Effect of pegging on Nepali Rupee and current scenario

I tried to learn about currency pegging and positive and negative aspect of currency pegging in the context of Nepal. I have prepared this article based on my learnings. Let's proceed...

What is Money and currency?

Money is an intangible item with value that makes the exchange of goods and services possible. They can be in the form of currency notes, cheques, drafts, letter of credit, bills of exchange, promissory notes etc. (defined in Nepal Rastra Bank Act, 2058) while “Currency Note” means paper money or coins that are in circulation. Previously, currencies of a country were backed up by gold and other precious metal which was called gold standard where each coin or note could have been exchanged for a fixed amount of a currency. Today, majority of countries have left gold standard due to various economic scenarios faced over time (Gold standard can be discussed some other day). Today, majority of currency has followed fiat money (does not possess intrinsic value in itself nor backed up by commodities), where currency has value simply because other party will accept it. Fiat money has its value because of faith that public put on government.

Determinants of exchange rate between currency

In modern world, any person can deal with goods and services globally. In order to be able to trade globally, parties must be able to acquire and exchange foreign currencies. Exchange rate between two currency is directly affected by demand and supply factor. There are many factors affecting demand and supply of currency. They are:

• Interest Rate: Generally, Investors are attracted by higher interest rate that increases demand for a currency and appreciates value of currency.
• Inflation: As inflation decreases purchasing power of currency holder. It decreases demand for a currency and depreciates its value.
• Balance of Trade: In foreign trade, if country is spending more foreign currency in import of goods and services than it earns through exports, it increases demand of foreign currency and decreases value of domestic currency and vice versa.
• Public Debt: When there is deficit in revenue and expenditure of government, government will raise funds from public for funding it’s program. Large public debts and deficit may create negative impression on investors for investment and lead to devaluation of currency.
• Political stability and economic performance: Investors are highly attracted to a country with political stability, social security and strong economic performance to invest their capital. It will increase demand for a currency and appreciates its value.
• Capital Inflow/Outflow: Capital inflow for major projects in a country or outflow for withdrawal of project may directly affect demand and supply of a currency and its value.
• Money Supply: Money supply within a country is majorly determined by policy taken by central bank of a country. Increase in money supply will decreases the currency value and vice versa.

Effect of appreciation and depreciation of a currency

In case of appreciation of domestic currency, Monetary payment to be made in foreign currency can be completed with lessor outflow of domestic currency. However, in case of monetary amount is to be received in foreign currency, lessor amount of domestic currency will be received and vice versa, same as been presented in table form for your better understanding as:

 

Cases	domestic currency devaluation		Domestic currency appreciation
Payment to be …………. in foreign currency	Made	Received	Made	Received
Domestic currency	Outflow will be more	Inflow will be more	Outflow will be less	Inflow will be less

If a person has property in convertible foreign currency, he/she shall be benefitted by the devaluation of foreign currency and if a person has loan in convertible foreign currency, he/ she shall be benefitted by increment in foreign currency.

In dual exchange rate system, increase/ decrease in value of currency shall be determined by demand and supply of each currency. Increase in value of one currency in dual exchange rate system will automatically make the valuation of other currency devaluated.

Floating Vs Pegged Exchange Rates

Exchange rate of a currency can be pegged or floating. Floating exchange rates are exchange rates that are determined based on demand and supply in the currency markets. They are always changing based on situation (similar to stock prices in stock exchange). In a pegged exchange rate, the value of one country’s currency is fixed to the value of another country’s currency. Market forces do not play a role. They are determined by government’s monetary authority (in case of Nepal, Nepal Rastra Bank). In order to maintain the exchange rate fixed, the monetary authority of a country buys or sells its domestic currency in exchange for another currency in fixed amount in foreign exchange market. This will make exchange rates relatively stable but requires a country to maintain large amount of foreign currency (pegged currency) in reserve so that it can release or absorb the currency as per necessity. Pegging has both advantages and disadvantages as described below.

Some List of currencies that are pegged

Country	Currency	Peg (on 11/19/19)	Equals one:
Aruba	Florin	1.79	U.S. dollar
Bahamas	Dollar	1	U.S. dollar
Bahrain	Dinar	0.38	U.S. dollar
Barbados	Dollar	2	U.S. dollar
Bosnia and Herzegovina	Mark	1.96	Euro
Bhutan	Ngultrum	1	Indian rupee
Brunei	Dollar	1	Singapore dollar
Bulgaria	Lev	1.96	Euro
Comoros	Franc	491.97	Euro
Curacao and Sint Maarten	Ang	1.79	U.S. dollar
Denmark	Krone	7.47	Euro
Djibouti	Franc	177.78	U.S. dollar
Eritrea	Nakfa	15	U.S. dollar
Hong Kong	Dollar	7.83	U.S. dollar
Iraq	Dinar	1,192.11	U.S. dollar
Jordan	Dinar	0.71	U.S. dollar
Lebanon	Pound	1,507.50	U.S. dollar
Lesotho	Loti	1	S.A. rand
Namibia	Dollar	1	S.A. rand
Nepal	Rupee	1.61	Indian rupee
Oman	Rial	0.38	U.S. dollar
Qatar	Riyal	3.64	U.S. dollar
Sao Tome and Principe	Dobra	24.56	Euro
Saudi Arabia	Riyal	3.75	U.S. dollar
Turkmenistan	New Manat	3.5	U.S. dollar
UAE	Dirham	3.67	U.S. dollar

 

Brief History of Nepali rupees and exchange rate with INR

Before the introduction of Nepali rupees, Mohor was the currency of Nepal. It was found that Nepali mohor were exported to Tibet and circulated there too. Current Nepali rupees were introduced for the first time in 1989 BS at an exchange rate of two mohors for each rupee. At that time, Both Nepali and Indian rupees were considered legal tendor inside Nepal.

History of currency exchange rate between Nepal and India

Since a long time, we are familiar with stable foreign exchange rate with India (I, e. 1 INR= NPR 1.6). However, same has not been the case always. Nepal had established dual exchange rate with Indian currency. As in ancient time, tradable goods between Nepal and India were very limited (salt, kerosene, textiles e.t.c), there was relatively stable dual exchange rate between the two currency.

However, In 1990, devasting earthquake hits Nepal, the demand of various goods, skilled Manpower and construction materials for infrastructural development rose that increase the valuation of Indian currency and decrease the valuation of Nepali currency.

During the period between 1939 AD to 1948 AD (BS 1996 to BS 2003), there was outbreak in World War II, which had created barrier in import of items from India. It lowered import from India and many Nepali citizen were employed in Indian Army which increase supply of Indian currency. The increase in supply of Indian currency and decrease in demand of Indian currency had devaluated Indian currency largely increasing the value of Nepali currency. (It can be found that the exchange rate reached 0.6 NPR = 1 INR)

During the period between BS 2007 to BS 2011, Nepal became victim of political instability. During the period, Rana regime ended but government was changed frequently. It was the time when there was extreme power struggle for government between Ranas, Political parties and King. Economic activities continued to slow down, investors lost confidence, Nepal suffered more capital outflow to India, inflation inside country was rising and rate of unemployment was increasing.

Why pegging and history of exchange rate

Indian rupee is relatively powerful and stable due to its high demand and supply in international market because of its size of economy. The tradable goods between two countries used to be basic items required for survival of people inside both countries. As economy of Nepal is highly integrated with India, small fluctuation in currency can have major impact in day-to-day lifestyle of people. Pegging our currency with relatively stable currency prevents volatility and inflation. As Nepal do not hold strong position in global trade (like USD, Yen, INR), Nepali currency is likely to have very less demand which can devalue the currency, making import more expensive and export at extremely low prices. So, a means for stabilizing the exchange rate was being explored. Nepal Rastra Bank was established in 2013 BS as a central bank of Nepal and Nepali Currency Circulation and Expansion Act was enacted in 2014 BS. After the establishment of Nepal Rastra Bank, a stable exchange rate of 1.6 Nepali Rupees (NPR) for one Indian Rupees (INR) was adopted. But, over time fixed exchange rate was changed to different rates according to economic and political scenario as:

Fiscal Year	Exchange Rate
2013 to 2022
2022/2023	101 NPR for 100 INR
2024/2025	1.35 NPR for 1 INR
2028/2029	1.39 NPR for 1 INR
2034/2035	1.45 NPR for 1 INR
2042/2043	1.68 NPR for 1 INR
2050/2051 to present	1.6 NPR for 1 INR

 

Role of NRB in pegging

In pegged system, the exchange rate of two currency is always made same by balancing the forces of demand and supply. Nepal Rastra Bank shall take necessary actions to peg Nepali rupee with Indian rupee in order to stabilize Nepali currency. When the demand of Indian rupee increases, appreciating its value from pegged one (i.,e 1 INR= 1.6 NPR), Nepal Rastra Bank purchases and increases the supply of Indian rupees from its foreign exchange reserves and vice versa.

PROS and CONS of Pegging Nepali Rupee

As pegged exchange rate has both advantages and disadvantages. It is a country’s policy to act accordingly that makes nation successful. We can take examples of countries like Argentina which went bankruptcy because of pegged policy (2000-2001) and countries like China that changed its policy from pegged to floating in 2005 and we can see it as second largest economy of the world. The pros and cons of pegging Nepali rupee are described as:

Pros

v  Pegged system helps to maintain stability in prices on import of essential commodities like oil, food grains, medicines e.t.c. Nepali resident are not affected by fluctuations in currency.

v  Pegged policy helps to gain benefit of credible and disciplined monetary policy of other country. As we know, Nepal has been facing problem of political instsability since long time and various policy and strategy changes according to government. Hence, Nepal can be benefitted from rationale and stable policy of Indian government from pegged exchange system.

v  Pegging currency with relatively stronger currency helps to reduce volatility and irregular fluctuations in foreign exchange rates. It also helps to control rate of inflation inside country.

v  Pegging currency helps to make international trade a lot more predictable. Risk associated with currency fluctuation is highly reduced for exporter and importer inside Nepal.

v  It can help Nepal to export relatively cheap items with low production costs.

v  Due to reduction in risk associated with currency fluctuations and inflation, foreign investors can find Nepal an attractive place for investment and helps to bring capital inflow for major projects.

 

Cons

v  Increased foreign influence: We all are familiar with the fact about that influence of India in domestic affairs of Nepal. It is a fact that when monetary policy of a country is in the hand of other country, we cannot act freely and independently in our own affairs. For e.g If India increases interest rate to control inflation inside India, we are bound to act accordingly.

v  Impact of disequilibrium: As Nepal has not reviewed it’s pegged exchange rate since long time (set before 30 years), Some economists argue that current exchange rate value have reached far from fundamental value. As a result, when currency tends to follow path of fundamental value by appreciating/ depreciating from current level, resident inside Nepal might suffer a lot due massive impact on foreign trade and foreign investment.

v  Impact of Indian Economy: In the current days, we are hearing news that inflation has hit hard on Indian economy. Indian rupee has constantly been depreciating against dollar (from around $1 = INR 70 in 2019 to $1 = INR 80 in 2022) as a result Nepali rupee also faces its impact. (From around $1= Nrs 105 to $1 = Nrs 125)

Impact of pegging with INR on dollar in current scenario

The value of dollar against any currency directly impacts the trade of a country as dollar is globally accepted currency used in international trade.  Though, the exchange rate between Nepali Rupees and Dollar are determined based demand and supply forces in currency market, the rate is directly affected by the exchange rate between Indian rupees and dollar due to the possibility of arbitrage opportunity. Due to pegged system, Nepali rupee get directly affected by any problem faced by Indian economy. Current depreciation of Indian rupee against dollar has made imports more expensive and has directly affected Nepali market too. We can directly experience increased cost of living in current days. Experts believe it may lead Nepal into major economic crisis. According to Nepal Rastra Bank, current inflation rate of Nepal is 8.5 percent.

Is Nepal benefitted by depreciation of Nepali rupee?

As appreciation/ depreciation of currency against dollar has its own advantages and disadvantages. However, based on published data and facts, we cannot be assured that we are actually grabbing any benefit from it. The benefit of depreciation of Nepali rupee could have been achieved through export. However, we all know that Nepal is not an exporting country. We are well aware about trade deficit that Nepal faces every year. Nepali economy was sustained through remittance which could have been increased by higher rate as a result of depreciation of Nepali rupee but same has not been observed. Currently, the amount of remittance is biggest headache of Nepal Rastra Bank. As a result, we are witnessing the news of import ban of various luxury items to maintain foreign exchange reserve. Due to recession in global economy, we couldn't witness the expected number of incoming tourists in Nepal after the COVID which also depriving Nepal from benefits of rupee depreciation. The biggest concern of NRB at present is foreign exchange reserve as we are dependent on import for even basic essential items for living.

Depegging the INR in current scenario

We may seem to be nationalist while talking on issue related to depegging Nepali rupee with Indian rupee. However, in current days, Nepal has so much dependency on Indian economy that we cannot find it beneficial. About two thirds of total imports in Nepal are from India. Recently, we had witnessed a case of demonetization of Indian rupee, where, Nepali importer had faced problems on importing goods due to shortage of Indian currency in market.

Though, pegging the Nepali rupee has some disadvantages, but if we look at our relation with India, we share open border with close geo political and socio-economic relations. India has share of major trade deficit Nepal faces. Pegging the currency has protected Nepal from volatility and inflation. Instead of raising issues on depegging Nepali rupee, we must be able to stand in recognizable position in international trade for creating demand of nepali currency. We must strengthen our export to make our currency tradable in good amount in foreign exchange market and increase foreign exchange reserve. After achieving this stage in economy, we might be able to get benefit from depegging nepali rupee.