Volume 2, Issue 3 (March, 2014) INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW A STUDY OF PEGGED EXCHANGE RATE BETWEEN NEPAL AND INDIA

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1 A STUDY OF PEGGED EXCHANGE RATE BETWEEN NEPAL AND INDIA Dr. D.SEETHANAIK Faculty, Department of MBA, University of Mysore, Mysore, Karnataka. ABSTRACT This paper focuses on exchange rate between Nepal and India. Real effective exchange rate of Nepal, pegged value needs. The paper analyzing exchange rate regimes of Nepal and characteristic of optimum currency for Nepal, export import from Nepal. Keywords: Exchange rate, pegged value, Optimum currency, Exim Introduction: An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in terms of another currency. A country's exchange rate is an important determinant of the growth of its cross-border trading and it serves as a measure of its international competitiveness India is Nepal's largest trading partner, with which it also shares an open border. Nepal has a large and growing trade deficit with India and an overall negative trade balance. The trade between Nepal and India comprises of 65% of total trade of Nepal and the trade deficit with India is 71 %. Economy of Nepal is growing slowly relative to India's, while the exchange rate is pegged with India at a parity that is believed to be overvalued. The peg is considered central to macroeconomic stability and is treated as the monetary policy anchor. Because of the large size of trade between Nepal and India, the currency is pegged to reduce the risk of currency fluctuation. Exchange-rate management in Nepal started only in the 1960s following the establishment of the central bank in the late 1950s. The immediate concern for the central bank was to mandate the use of the domestic currency throughout the country, which until then was dominated by the use of the Indian rupee for all practical purposes. Soon after its inception, Nepal's central bank announced a series of reform measures targeted at carrying out an orderly currency substitution. As a policy decision, the central bank announced a fixed parity of 1.6 Nepalese rupees (NPR) per Indian rupee (lnr), and allowed unlimited convertibility of the Indian rupee at this rate. It also started quoting exchange rates for some major convertible currencies. Since then, the exchange-rate regime has evolved from a managed peg to a peg based on a basket of currencies and then, after a brief period, to the current peg with the Indian rupee. The current nominal exchange rate peg stands at 1.6 NPR/INR. The centrality of the exchange rate with India is rooted deeply in Nepal's historical ties with its southern neighbor. Nepal shares an open border with India that extends more than 1400 kms (almost 900 miles) along its eastern, southern, and western sides. The treaty to keep the border open allows for the easy flow of labour and capital. 24

2 Problem Statement Any country having a great portion of its trade with a particular country and high inclination in every economic aspect pegs its currency to that country's to save itself the tension of fluctuating exchange rates. India is Nepal's major trade partner, having 65% of trade being carried out with India. Before the establishment of Nepal Rastra Bank, there was widespread circulation of Indian currency as a medium of exchange in many parts of Nepal. The exchange rate was determined by a few money changers. They used to fix the rate on the basis of demand and supply in the market. Nepal had faced the challenge of a dual currency system, i.e., prevalence of the Indian rupee and issuance of the Nepali rupee. The government was trying to abolish the dual currency system. Thus, a fixed exchange regime was introduced by (a) Fixing the exchange rate (Nepali Rs. 160 for Indian Rs. 100) on April 13, 1960; (b) Nepal Rastra Bank pledging to buy and sell any amount of Indian rupees at the exchange rate fixed by it and (c) Establishing a large number of exchange counters throughout Nepal. At present, Nepal has been following two sets of policies regarding the exchange rate one for the Indian rupee and another for convertible currencies. Now India is under the managed floating rate system. However, Nepal's competitiveness is being affected because of a long fixed exchange rate and indirect appreciation of the Indian currency. India's fast growth has pushed up the Indian rupee while at the same time the Nepali rupee is facing devaluation. Devaluation makes exports cheaper and imports costlier, which can be considered good for exports. Objectives of the Study To determine the real effective exchange rate of Nepal. To determine whether the pegged value needs to be reconciled. To study the exchange rate regimes of Nepal. To study whether the characteristics of optimum currency area fits for Nepal. Research Methodology The study employs quarterly economic bulletin of Nepal Rastra Bank (NRB) for the data on exchange rate, price index for Nepal and similarly annual reports on these indicators of India from Reserve Bank of India website. Moreover, the data comes from other sources like International Monetary Fund (IMF), Ministry of Commerce (both India and Nepal) and International Financial Statistics (IFS). Then the real effective exchange rate is calculated using the weighted price index of trading partners of calculating the real effective exchange rate. To determine whether the pegged value needs to be reconciled or not, the real effective exchange rate analysis is done. Limitations Macroeconomic variable are varying rapidly and are subject to government regulation. The study is for the academic purpose. Due to data constraint, real effective exchange rate calculation is based upon data from 2001 to

3 Due to easier availability of consumer price index and appropriateness, it is used to measure real effective exchange rate. Due to open and porous border between Nepal and India, data are subject to deviation. ANALYSIS AND FINDINGS Exchange rate regime of Nepal Currently, Nepal is adopting dual exchange rate arrangement. It is dual because the Nepali currency (NC) is pegged with the Indian currency (IC) whereas it floats with the convertible currencies. This system of exchange rate was introduced since February 12, 1993 Prior to March 4, 1992; the rupee was theoretically pegged to a currency basket. The regime of currency basket system was introduced since June 1, 1983 (Maskay and Thapa 2000). The basket regime had two notable features. First, the currency basket, at which the NC was pegged, was never disclosed. Second, although the rupee was pegged to a currency basket, the NC-IC rate remained fixed. This shows that Nepal has been following the de facato pegged exchange rate system since the 1960s. Changes in NC-convertible currencies' rates or for that matter the NC-US dollar rate are effected to avoid the emergence of broken cross rates between the NC vis-it-vis the US dollar and the IC vis-a vis the US dollar (Thapa, 1999). Under the circumstances, the nominal changes in the NC-IC rate occur whenever NC is devalued / revalued officially. On the other hand, the NC- US dollar rate changes occur whenever the IC-US dollar rate changes. India has flexible exchange rate regime. In this context, it has to be taken a note that the market forces such as demand for and supply of dollar also affect the NC-US dollar rate in the domestic market even though such changes may be emanating from India. The point is that Nepal cannot keep the NC overvalued against the US dollar relative to the IC- US dollar rate. In that case, due to the open border with India, it will be hard for Nepal to meet the demand for the US dollar. On the supply side, private remittances and export earnings will be routed through India if NC is overvalued against the US dollar in relation to IC vis-a-vis the US dollar rate. In the process, Nepal will face a situation of dwindling inflow of convertible currencies and increasing inflow of IC reserves. This means that the composition of Nepal's international reserves will change in favour of IC. Nor has Nepal incentive to keep the NC significantly undervalued against the US dollar relative to the IC-US dollar rate. Obviously, the advantages of significantly undervalued currency exist in terms of enhanced incentive for Nepali exports to overseas market. But Nepal being a small economy has theoretically unlimited world market for its products. But the fact is that Nepal has problems in the supply side. Hence, Nepali export base has remained fragile for a long period of time. On the other hand, there are many underlying disadvantages of keeping the NC undervalued against the us dollar. Escalation of budget deficit due to increasing foreign debt servicing for the government and increased cost of raw materials are the two examples of disadvantages arising from unnecessarily undervaluation of NC against the us dollar. This suggests the need for keeping the real exchange rate (RER) constant. The Nepalese exchange rate policy has been strongly influenced by the exchange rate policy visit-vis the IC. The influence of India has geographical dimension which largely determines the commercial relationship between Nepal and India. While Nepal borders with China and India, the Himalayan mountain range minimizes Nepal-China contact and which in turn manifests India's importance to Nepal which lie in the Ganges Valley. This geographical reality is partly reflected in the 1950 Treaty of Peace and Friendship with India as well as in the nature of Nepal-China trade direction. 26

4 There is presently limited legal restriction on labour and capital movement between Nepal and India. The importance of the IC for maintaining Nepalese financial stability has been recognized by the Nepalese government. The Nepalese Government adopted the policy of unlimited convertibility of Nepalese Currency (NC) to IC in Nepal. The pegged exchange rate between Nepal and India has existed for over forty years. Real Effective Exchange Rate Calculation (REER) Nepal quotes both buying and selling rates of NC with 12 foreign currencies. Only buying rates of NC are also quoted for 8 foreign currencies. Given, the pegged exchange rate regime of NC with IC, nominal exchange rate between NC and IC remains constant unless authorities devalue or revalue. On the other hand, nominal exchange rates of NC with other currencies are subject to change on a daily basis. For the purpose of the study, we can calculate the nominal exchange rate indices of NC with 20 foreign currencies. We can also construct RER indices of NC with these currencies by taking price differential of Nepal with those currencies' countries. We need to arrive at a single measure of exchange rate index for the study. Calculating the REER index has the following merits. Unlike the nominal exchange rate (NER) and the Real Effective Exchange Rate which are bilateral exchange rate indices, the REER is the composite exchange rate index. The composite exchange rate index i.e. REER can be arrived at by taking trade shares of trade partner countries and multiply such trade weights with respective RER indices and sum them up. For the purpose of the study, the NER index is calculated in terms of foreign currency value of local currency. In this case, a rise in the index represents a nominal appreciation of the local currency. While calculating the Real Exchange Rate (RER), the NER is adjusted for the price differential by keeping the domestic price (Pf) in the numerator and foreign prices (P ) in the denominator. Thus, a rise in the RER index also shows a real appreciation of local currency. The Problems in the Calculation of the Real Exchange Rates The Choice of the Price Index In practice, different price indices can be used in the calculation of the real exchange rates on the basis of purchasing power parity. The wholesale price index (WPI) and the consumer price index (CPI) are two of the leading indices that can be used in these calculations. The gross domestic product (GDP) deflator and producers' price index (PPI) are also among the alternatives. The most important criticism to the real exchange rates calculated by using the WPI is that the commodities under this index is formed of tradable that are similar in nature. It is argued that the prices of these commodities are not being expected to differ substantially when measured in a common currency unit. Therefore, the movements in a real exchange rate index calculated by using the WPI would not represent the changes in a country s competitiveness level sufficiently. The same criticism is also valid for the PPI. Important Points in the Analysis of the Real Exchange Rate Developments The first point in the analysis of exchange rate is choose a base year such that, in that specific year, a given economy maintains both internal and external equilibrium. Therefore, it may be misleading to make comparisons with the preceding period. For example, the exchange rate in 1996 may appreciate 27

5 in real terms compared to However, it may show no change in the real value when it is compared to the base year, which is Nominal Exchange Rate The calculation of REER involves determining the exchange rate of Nepal and India with respect to American dollar. The period for the purpose of calculation has been considered to be The data have been presented in the form of the table which is shown below. Table 1 : Exchange rate with respect to US dollar Trade weight Year Nepal India USA From the above table we can see that the trend between the Indian rupee and Nepalese rupee is same as the Nepalese rupee is pegged with the Indian rupee. Consumer Price Index A consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households. The consumer price index of Nepal, India and US has been presented in the table below with year 2005 as a base year. Table 2 Consumer Price Index Base year : 2005 Trade weight Year Nepal India USA

6 It can be observed from the above table that the CPI for US has been rising steadily. The increase in the inflation rate of consumer products in US has been steady. However, with India and Nepal, there has been a steep rise in the CPI. The rise in CPI is comparatively high in Nepal as compared to India. The price level of Nepal has been more as compared to India. REER Competition: The formula has been used in excel sheet to compute the real effective exchange rate. In order to calculate the effective exchange rate, the trade weights based upon the trade between Nepal and India and Nepal rest of the world have been considered. The trade weight assigned to India is 0.65 and with rest of the world is As all other transaction is done in terms of dollar, the trade weight of rest of the world is taken in terms of dollar. The table below shows the calculated REER. Table 3 : REER Competition Trade weight Country Nepal India USA REER REER of Nepal with corresponding year has been presented below; Table - 4 REER of Nepal Year REER

7 It can be observed from the above table that the REER of Nepal had a steep rise in the years After 2004, there has been a downward slope in the REER trend. The REER has been stable after the year Table 5 : Export Import Statistics of Nepal (Rs in million) Particulars Total 173, imports From India From other countries Total exports To India To other countries The above table shows that the total import increased from Rs million in to Rs. Rs million in The total import from India increased from Rs million in to Rs million in Similarly, total exports increased from Rs. 60,234 million in to Rs. 74,261 million in The exports to India from Rs. 40,714 million in to Rs. 49,616 million in Table 6 : Major trading partners of Nepal (Rs in thousand) Countries Exports India 50,933,222 U.S.A 5,551,916 Germany 2,965,891 Bangladesh 2,578,080 U.K 1,461,905 France 1,062,887 China P.R 985,693 Italy 792,245 Canada 782,059 Japan 767,227 The largest export is to India which accounts for Res. 50,933,222 followed by US, which is Rs. 5,551,916. SUMMARY OF FINDINGS This study analyzed the exchange rate regime Nepal has been following, calculated the real effective exchange rate and the relevance of theory of optimum currency area characteristics in Nepalese 30

8 context. The importance of the pegged exchange rate was briefly reviewed in this study and is well documented in the literature. Based on an extensive review of the literature on the types of exchange rate regime a country can follow, a background of the exchange rate system in Nepal is studied. The calculation of REER is based on the factors like exchange rate between Nepal and India in terms of American dollar for the period of 1993 to 2010, the consumer price index of the three countries and trade weights. The Nepal has been following fixed exchange rate regime since There have been 8 adjustments till date and at present we are with the same pegged exchange rate with India since 21 years. REER has been calculated using the data for the exchange rate since 2001 to 2G 10, the consumer price index of Nepal, India and US. US dollar being the currency for doing business with the rest of the world has been used instead of other trading partners. Using a excel sheet, the calculated REER shows that the REER value of Nepal have been overvalued. Nepalese currency has depreciated in the real terms; however the nominal exchange rate is fixed since many years. Actually for a country which is export based, it is beneficial to devaluate the currency in this context, however for a country like Nepal, which is an import based country, it would not be beneficial to devaluate the currency. CONCLUSIONS AND SUGGESTIONS CONCLUSION A country's exchange rate is an important determinant of the growth of its cross-border trading and it serves as a measure of its international competitiveness. Nepal has been following a pegged exchange rate since decades. The nominal exchange rate is fixed, however the real effective exchange rate gives the inflation adjusted exchange rate. A rise in the REER index means that the domestic currency is appreciating in value and this can occur either through an increase in the domestic price level or a fall in the foreign price level. A fall in the index signifies currency depreciation due to a lowering in the domestic price level or an increase in the foreign price level. An appreciation of the REER is likely to translate into a worsening of a country's trade balance as it is expected that consumption of its exports will be discouraged as they become more expensive while the country's import bill should rise because these will now be relatively cheaper. The calculation of the REER from the above study showed that the Nepalese rupee is depreciating its value either because of the increase in the domestic price level. The reason behind the increased domestic price level is the dependency on the imports and lack of export incentives. However, Nepal being a import based country, the reconciliation of the currency may not be a suitable choice for the present situation. SUGGESTIONS The calculation of the REER from the above study showed that the Nepalese rupee is depreciating its value either because of the increase in the domestic price level. The reason behind the increased domestic price level is the dependency on the imports and lack of export incentives. However, Nepal being import based country; reconciliation of the currency may not be a suitable choice for the present situation. Thus, to correct the trade deficit in Nepal, we should increase the export by mobilizing the domestic resources which cartel imports in one hand and we should decrease imports by using the fiscal tools, by increasing the efficiency of tax administration, by establishing the import substitution type of industries, etc. on the other hand. 31

9 Nepal should play an initiative role to create a monetary unit with the other South Asian Association for Regional Cooperation (SAARC) members. This will help to develop the economy of the member countries. From the experience of European Union experience, it may look like it's a difficult decision to be made, however, if well implemented; it would be a better aspect to develop the economy of this region. Policy makers at a macroeconomic level should educate people on use of domestic products and give less priority to foreign products. Bibliography Text books : Cheol S. Eun and Bruce G. Resnick, International Financial Management, Tata McGraw-Hill Publishing Co, Fourth Edition, Geert J Bekaert, Robert J. Hodrick, International Financial Management, Prentice Hall Series, 2nd Edition, Jeff Madura, International Financial Management, Thomson Asis Pvt. Ltd 7th Edition, Madhu Vij, International Financial Management, Excel Publications, Research Papers: A.M. Gulde, E. Jafarov, and V. Prokopenko, A common currency for Belarus and Russia? IMF working paper WP/04/228, Galey K. An Analysis of pegged exchange rate between Bhutan and India, Journal of Bhutan Studies, vol. 1 No. 1, Jair Santoya and Candice Soutar, Estimating the Real Effective Exchange Rate (REER) for Belize, M.J. Artis, Reactions on the optimal currency area (OCA) criteria in the light of EMU, International Journal of Finance and Econoics 8(4), R. MacDonald, and L.A. Ricci, Estimation of the equilibrium real exchange rate for South Africa, South African Journal of Economics 72(2),