rastra Bank (NRB) has been able to increase its dollar assets thanks to remittances sent home from Nepali migrants working abroad. A widely held belief is that the
greater the foreign exchange reserve, the better it is. This notion stems largely from a well-known tenet in international economics that hard cash reserves help maintain confidence in a country's currency and
attracts foreign investors. Moreover, recent events like the 1997 Asian financial crisis and the 1994 Mexican peso crisis seem to have further underscored the importance of foreign exchange reserves among central bankers.
Academic studies suggest that the optimum level of foreign currency reserves, however, depends on various factors like the size of a country's economy, its trade deficit and foreign exchange policy. Furthermore, holding more foreign exchange than necessary is not good, and there is an
opportunity cost (in terms of higher returns) for every extra dollar in the treasury. Because Nepal has a large and widening trade deficit, NRB needs to maintain adequate foreign exchange reserves to meet various obligations and ensure confidence in the market.
However, NRB needs to rethink its foreign exchange reserve management in terms of the composition of the currencies. Recently, the Indian rupee (INR) appreciated strongly against the US dollar (USD) – the unofficial reserve currency – and due to our fixed exchange rate regime with India (about which I elaborate below), the Nepali rupee (NPR) has also become stronger against the greenback. When
the NPR gains against the USD, the value of NRB's foreign exchange reserves, however, declines (Nepal's
export industry also loses its competitiveness; but I have ignored other issues here). For example, at the current value, a one-rupee gain in the NPR vis-à-vis the USD will shrink the value of NRB's reserves by approximately Rs 3 billion. Recently, the USD has been losing ground against all major currencies.
With the US economy slowing down and the Federal Reserve lowering interest rates, it's very unlikely that the greenback can initiate a rally for at least a few years. Moreover, with India's economy projected to grow at a high rate in the coming decades, it is clear that the INR will continue to
gain against the USD.
Given our current fixed exchange rate policy, the value of NRB's reserves will continue to decline if it
doesn't act soon. One solution for Nepal's central bank would be to diversify the reserves portfolio and
add other currencies like the euro and the Chinese yuan. The second solution (not exclusive from the first) is in NRB's exchange rate policy. At a time of spiraling inflation (a global phenomenon),
a sliding dollar and carry trade and capital flight scenarios, a proper analysis needs to be done
regarding NRB's monetary policy, especially its fixed exchange rate policy with the INR. For over a decade now, NRB has pegged the Nepali rupee to the Indian rupee. This fixed exchange rate system
of NPR 1.6 for INR 1 has persisted for a long time without any revaluation. Recently noted economist Dr
Raghab D Pant has suggested that NRB should reexamine its pegged exchange rate policy. In international economics, one of the most debated issues is the choice of an exchange
rate regime.
Prior to the 1997 Asian financial crisis, Southeast Asian countries like Thailand, the Philippines
and Malaysia, among others, fixed their exchange rates against the USD. After the crisis, Thailand and others moved away from the fixed system towards a floating rate mechanism. China, which was unaffected by the 1997 crisis due to its capital control laws, still has a unique system of predominantly
fixed exchange rate system vis-à-vis the USD. One of the major reasons why countries fix their exchange rate against their major trading partners is to avoid exchange rate fluctuations and maintain price stability. Most of the export-dependent countries have over the years pegged their currencies
to the USD (unofficial world currency). India is Nepal's major trading partner and largest export destination, so fixing the exchange rate to avoid price fluctuations is certainly advantageous. An International Monetary Fund (IMF) study suggests that a fixed exchange rate, by fostering
confidence among international investors, can lead to higher foreign investments and higher growth.
However, the study also suggests that if a currency is pegged at the wrong level, it can lead to misallocation of resources and speculative actions. Because there hasn't been any revaluation on NRB's part for a long time, it is very likely that the current "pegged" exchange rate is incorrect.
Moreover, when a country (read Nepal) fixes its exchange rate, it also imports the monetary policy of the country (read India) to whose currency its currency is pegged. In other words, Nepal doesn't have a monetary policy of its own. That is, if India increases the money supply, its currency depreciates. NRB then has to intervene to prevent its currency from appreciating against the Indian rupee, so it too has to increase its money supply. Therefore, the Reserve Bank of India's (RBI) monetary policy affects Nepal which ends up importing India's inflation.
The issue here is how India's spiraling inflation (close to 12 percent) is affecting our economy. Prices in Nepal have surged recently, and reports show that the inflation has entered "double digit" territory. But how much of the price increment is due to global "supply shocks" like increasing oil prices and
food crisis, and how much is due to our exchange rate policy with India? Though the recent increase in India's CPI can also be attributed to global "supply shocks", its lax monetary policy has also exacerbated the problem. To sustain its unprecedented recent growth, the monetary authorities in India allowed interest rates to remain too low for too long. Recently, the RBI hiked interest rates to tackle rising prices. However, the hike will take time to show its effects and pull down inflation.
Also lately, thanks to India's booming economy, a lot of money is flowing out from Nepal to India in
search of higher returns in real estate and the stock market. Due to this rapid outflow of the INR, it is in short supply in the market. NRB has thus been forced to sell its dollar reserves to buy enough INR and maintain the currency peg. This is not sustainable over a period of time and is a recipe for disaster. Inevitably, after gaining an understanding of the true exchange rate from market dynamics, speculators
(like George Soros who made billons from betting against the British pound in 1992) will start buying
Indian rupees and selling Nepali rupees. This will eventually compel NRB to devalue the currency.
Published on The Kathmandu Post on August 21, 2008
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