This blog post relooks at some of the issues surrounding the pegged exchange rate between Nepali rupee and Indian rupee, and its effect on competitiveness. For earlier articles on the exchange rate, see this content: Stay the course on the exchange rate; Q&A on exchange rate; confidence on the Indian rupee in Nepal; and services exports’ competitiveness. Nepal has been keeping a pegged exchange rate to the Indian rupee for a long time.
NRs 1.60 was prevalent even in FY1965. But, the Nepalese rupee has been revalued and devalued as per the evolving nature of Nepal’s and India’s economies. NRs 1.39). Then effective from October 9, 1975, the exchange rate of the Nepalese rupee vis-a-vis the united states dollar was modified. The exchange rate of other convertible currencies was quoted daily with reference to the US money rate in the international currency market. June 1 On, 1983, the exchange-rate system pegged on US dollar and Indian currency was replaced with a basket of money system.
On July 1, 1991 the Nepalese rupee was revalued against Indian money by 1.8 percent. And, on March 4, 1992 the Nepalese rupee was made partially (65:35) convertible on current account. As mentioned previously, the main rationale for the calls for the revision of the exchange rate, whether going for a versatile system or devaluing the exchange rate fully, is to narrow down the widening trade deficit.
The prevailing notion among some analysts and policymakers is that the existing peg needs to be devalued-a deliberate downward adjustment to the official exchange rate-so that Nepal’s export price competitiveness is improved and therefore exports boosted. Rodrik (2008) showed that undervaluation of currencies (i.e. a higher real exchange rate) not only reduces the trade deficit but also stimulates economic growth in developing countries.
The caveat of this finding would be that the operative route is the tradeable sector (mainly industry), which should have a pretty strong foundation such that it can benefit from the devaluation of the exchange rate. In other words, developing countries that can increase the relative profitability of their tradables are most likely to accomplish higher growth from currency devaluation.
Unfortunately, at the moment, Nepal doesn’t have a strong industrial base credited to persistent structural constraints to financial activities (also see why is Nepal poor?). Although existing basic economic principles and widening of the trade deficit with India necessitate a devaluation of the exchange rate, it can only just work if Nepal gets the prerequisites in place for the export-oriented industries to take off.
However, given the current fluid politics situation, it is easier said than done. Note that hastily devaluing the exchange rate would risk undesirable effect on the already deteriorating trade deficit because of the J-curve effect. In the brief run, a genuine devaluation might not always reduce total transfer volume as export and import cable connections are confirmed in advance.
It means that the worthiness of the current import volume would be higher in terms of domestic currency, leading to an adverse impact on the balance of trade. In the long run, as import quantity gets affected by increased comparative prices, total imports might decrease. Hence, a real depreciation might cause more damage at first before the expected changes begin to kick in, that also provided that Nepal already gets the prerequisites for export-oriented industries to take off. A devaluation of the exchange rate will continue to work only when the prerequisites are in place and institutional and market failures looked after. Caramazza, Francesco, and Jahangir Aziz.
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IMF. NEPAL Article IV Consultation. Sapkota, Chandan, and Adnan Kummer. Yagci, Fahrettin. Choice Of Exchange Rate Regimes For Developing Countries. Nepal initiated the Structural Adjustment Program. Technically devaluation of the exchange rate makes exports less expensive and discourages imports, that could help reduce both trade deficit and current account deficit. The assumption is that the cost differential between Nepal and India are carefully related with the comparative price structures in both economies. Furthermore, maintaining a devalued real exchange rate requires a higher saving in accordance with the investment, or lower expenses relative to income.
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