1.6 NPR/INR : From past to present

currency board

History of NPR and INR

The choice of the exchange rate regime is the fundamental macroeconomic policy choice, especially for small open economies like Nepal. In the context of Nepal – Nepal’s currency has been pegged with INR since the modern history of Nepal began and this has been due to and also a reason for the economic openness, financial integration, social and cultural assimilation with India.

Geographically, Nepal is located between the two countries, India and China. The north is outlined with the rugged Himalayas, whereas the south is surrounded by an open terai stretching across east to west causing greater Indian influence compared to Chinese influence in terms of culture, economy, heritage – blah blah blah. We know it. In other words, Nepal is a “India-locked” country. The geographical situation has affected Nepalese policy with India and is best represented by the 1950 Trade and Transit treaty which provides for unrestricted labor and capital movements between both countries.

Throughout the history Nepal has entered various type of exchange rate regime with India.

YearSystem AdoptedExchange Rate
1857 to 1933Fixed PegExchange was fixed at 128 NPR / 100 INR
1933 to 1952Free FloatExchange rate fluctuated from 71 to 148 NPR / 100 INR
1952 to 1960Soft PegExchange rate fluctuated from 131 to 177 NPR / 100 INR
1960 to 1966Hard PegExchange was fixed at 160 NPR / 100 INR
1966 to 1968Soft PegExchange rate fluctuated at around 101 NPR / 100 INR
1968 to 1983INR, Gold and USD weighted Basket PegExchange rate fluctuated from 135 to 145 NPR / 100 INR
1983 to 1994Trade weighted Basket PegExchange rate fluctuated from 145 to 165 NPR / 100 INR
1994 to DateHard PegExchange was fixed at 160 NPR / 100 INR

Some links to gazette announcement of exchange rates:
1. http://rajpatra.dop.gov.np/welcome/book/?ref=769
3. http://rajpatra.dop.gov.np/welcome/book/?ref=1397

2. http://rajpatra.dop.gov.np/welcome/book/?ref=12558 

Note: In a soft peg exchange rate policy, the foreign exchange market usually determines a country’s exchange rate, but the government sometimes intervenes to strengthen or weaken it. In a hard peg exchange rate policy, the government chooses an exchange rate. In a hard peg government stands ready to buy/sell unlimited amount of the foreign currency at the predetermined rate.

Until the time of King Mahendra who led the establishment of Nepal Rastra Bank there was a rampant problem of dual currency system in Nepal – both INR and Moru. The central bank of Nepal, Nepal Rastra Bank, was in fact established only after 19 years of establishment of the first bank of Nepal in 1937, Nepal Bank Ltd. Before 1956, Nepal did not have its own foreign currency reserve but rather maintained it in the central bank of India. For getting the foreign currency amounts required to bear the expenses of Nepali Embassy in London and health treatment expenses of King Tribhuvan, an application had to be submitted to the Reserve Bank of India.

One of the problems that distressed the Nepalese economy was the circulation of two types of currency, Nepalese and Indian simultaneously. Nepal had a dominant use of the Indian rupee. Until the end of Rana Regime, although Nepal had been minting coins internally through the Treasury Office – the official notes had not been printed – so there was a massive circulation of the Indian Paper Notes in Nepal. As soon as the Nepal Rastra Bank, the central bank of the country, was established in 1956, it began to work towards making the Nepali rupee the sole legal tender and tried to do away with the existing dual-currency system in Nepal. Accordingly, the dual currency system was abolished under Nepal Currency Circulation and Expansion Act of 1957.

In the 1950s, Nepal had a flexible exchange rate regime with the Indian currency, during which Nepal had observed a substantial fluctuation of the exchange rate, undermining the use of Nepalese currency even in the domestic markets. Hence, in order to increase public confidence on Nepalese currency and expand its uses in the economy, the NRB started pegging the Nepalese currency with Indian currency since 1960. In the 1980s, although Nepal adopted the currency basket system to determine the exchange rates, the exchange rate with Indian currency did not change on day to day basis in practice. Given the open border with practically almost free flow of people, goods and services across the border, Nepal has no choice but to adopt the pegged exchange rate with Indian currency.

Even the first “Moru Notes” issued by the “Sadar Muluki khana” (Central Treasury Office) of Nepal were issued by the Printer: India Security Press, Nashik – and the notes were signed by a Kajanchi (head of the treasury). Seeing this massive dependence on India, King Mahendra, the son of King Tribhuvan established a central bank in 1956 in order to reduce dependence on India, replace Indian currency being circulated in the market and strengthen the countries’ sovereignty by making Nepal independent in foreign currency exchange. Himalayan Shumser JBR became the first governor of NRB and the coin minting and note issuing responsibility was transferred from the treasury office to the central bank. It was at that time Nepal opened foreign currency accounts in the United Kingdom and Canada along with India. Immediately after the establishment of NRB the note printing was also transferred to the security printers in the UK and Canada instead of India.

Later, the Foreign Exchange Regulation Act, 1963 enacted NRB as the custodian of foreign exchange reserves of the country. Nepal’s choice for a fixed exchange rate with Indian Currency along with supporting government policies contributed significantly in stabilizing confidence in both the domestic currency and in exchange rate among the local traders (we will discuss the meaning and the impact of NPR and INR peg in separate a section below). Additionally, during this decade, the national policy of relations with foreign institutions was implemented which created the foundation for membership with international organizations such as the International Monetary Fund (IMF) and the World Bank (WB) in 1961. So many other financial institutions, such as Agricultural development Bank, Rastriya Banijya Bank, Rastriya Beema Sansthan, Co-operative Banks and so many other Financial Institutions were established during that time. The decade of the 1960s was truly a historic moment considering the development of the monetary market of Nepal and there is much to be appreciated about King Mahendra and his legacy.

The period of 1930s to early 1960s saw a massive positive and negative exchange difference between NPR and INR. The depreciation of NPR in the 1930s were due to the Lifting of import restrictions; Import from India rose, causing demand for the Indian Currency to increase. – Import of construction material after the Great Earthquake in 1933. Soon followed an appreciation of NPR during the first half of the 1940s. Outbreak of the World War II lowered confidence in the British Currency. India was still a part of the British Empire, which subsequently led to a loss in the confidence of Indian Currency. Difficulty in importing from India and foreign countries due to the World War II. The supply of Indian Currency increased as remittance was received from the Nepali Gurkha employed in the Indian Army. After the end of the World War II NPR again began to depreciate in value. This was mainly due to the commencement of issuance of the Nepali Currency notes through Nepal Rastra Bank. To bring Nepali notes into circulation, the government purchased Indian Currency at a higher rate than the market value. Decrease in remittances from the Gurkha and rise in import after the war ended, reduced the supply of Indian Currency. Change in the regime from the Rana autocratic rule to a democratic rule caused a huge capital outflow from Nepal to India. Inflation caused by the aimless printing of currency by the new government due to insufficient revenue to cover the expenditure.

Significantly, on June 6, 1966, the Indian government substantially devalued its currency. Nepal on its part had to do little as the Nepali rupee had already been pegged to the Indian rupee. But the end result was that the Nepali currency automatically appreciated vis-à-vis the Indian currency on account of the pegging factor. India devalued its currency in 1960s as part of a set of economic reforms aimed at addressing the country’s balance of payments crisis and boosting exports. At the time, India’s economy was facing a number of challenges, including low economic growth, high inflation, and a large trade deficit. The devaluation of the rupee was seen as a way to make Indian exports more competitive on the global market and to encourage more foreign investment in the country.

How is a “peg” maintained?

Simply because two countries have agreed to fix the exchange rate for their currencies doesn’t have a force unless each government stand by to purchase unlimited quantities of the foreign currencies at the agreed rate as required. For this sand by facility the central banks of the countries hold a substantial foreign exchange reserve to facilitate the transaction.

Why does central bank hold forex reserve?

Central banks need foreign currency reserves for a number of purposes such as funding foreign exchange market operations that arises as part of central banks’ monetary policy function, foreign debt servicing, controlling excessive volatility of exchange rate, facilitating foreign trade and remittances, taking precautionary measures associated with potential balance of payments crisis and improving access to international capital market by signaling country’s financial strength. Successful management of foreign reserves boosts the confidence of any country’s monetary policy, banking and financial system, and stability of the national currency.

But there is no unanimous view on how much of the foreign exchange reserve any country should hold.

  1. The old rule of thumb of maintaining reserves equivalent to three months of imports has become obsolete as openness and external vulnerability are no longer merely defined in terms of trade shocks.
  2. Three has been new ‘Greenspan-Guidotti rule’ of full coverage of total short-term external debt for a year. Guidotti–Greenspan rule
  3. Jeanne and Ranciere in their IMF working paper of 2006 derive a formula for the optimal level of reserves by constructing a model for a small open economy, according to which a reserve-to-GDP ratio of 10 percent seems to be an optimal reserve.

However, there are many factors affecting reserve adequacy, for example a higher level of reserves would be preferable in countries with weak macroeconomic fundamentals, fragile banking system, volatility of capital flows, and less – developed domestic foreign exchange market like ours. The thump rule for the adequacy of the net foreign exchange reserves adopted by Nepal is around 7-8 months equivalent of the import cost of the merchandise and services.

The US dollar continues to be the dominant currency held by central banks all around the world at 62.25% while the Euro represents 20.26%. Holdings of the Japanese yen and the pound sterling stand at about 5% whilst the Canadian dollar, the People’s Republic of China’s (PRC) renminbi and the Australian dollar represent less than 2% each. Gold is excluded from the IMF data, although precious metals in some cases represent a significant part of reserve assets.

Global foreign exchange reserves—which are used by countries to pay for goods and services, and to hedge against exchange rate risks—reached $13 trillion in the fourth quarter of 2021, according to the International Monetary Fund (IMF). About $8 trillion of the world’s reserves are held by emerging and developing economies. China has the largest reserves, at more than $3 trillion, followed by Japan. Much of the growth in Asian foreign exchange reserves has occurred since the Asian financial crisis in 1997-1998, when the region suffered severe economic dislocation and currency value fluctuations. Today, the ten largest central banks in Asia account for more than 57% of global foreign exchange reserves.

Forex Reserve Holding Pattern

In the context of the currency peg of NPR and INR central bank also has to maintain enough foreign currency reserve to stand ready to buy any amount of the exchange demand between NPR and INR. These reserves does not necessarily need to be maintained in INR they can be maintained in other foreign currencies as well. Its just that at the time of need those foreign currency reserves will need to be sold to buy INR for the purpose of trade.

The table above shows the composition of the foreign currency assets as obtained from the books of Nepal Rastra Bank. It is a quite diversified bucket of the foreign currency but as expected a substantial portion of the assets are held in the INR – India being the major trade partner of Nepal. Not just that the choice for other foreign currencies also depends on what is most beneficial when converted to INR – as the other forex reserves gets routinely sold to buy INR to facilitate the trade transactions with India.

These foreign investments are held in the form of liquid cash balance with NRB as well as with the financial institutions and central banks all around the world. Most of the foreign assets are in the form of investments in the treasuries, bonds and time deposit notes issued by the foreign governments. Loans under foreign repurchase agreement, SDR holdings in IMF and Investments in paper gold are also included in the foreign currency assets.

Although Nepal’s merchandise export growth has remained slower than that of imports due mainly to slow economic growth, lack of exports competitiveness and structural impediments in the economy, foreign exchange reserves have been increasing due mainly to the elevated level of remittance inflows. Nepal typically has a practice of maintaining the level of foreign exchange reserves that are sufficient to cover the merchandise and service imports of around 8-9 months. NRB has been diversifying the compositions of foreign exchange reserves in recent years. In addition to investing in US Dollar and INR denominated assets, NRB has now started investing a large chunk of foreign currency reserves in Chinese and Japanese currency instruments. This is also guided by the payment obligations (trade financing, FDI servicing, and debt servicing) and in different currencies. Treasury bills and fixed deposits are the common investment instruments.

Even the emerging economies with market-determined exchange rate regime have accumulated substantial amount of foreign exchange reserve as a lesson learned from the East Asian financial crisis of late 1990s to maintain the stability in the exchange rate and to avoid a possible financial crisis that can emanate from sudden stop of capital inflows or sudden outflows of capital from the country. A large holding of foreign exchange reserves can provide a buffer against speculative attacks. (more detailed discussion below)

OMO Actions for peg

Nepal and Bhutan have a similar type of exchange rate arrangement – pegged with Indian currency along with free and unlimited convertibility in Nepal. While its 1.6 Nepalese Rupees for 1 Indian Rupees – the rate for Bhutanese Ngultrum is 1 for every Indian Rupees. As the countries have strong trade and investment linkages with India, management of Indian currency reserves becomes all the more important. We have been doing this also through stand by, swap, line of credit, and direct Indian currency purchase arrangements; and the stress for Indian currency reserves management stands as the primary challenge for the Nepal Rastra Bank – much of the demand led consumption in Nepal depends on India and the capacity to trade freely at the predetermined exchange rate.

There is an import led demand of INR in Nepal thus NRB at a certain interval will need to buy INR by selling Nepalese Currency, US Dollar or other foreign currency reserves. Being ready to buy INR in this mechanism is called remaining “stand by” for the purchase. Under swap agreement the GON and GOI treasury bills and bonds are exchanged. A line of credit in a fixed exchange rate system refers to an arrangement in which a central bank provides a borrowing facility to another central bank or a commercial bank. The purpose of this line of credit is to provide the borrowing party with access to foreign currency in the event of a balance of payments crisis or other financial emergency.

The Open Market Operations (OMO) committee under the chairmanship of Deputy Governor carries out OMO every week on the basis of Liquidity Monitoring and Forecasting Framework (LMFF). LMFF duly considers foreign exchange interventions while forecasting liquidity of the banking system. Given the pegged exchange rate system, NRB has to intervene in the foreign exchange markets frequently and the liquidity injected through the purchase of foreign exchange has to be sterilized through selling bonds and other instruments in the market. Management of foreign exchange reserve is crucial to defend the existing pegged regime from external shocks.

In case of pegged exchange rate, a change in balance of payments is reflected in change in foreign exchange reserves of the central bank. This means that to ensure that the exchange rate is maintained at NPR 160 to INR 100, the supply of the Indian Currency needs to increase. The supply of the Indian Currency is controlled by NRB with the help of its foreign exchange reserve. These foreign exchange reserves are maintained by the earnings collected through tourism, exports and remittances, which NRB uses to purchase Indian Currency to increase supply within the Nepali economy. Buying and selling of currency is made in spot market, forward market, futures market, swap market, and option market. Additionally, change in real price, structural change, speculation, inflation, interest rate, public debt, and status of terms of trade make effect in equilibrium position of exchange rate. Yet, demand and supply of the currency determine appreciation and depreciation of currency.

Changes in foreign exchange reserves have liquidity implications in the domestic markets and such reserves need to be managed prudentially considering return, risks and liquidity. For this, a central bank needs to play a role of fund manager or portfolio manager to maximize returns and minimize risks subject to considerations of liquidity, diversity and safety. With growing trade deficit with India, the management of Indian currency has been a major challenge for NRB on reserve management front. For this, NRB has been following two-pronged approaches – firstly purchasing Indian currency by selling US dollar and second by allowing importers to import, especially raw materials and machinery equipment, from India by paying US dollar. In Nepal, central bank, banks and financial institutions, money changer companies, remittance companies, hotel and travel companies, trekking and tour companies and hospitals are involved in foreign exchange transactions.

Mundell-Fleming Trilemma in Nepal

The Mundell-Fleming Trilemma is a theoretical concept in international economics that states that it is impossible to achieve three desirable goals simultaneously in an open economy: a fixed exchange rate, free capital mobility, and an independent monetary policy. The trilemma states that a country can have only two of these three objectives at any given time.  Mundell Fleming Model – Wikipedia

In practice, most countries adopt a combination of these objectives, depending on their specific economic and financial circumstances. For example, some countries may prioritize a fixed exchange rate in order to maintain stability and reduce uncertainty, while others may prioritize monetary independence in order to respond to changes in the economy. Some popular examples include:

  1. Eurozone: The Eurozone countries have a fixed exchange rate (the euro) but have given up monetary independence, as the European Central Bank (ECB) sets monetary policy for the entire zone. Capital mobility is also high, as capital flows freely within the Eurozone.
  2. China: China has maintained a fixed exchange rate with the US dollar for many years, but has limited capital mobility to support its domestic economic priorities. The People’s Bank of China sets monetary policy independently.
  3. Switzerland: Switzerland has a floating exchange rate, but has also implemented strict capital controls in order to limit the influx of foreign capital and protect its domestic economy. The Swiss National Bank sets monetary policy independently.
  4. US: The United States has a floating exchange rate and an independent monetary policy, but capital mobility is high, with free movement of capital in and out of the country.

Translating this into the Nepalese economy, we have a fixed exchange rate system with India which means that in order for the NRB to have an influential and independent monetary policy the capital flows of the country needs to be tightly controlled. At least this is how our country has been operating. Since India is a major trading partner of Nepal (albeit from an import perspective) – the fixed exchange rate regime of Nepal with India is quite significant.

Models for Exchange Rate Determination

There are many models for exchange rate determination. However, choosing a model that is most appropriate for Nepal-India relations is important for understanding factors which influence NC-IC exchange rate relations. There are four major models of exchange rate determination; Purchasing Power Parity (PPP), the monetary model, the Dornbush overshooting model and the portfolio balance model. Each of these models can in turn be eliminated after determining their appropriateness in the Nepal-India context but we will discuss their meaning and methodology in below – nonetheless.

Purchasing Power Parity Model

PPP model is usually not used and ignored in exchange rate determination as there are measurement problems for PPP using the proxy of Consumer Price Index, and international empirical evidence thus far is not supportive of PPP usage. Nevertheless, it will help us with our findings. The Purchasing Power Parity (PPP) model of exchange rate determination states that the exchange rate between two currencies should equal the ratio of the two countries’ price levels. In other words, PPP is based on the idea that a basket of goods should cost the same in each country after converting the price of the goods into the local currency. We will use the price inflation indices of Nepal and India to establish this relationship.

Dornbush Overshooting Model

Dornbush overshooting can be ignored as well, since the model gives greater emphasis to capital markets which is not reflective of Nepal-India relations over the period. According to the model, a sudden change in economic fundamentals, such as an increase in interest rates or a sudden shift in capital flows, can cause an initial overshooting in the exchange rate. This overshooting is caused by a change in expectations about future exchange rates and a lag in the adjustment of prices and wages in response to the change in fundamentals. The model predicts that after the initial overshooting, the exchange rate will gradually return to its long-run equilibrium level, determined by the underlying economic fundamentals. The speed of this adjustment is influenced by the flexibility of prices and wages in the economy and the expectations of market participants.

Dornbush Overshooting Model

Portfolio Balance Approach

The portfolio balance approach can also be ignored since the model does not reflect the level of financial development between Nepal and India. According to this theory, a country’s exchange rate is determined by the relative supply and demand for its assets, including bonds, stocks, and currency.

For example: the Portfolio Balance Approach can be applied to study the US dollar by analyzing the supply and demand for US dollar-denominated financial assets, such as bonds and equities. The approach assumes that investors will choose to hold a mix of financial assets from different countries in their portfolios, in order to diversify their risk and maximize their returns. When demand for US dollar-denominated assets increases, the value of the US dollar is expected to appreciate relative to other currencies. This can happen, for example, if investors believe that US economic conditions are improving, leading to higher returns on US assets. On the other hand, if demand for US dollar-denominated assets decreases, the value of the US dollar is expected to depreciate relative to other currencies. This can occur, for example, if investors become concerned about the stability of the US economy or if they are seeking higher returns in other countries. 

Portfolio Balance Approach

In the above chart the compounded increment rate has remained at 18% in India and 17% for Nepal. The chart is logarithmic representation of the increments – so it is isn’t as linear as eyeballing goes. 

Monetary Model

The monetary model of exchange rate determination likewise has some problems; however it is the best of the given models since it makes some explicit assumptions, discussed below, which reflect the open border situation between Nepal and India. Thus, the monetary model of exchange rate determination is chosen to be the most appropriate model in explaining NC-IC exchange rate movements.

The Monetary Model of Exchange Rate Determination is based on the relationship between money supply, money demand and interest rates. The factors that are dependent for the monetary model of exchange rate determination are:

Money Supply

The amount of money available in an economy affects the exchange rate as it influences the demand for the currency. If there is an increase in money supply, the exchange rate may decrease.

Money Demand

The demand for money in an economy depends on the level of economic activity and the interest rate. If the demand for money increases, the exchange rate may increase.

Interest Rates

Interest rates have a significant impact on the exchange rate as they affect the demand for money and capital flows between countries. If interest rates in one country are higher than another, investors may move their money to the country with higher interest rates, leading to an appreciation of its currency.

Exchange Control Actions

Exchange control is made through unilateral method and bilateral method. Unilateral method includes bank rate policy, import and export policy, exchange equalization fund, exchange pegging, multiple exchange rates, rationing of foreign exchange, and blocked account whereas bilateral method includes clearing agreement, payment agreement, installment agreement, differed payment agreement, and compensation agreement etc as per necessity.

Unilateral exchange control actions are measures implemented by a single country to regulate the flow of capital in and out of the country. These actions can include restrictions on the amount of currency that can be purchased or sold, limits on foreign investment, and taxes on international transactions. These actions are designed to influence the exchange rates between the currencies – which includes:

  1. Bank Rate Policy: If central bank of country increases the interest rate, it will increase the deposit of foreign currency with the increased interest rate of commercial banks.
  2. Import and export policy: The export and import policy of the government supports to control foreign exchange in the country. If there is adverse trade situation, country may use the method of quota, increased custom and tariff rate, licensing provision etc. Government may provide grant and subsidies in the industry or area which can contribute to the exportable goods.
  3. Exchange equalization fund: Central Bank can establish exchange equalization fund to make transaction of currency. This fund includes gold, silver, treasury etc. which are used to buy or sale foreign currency to stabilize demand and supply of domestic currency.
  4. Exchange pegging: Central Bank can use the method of pegging up and pegging down by keeping margin in exact rate and market rate. Authority may use it for balancing the value of domestic currency. In relation with large economy and the country having cultural similarities, exchange pegging is better.
  5. Multiple exchange rates: This is the method of using more than one market rate of exchange. Through this policy government tries to make different rate for importer and exporter. However, it has difficulties to implement because untargeted people may misuse the market and get benefit of it.
  6. Rationing of foreign exchange: Currency received by exporters is deposited in the central banks and the foreign currencies are provided to those importer which are prescribed by the government or regulated by the licensing system.
  7. Blocked account: This is the method of blocking account to send capital from domestic account to foreign accounts. It is done especially on the time of emergency and war.

Bilateral exchange control actions are measures that are agreed upon by two countries. For example, if two countries agree to limit the amount of each other’s currency that can be bought or sold, this would be considered a bilateral exchange control action. These actions are usually implemented to manage the exchange rate between the two currencies and to maintain stability in the international financial system.

  1. Clearing agreement: A clearing agreement for bilateral exchange control is an arrangement between two countries to settle their trade transactions with each other through a clearing system, rather than directly exchanging their currencies. This agreement is usually established during times of currency controls or restrictions, in order to facilitate trade between the countries and reduce the need for hard currency. The clearing system allows the countries to use a third currency or a common basket of currencies for trade transactions and to settle their debts through periodic reconciliation of the balances. The clearing agreement can help to reduce the impact of exchange rate fluctuations, improve the stability of trade between the countries, and facilitate the coordination of monetary and fiscal policies.
  2. Payment agreement: This method was introduced to remove the shortcomings of clearing agreement because clearing system was time taking and longer as it was centralized in central bank. Similarly, payment agreement is made by the central banks for the payment of foreign currency. It is delegated to commercial banks which performs the task of the payment. There will be no hindrance in import and export of goods and service because the payment is guaranteed by authority as prescribed in the agreement.
  3. Installment agreement: This agreement is also called standstill agreement in which agreement is concluded to pay foreign currency in installment basis. Under this method, short term debt is paid and long term debt is accepted to control the effect of foreign currency in domestic level.
  4. Deferred payment: This agreement follows transfer moratoria in which payment is not done instantly. When there is the good symptom of improvement of foreign exchange in domestic level, then only payment is made for previous transactions.
  5. Compensation agreement: A compensation agreement for bilateral exchange control is a type of agreement between two countries, aimed at addressing imbalances in the flow of trade and financial transactions between the two countries. The agreement specifies that any surplus of one country’s currency will be used to purchase the other country’s currency, in order to balance the overall flows of payments. This type of agreement is typically used as a way to support a fixed exchange rate system, and to promote stability in the exchange rate between the two currencies. By reducing imbalances in trade and financial transactions, the agreement helps to prevent large fluctuations in the exchange rate, which could have destabilizing effects on the economies of both countries.

East Asian Financial Crisis

The East Asian financial crisis was triggered by a combination of factors, including a real estate bubble, high levels of foreign debt, and currency speculation. The crisis began in Thailand in July 1997, when the Thai baht was forced to float after its value dropped dramatically in response to speculation by currency traders. The crisis quickly spread to other countries in the region, including Indonesia, South Korea, and Malaysia, as investors lost confidence in their economies and pulled out their investments. This led to a sharp decline in the value of local currencies, a rise in interest rates, and a sharp drop in economic growth.

The East Asian Financial Crisis was a financial crisis that affected several countries in the East Asian region including Thailand, Indonesia, South Korea, and Malaysia. It began in 1997 and lasted until 1998. The crisis was triggered by a combination of factors, including a sharp decline in the value of their currencies, a high level of debt in the banking and corporate sector, and speculation. The crisis led to a loss of confidence in these countries, causing large-scale withdrawals of foreign investment and leading to a shortage of foreign exchange. The crisis resulted in widespread economic problems, including falling economic growth, rising unemployment, and a sharp decline in stock prices.

The East Asian Financial Crisis, which occurred in the late 1990s, had several lessons for the global financial community including:

  1. Need for macroeconomic stability: The crisis showed that countries need to maintain macroeconomic stability, including low inflation and manageable levels of public and private debt, to avoid financial instability.
  2. Importance of reducing currency and maturity mismatches: The crisis showed the dangers of currency and maturity mismatches, which can increase the risk of financial instability during periods of stress.
  3. Need for international financial cooperation: The crisis demonstrated the need for international financial cooperation to address financial instability, support affected countries, and promote economic recovery.

Primarily, macroeconomic imbalance coupled with the currency speculation attacks, high levels of government and corporate debt, overinvestment in certain industries, large current account deficits, and weak banking systems.

We can try and elaborate the main problems that surrounded the currency crisis in the east asia:

  1. Speculative Attacks: Speculative attacks in a fixed exchange rate system occur when market participants believe that the fixed exchange rate is no longer sustainable, and they start to buy the foreign currency and sell the domestic currency in large quantities. This increase in demand for the foreign currency puts pressure on the exchange rate, causing it to appreciate and potentially leading to a devaluation of the domestic currency. A speculative attack can be triggered by several factors, including a loss of confidence in the government or the central bank, a large trade deficit, or a rise in inflation. In some cases, speculative attacks can occur without any clear underlying cause, as market participants may simply be trying to take advantage of perceived weakness in the fixed exchange rate system. In the face of a speculative attack, the central bank has two main options: to defend the fixed exchange rate and use its reserves to buy its own currency, or to allow the exchange rate to float and adjust to market conditions. If the central bank chooses to defend the fixed exchange rate, it may be able to succeed in maintaining the exchange rate, but this can be expensive, and it may deplete the central bank’s foreign currency reserves. If the central bank allows the exchange rate to float, it may result in a devaluation of the currency, which can have negative effects on inflation and the economy, but it may also help to restore confidence in the long term.
  2. Sharp Capital Outflows: This can occur when investors, individuals, or businesses suddenly decide to move their capital out of the country, either by selling assets or by withdrawing investments. In a fixed exchange rate system, sharp capital outflows can have a significant impact on the exchange rate, as the reduction in capital inflows puts downward pressure on the value of the currency. As investors and individuals sell the domestic currency and buy foreign currency, the demand for the domestic currency decreases, leading to a devaluation of the currency and a potential loss of confidence in the central bank’s ability to maintain the fixed exchange rate. Sharp capital outflows can be triggered by a number of factors, including political instability, economic uncertainty, or a change in the interest rate differential between the domestic country and foreign countries, or speculative attacks. In order to address sharp capital outflows, the central bank may try to defend the fixed exchange rate by using its foreign currency reserves to buy its own currency, or by adjusting its monetary policy to increase the interest rate and reduce the risk of capital outflows.

Pegging NPR with INR

These are general pros and cons, and their actual impact on Nepal may vary depending on a number of factors, including the specifics of the peg arrangement and the performance of the economies of Nepal and India.

The Pros

Pegged exchange rate regime has its own pros and cons in the economy. Pros include the exchange rate stability, low transactions costs with trading partner, reliable anchor for monetary policy, and credibility of the central bank.

  1. As India is Nepal’s major trading partner (contributing to more than two-thirds of Nepal’s foreign trade), major source of FDI, and tourist inflow to Nepal, the peg has served well in terms of reducing trade and investment uncertainty, anchoring prices, and helping investors to work out terms of trade and make investment decisions.
  2. Nepal’s fixed exchange rate arrangement mostly served the country well while economic growth in India remained high, inflation stood low, and the currency remained stable. The existing pegged exchange rate regime with Indian currency has been helping to maintain macroeconomic stability and Nepal intends to remain in the existing regime unless there are serious implications on the peg.
  3. As importance of foreign exchange reserves increases in case of pegged exchange rate regime, NRB has been formulating monetary policy to ensure that excess credit growth does not adversely affect balance of payments. Empirical studies in the past have shown that one rupee credit growth may lead to the same rupee equivalent drop in foreign exchange reserves. In a pegged exchange rate regime, the central bank has to maintain a certain level of foreign exchange reserves to support the value of its currency. If credit growth in the economy is high, it can lead to an increase in demand for foreign currency to finance imports or repay foreign debts. This increase in demand for foreign currency can put pressure on the central bank’s foreign exchange reserves, causing them to decrease. In this case, the central bank may have to intervene in the foreign exchange market to sell its own currency and buy foreign currency, which can further deplete its foreign exchange reserves. The relationship between credit growth and foreign exchange reserves is sometimes referred to as the credit-reserve nexus.
  4. Although Nepal’s Gross Domestic Product (GDP) formation has changed since the introduction of the pegged currency system in 1960, only seven adjustments have been made to the Nepal’s exchange rate policy. Despite the drawbacks of the pegged system, it has protected Nepal from volatility and inflation. Nepal lacks a notable position in the international trade, which leads to a low demand for the Nepali Currency. To take advantage of the pegged system, Nepal must focus on developing an export sector to strengthen the value of the Nepali Currency and maintain the foreign exchange reserves.
  5. Fixed exchange rate regime, no doubt, poses limitations to the conduct of independent monetary policy. But it’s also important to consider that other factors like the state of financial deepening, possibility of currency substitution, degree of capital flows, and monetary independence from fiscal policies and authorities are equally important determinants of effective monetary policy implementation. And the peg has definitely served to address some of these limitations. The stability of the NC-IC exchange rate, seen above, has been both sensible and workable in stabilizing the Nepalese economy for good healthy growth (Maskay, 2000).
  6. On the other side of the border, India has emerged as the world’s second fastest growing economy with an annual rate of economic growth of around 9 per cent. In the international market, the value of the Indian rupee is increasing due to the growing strength of the economy. But in Nepal the Nepali rupee has been losing its value on account of the poor economic growth of 3.4 per cent. If there was a floating exchange rate arrangement between the Nepali and Indian rupees in the place of the existing fixed exchange rate, the value of the Nepali currency would be far lower than what is it is today. Perhaps, this could have a more adverse impact on Nepal’s economy.
  7. There is also the issue raised to review this exchange rate system but many economists are in the favor of fixed rate with India because of the porous border with India and smaller GDP of Nepal. If flexible rate is accepted, there is the possibility of smuggling of Nepalese and Indian currency between two borders. As the exchange rate is an important mechanism to facilitate trade and foreign transactions with India (i.e. it gives certainty to the value of future goods) it is important to examine the factors which influence the probability of changes in the NC-IC exchange rate.
  8. Pegging our currency to a much stronger Indian Rupee prevents volatility and inflation. If Nepali Rupee existed as a free-floating currency, it would experience extreme volatility and inflation because Nepal does not hold a prominent spot in the global trade (like the US dollar, Indian rupee). The demand for Nepalese currency is significantly low, which will devalue its independent free-floating price. This leads to uncontrolled inflation: increased prices in foreign import goods and extremely low export prices.
  9. Moreover, a floating exchange rate does not appear to be practical for Nepal as the central bank of the country is not fully equipped to run an independent monetary policy because of its own limitations. It can do very little to control inflation through its monetary policy. Until inflation is controlled in India, the central banking authority can do little about it in Nepal.
  10. In the existing situation, any effort to do away with the pegging arrangement would further invite capital flight from Nepal and thus affect business, trade and other economic activities. Besides, it would also bring about hyper-inflation in the country. Hence, it will be a mere waste of time and energy to even consider doing away with the pegging arrangement between the Nepali and Indian currencies.
  11. The second factor is investment. The Foreign Direct investment (FDI) coming 8from various countries can be uplifted with the   peg      This   further stabilizes the value of Nepalese currency and   also   helps   in   gaining   trust   of investors upon it. Peg is practiced to gain the   trust   of   foreign   investors   and  it benefits the country in various aspects. The fixed peg is probably the major reason for India being the top source for foreign direct investment in Nepal.
  12. The fixed exchange rate with IC is also acting as an anchor to the price level. By pegging our currency with IC, we are importing inflation from India and it has been instrumental in anchoring inflation over last several years. It imposes price discipline because if price level in Nepal is too high compared to India, we will face loss of reserves. Since deficits in BOP and reserve loss cannot go forever, we need to restrain excessive rate of inflation and thus faces some price discipline. In addition, the pegged arrangement is an important signal of policy commitment achieving low inflation because the loss of monetary autonomy due to pegging of currency limits the ability of the central bank to pursue excessive expansionary monetary policy.
  13. International Monetary Fund (IMF, 2011) has highlighted Nepal’s high inflation, widening trade deficits and erosion of international competitiveness due to the pegged exchanged rate with India. Even though the peg is to keep the inflation tie-up, the Nepalese inflation is not exactly moving with Indian non-food inflation. IMF has identified an appreciation of the real effective exchange rate (REER) by 8 percent on an average in the year 2010-11 compared to that of 2009-10. The Overvaluation of the Nepalese currency by 14.4 percent, 20.2 percent and 19.1 percent was observed using three different approaches – Macro Balance (MB), External Sustainability (ES) and Purchasing Power Parity (PPP). Despite the overvaluation, the peg is considered to be stable and transparent.

So far, evaluations of the exchange rate arrangement have indicated that the benefits from the peg outweigh the losses and Nepal would continue the current system for the medium term. Similar intentions have been expressed by NRB and India has also not been keen to drop the fixed exchange.

The Cons

On the other hand, cons include lack of independence in monetary policy (especially if capital flows are high), possibility of speculative attacks, necessity of hoarding adequate reserves, easy transmission of external shocks with monetary implications.

  1. Conduct of monetary policy is obviously very challenging task under pegged exchange rate regime since the change in balance of payments situation is directly reflected in foreign exchange reserve of the central bank with monetary implications. In addition, the burden of foreign exchange reserves management also comes to the central bank, being a custodian and manager of country’s foreign exchange reserves. However, given that monetary policy has less to do with inflation than domestic output growth or exchange rate policy in Nepal – as it is the case for a small open economy- NRB stands to defend the peg (may be even with the cost of breaching monetary target) for price stability reason as well.
  2. India is quickly becoming a export led economy and it has its incentive to devalue its currency and keep its exchange rate with US dollars low – to make its exports competitive in the global market. Since the foreign exchange against NPR is in turn derived from the exchange rate with INR – the monetary policy of the India trickles into Nepal. But if India dominates the world economy or achieves self-sustaining economy it will no more have the incentive to devalue its currency. Then Nepal would be under a difficult situation to sustain the trade imbalance with India. INR has to be bought by selling off other foreign exchange reserves in an expensive trade which will lead to depletion of our foreign exchange reserves.
  3. As discussed, the pegged system implies a dependency on the Indian economy. Any shock in the Indian economy impacts Nepal equally. For instance, the demonetization of the Indian Currency brought volatility across sectors, as Nepal faced a shortage of Indian Currency. As a result, the economy of Nepal was impacted since trade between the two countries became difficult.
  4. Nepali Currency pegged with the Indian Currency subsequently influence the value of the Nepali Currency against the US dollar. The value of the US dollar is important for any country as it is a widely accepted global currency, and can be used for any international trade. Additionally, 90% of the forex trades include the US dollar. Therefore, when the value of Indian Currency weakens against US dollar due factors such as inflation, rise in oil prices, uncertainty brought by war – the value of Nepali Currency also depreciates. Recently the Indian Currency’s value against the US dollar has been depreciating, which has caused the Nepali Currency to depreciate as well.
  5. A central bank with a fixed peg with foreign currency also loses control over its monetary policy. Hong Kong pegs its currency to the US dollar. Post-financial crisis of a decade ago, the Federal Reserve drastically lowered its benchmark interest rates. Hong Kong followed suit, which helped lit a fire- arguably unsustainably- under its property market.  
  6. In the meantime, the makeup of the Nepalese economy has changed. Remittances currently account for more than two thirds of the GDP. A weak currency helps as these funds get translated into more rupees. But then again Nepal is entering an investment phase in which the country needs to build its infrastructure. A weak currency could be costly. This is where it gets tricky.  Macro variables are not static. As the economy evolves, sectors that were given the maximum emphasis/weight by policymakers may cease to do so as time passes.
  7. According to Sharma (2004), ‘India’s abnormal profit motive reflected in trade negotiations and tariff and non-tariff barriers imposed infrequently upon Nepal is also causing heavy trade deficit and hence, damage to the Nepalese economy.’ Similar arguments are put by Koirala et al. (2005), Prasad (2007) and ADB (2004) that underline the restrictive Nepal-India Trade Treaty for damaging exports of Nepal after 2002 which is responsible for a two-digit TD.
  8. The fix peg has also limited the shocks absorption capacity of Nepalese economy. Due to the fixed rate, the shocks are largely absorbed by the changes in economic activity and employment instead of being absorbed by the changes in nominal exchange rate, which is painful and protracted process. For example, if Indian economy suffers from adverse shocks, it will also be transmitted quickly and affect the Nepalese economy due to quick pass through from exchange rate to prices. In addition, wage and price flexibility, and factor mobility are essential in the pegged regimes to moderate the impact of adverse shocks. These situations are also absent in Nepal.

Important Datasets Nepal and India