Speculate This!!!

Recent comments from the Governor of the Nepal Rastra Bank (NRB) published in the Financial Times (FT) — a leading United Kingdom based newspaper — has once again put Nepali currency’s (NC) fixed exchange rate system vis-à-vis Indian currency (IC) into the spotlight. Though appropriate and beneficial for the Nepali economy in the long run, the governor’s quote on FT’s May 23 edition to the effect that Nepal needs to reconsider its long standing currency peg “in the medium term” and the subsequent issuance of a press release to neutralise the possible negative effects of the governor’s statement by the NRB next day — that categorically stated that the exchange rate peg would not be changed — has created a lot of uncertainty in the market.

In the same story, the governor also said that Nepal has no option in the short term but to maintain the currency peg, and the country would only be able to alter the peg when there is political stability, greater confidence in the economy, lower inflation and higher reserves. However, why would a speculator, or a smart investor, hold on to the NC when she knows that the currency would eventually be devalued?

For example, if someone can figure out that the current NC to IC peg of 1.6 would be changed to 1.8 in one year, she is better off taking her money out of the Nepali banks and putting in the Indian banks. Let’s assume that the investor can earn 6 percent in the FD account in India, then if she were to convert NC to IC at existing exchange rate her total return would be 19.25 percent (6 percent from FD, 12.5 percent from the appreciation of the IC, and 0.75 per cent from the interaction effect between FD return and IC appreciation) in the event of possible devaluation of the NC in a year’s time. When everyone starts doing this it would create a self-fulfilling prophecy, and then Nepal would have to abandon the currency peg sooner rather than later because of the acute shortage of the IC in the market and its inability of support the peg through the selling of the foreign currency reserves to satisfy the demand for IC.

Nepal will have to eventually devalue its currency at some point. The current level of the peg is just unsustainable. The growth differential between Nepal and India will compel the government to devalue. The million dollar question is: when? In a perfect world, as the governor said, it would be beneficial for the economy if Nepal can devalue when there is a stable political system, a well performing economy, lower inflation and higher reserves. However, there isn’t anything called perfect world in foreign exchange market. History is testament to this as evident from the events in Mexico in 1994 and Thailand in 1997. When there is a word out that the government is mulling to devaluate its currency, it won’t be the government that will decide when to devalue but the market. A speculator anticipating the devaluation would not stay idle and keep her money in NC — she will covert to IC. Taking the cue from the speculator, everyone would then follow the suit. When everyone starts doing the same, government will be left with no option but to devalue.

It’s a cardinal sin in the fixed exchange regime to even talk about possible devaluation even though it would likely benefit the economy in the long run. One cannot just talk about possible devaluation in the future and expect the market not to react, especially when the foreign reserves are dwindling. By just bringing forward the topic — which though has a lot of merit on its own right but which should not have been divulged in public — the governor has possibly put the fate of the NC in the hands of the speculators.

This article was first published in the Kathmandu Post on June 13, 2010

Link: http://www.ekantipur.com/the-kathmandu-post/2010/06/12/oped/speculate-this/209344/