Friday, March 29, 2013

Pegged exchange rate between Nepali rupee and Indian rupee and competitiveness

This blog post relooks at some of the issues surrounding the pegged exchange rate between Nepali rupee and Indian rupee, and its impact on competitiveness. For an earlier posts on exchange rate, see these posts: Stay the course on exchange rateQ&A on exchange rate; confidence on the Indian rupee in Nepal; and services exports competitiveness.

Nepal has been maintaining a pegged exchange rate to the Indian rupee for a long time. The peg of NRs1.60= IRs 1.0 has not been revised since 1993. With the changing pattern of trade, especially exponentially rising imports and small volume of exports together with low productivity, there are calls to either change the peg or float it freely with all currencies.[1] However, in successive Article IV reports, the IMF has been arguing that maintaining exchange-rate peg to the Indian rupee should be the key near-term policy priority because “abandoning it now would create significant uncertainty given weakness in the banking sector, likely leading to deposit and capital flight”(IMF 2011). Meanwhile, there is already a depreciation of exchange rate in the informal market, which was quite visibly seen in the border areas (IRs 1.0 = between NRs 1.65 and NRs 1.68).

The main reason for the calls to change the exchange rate is that it does not reflect the changes in trade and economic fundamentals since the time India and Nepal opened up their economies in the early 1990s. Between FY1993 and FY2010, the average annual GDP growth rate of the Indian economy and Nepalese economy was 7.0 percent and 4.4 percent respectively (see Table). On an average, the Indian economy had sectoral growth in agriculture, industry and services of around 3 percent, 7.3 percent and 8.6 percent respectively. The Nepalese economy had sectoral growth in agriculture, industry and services of around 3.1 percent, 4.4 percent, and 5.3 percent respectively. The simple average annual growth rate of the major indicators shows that the sectoral growth in Nepal had been lower than in India, except for that in agriculture. The trade deficit widened from Rs 10.92 billion in FY1993 to Rs 177.12 billion in FY2010. This alarming rise in trade deficit has been the main concern and rationale for revising exchange rate so that exports are encouraged and imports discouraged.

Table: Changes in Nepalese and Indian economies, FY1993-FY2010

Average annual growth rate, FY1993-FY2010
Nepal India
Real GDP 4.39 7.03
  Agriculture 3.14 3.03
  Industry 4.13 7.30
  Services 5.26 8.61
Exports 9.50 14.05
    to India 22.27
Imports 15.24 14.35
    from India 18.31
Nepal's trade with India (Rs billion)
FY1993 FY2010
Exports 1.62 39.99
Imports 12.54 217.11
Trade deficit 10.92 177.12
Exchange rate (NRs/IRs)
1.6 1.6
Real 1.36 1.92
Source: ADB and NRB data

Looking at the evolution of exchange rate between Nepalese rupee and Indian rupee and that with the dollar, it is clear that the existing exchange rate of IRs 1 = 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. On June 6, 1966 following the devaluation of the Indian rupee, the exchange rate of Nepalese rupee vis-a-vis the Indian rupee appreciated by 57.5 percent (IRs 1 = NRs 1.0125). On December 8, 1967 the Nepalese rupee was devalued by 24.8 percent (IRs 1= NRs 1.35). 

Following the realignment of currency on December 17, 1971, the exchange rates of the Nepalese rupee vis-a-vis, Deutsche Mark, Japanese Yen and Indian rupee were revised effective December 22, 1971 (IRs 1 = NRs 1.39). Then effective from October 9, 1975, the exchange rate of the Nepalese rupee vis-a-vis the US dollar was revised. The exchange rate of other convertible currencies was quoted daily with reference to the US dollar rate in the international currency market. On June 1, 1983, the exchange rate system pegged on US dollar and Indian currency was replaced by a basket of currency system. On November 30, 1985,[2] the Nepalese rupee was devalued against foreign currencies (IRs 1 = NRs 1.68).

On July 1, 1991 the Nepalese rupee was revalued against Indian currency by 1.8 percent. And, on March 4, 1992 the Nepalese rupee was made partially (65:35) convertible on current account. It was followed by a change in proportion to 75:25 on July 12, 1992. On February 12, 1993 Nepalese rupee was revalued against Indian rupee by 3 percent to NRs 1.60 for 1 IRs and Nepalese rupee was made fully convertible on current account.

Figure: Exchange rate between Nepalese rupee and Indian rupee and US dollar
Source: Quarterly Economic Bulletin April 2011, Nepal Rastra Bank

As mentioned earlier, the main rationale for the calls for the revision of exchange rate, whether going for fully flexible system or devaluing the exchange rate, is to narrow down widening trade deficit. The prevailing perception among some analysts and policymakers is that the existing peg has to be devalued—a deliberate downward adjustment to the official exchange rate—so that Nepal’s export price competitiveness is improved and hence exports boosted.[3] The computation of the real exchange rate[4] also corroborates this argument.

Rodrik (2008) showed that undervaluation of currency (i.e. a high real exchange rate) not only reduces trade deficit, but also stimulates economic growth in developing countries. The caveat of this finding is that the operative channel is the tradeable sector (mainly industry), which should have a pretty strong foundation so that it can benefit from the devaluation of exchange rate.[5] In other words, developing countries that can increase relative profitability of their tradables are most likely to achieve higher growth from currency devaluation. Unfortunately, at present, Nepal does not have a strong industrial base due to persistent structural constraints to economic activities (also see why is Nepal poor?).

Figure: Real and nominal exchange rates between NRs and IRs after 1993
Source: Author’s computation using data from WDI (for inflation) and NRB (for nominal exchange rate); RER= Real exchange rate; NER= Nominal exchange rate

Though the existing economic fundamentals and widening of trade deficit with India necessitate a devaluation of the exchange rate, it can only work if Nepal has the prerequisites in place for the export-oriented sectors to take off. The prerequisites are mostly related to addressing the supply-side constraints such as power outages, labor disputes, increasing cost of labor and raw materials, strikes, and policy paralysis in terms of implementing already committed provisions in Trade Policy 2009 and Industrial Policy 2010, among others. It is expected that addressing these constraints would lower cost of production, encourage innovation, and research and development, which will make exports competitive and substitute a portion of import demand by domestic production. 

However, given the current fluid political situation, it is easier said than done. Hence, it is wise to think of favorably revising the pegged rate after the political situation is stable and the basic prerequisites for industrial sector to take off are in place, i.e. after institutional and market failures are duly taken care of.[6] Maintaining a stable and competitive real exchange rate requires a “supportive policy environment which would include prudent macroeconomic policies, a strong financial sector, and credible institutions” (Yagci 2001). For a developing country with limited links to global financial markets, low diversified production base and export structure, underdeveloped financial markets, lack of monetary credibility, and prone to bouts of high inflation, staying put on the existing peg until the necessary foundations are in place seems to be a good option (see Caramazza and Aziz (1998) for the pros and cons of fixed or flexible exchange rate regimes).

Note that hastily devaluing the exchange rate would risk adverse impact on the already deteriorating trade deficit because of the J-curve effect. In the short run, a real devaluation might not necessarily reduce total import volume as export and import connections are confirmed in advance. It would mean that the value of the current import volume would be higher in terms of domestic currency, leading to adverse impact on balance of trade. In the long run, as import volume gets affected by increased relative prices, total imports might decrease. Hence, a real depreciation might cause more damage initially before the expected changes start to kick in, that also provided that Nepal already has the prerequisites for export-oriented sectors to take off. Additionally, if the share of intermediate goods and raw materials used in production of export items are high in imports or the share the import demand is pretty much price inelastic,[7] (such as demand for petroleum fuel and LPG) then a real devaluation of exchange rate might not necessarily lead to reduction in imports and trade deficit. A devaluation of exchange rate will work only if the prerequisites are in place and institutional and market failures taken care of.


Caramazza, Francesco, and Jahangir Aziz. Fixed or Flexible? Getting the Exchange Rate Right in the 1990s. Economic Issues 13, Washington, D.C.: International Monetary Fund, 1998.

Chinn, Menzie D. "A Primer on Real Effective Exchange Rates: Determinants, Overvaluation, Trade Flows and Competitive Devaluation." Open Economies Review, 2006: 115-143.

IMF. NEPAL Article IV Consultation. IMF Country Report, Washington, DC: International Monetary Fund, 2011.

Rodrik, Dani. "The Real Exchange Rate and Economic Growth." In Brookings Papers on Economic Activity, by Douglas Elmendorf, Gregory Mankiw and Lawrence Summers, 1-47. Washington, D.C.: Brokings Institution, 2008.

Sapkota, Chandan, and Adnan Kummer. "Exchange rate: Stay the Course." Republica, March 23, 2010: 6.

Yagci, Fahrettin. Choice Of Exchange Rate Regimes For Developing Countries. Africa Region Working Paper Series No.16, Washington, D.C.: World Bank, 2001.

[1] For a discussion on the pros and cons of changing the peg, see Sapkota and Kummer (2010)
[2] Nepal initiated the Structural Adjustment Program.
[3] Technically, devaluation of exchange rate makes exports less expensive, and discourages imports, which could help reduce both trade deficit and current account deficit.
[4] Real exchange rate is computed as RER = e*(PI/PN), where e is the nominal exchange rate, which is adjusted by the ratio prices in India (PI) to prices in Nepal (PN). Here, prices mean consumer price index (annual growth rate). The decline in real exchange rate value is interpreted as an appreciation of the exchange rate (or loss of cost competitiveness of exports). The assumption is that the cost differential between Nepal and India are closely related with the relative price structures in the two economies. For a detailed discussion on computing various real effective exchange rates, see Chinn (2006).
[5] Furthermore, maintaining a devalued real exchange rate requires higher saving relative to investment, or lower expenditures relative to income. Rodrik (2008) lists various policy tools to achieve these: fiscal policy (a large structural surplus), income policy (redistribution of income to high savers through real wage compression), saving policy (compulsory saving schemes and pension reform), capital-account management (taxation of capital account inflows, liberalization of capital outflows), or currency intervention (building up foreign exchange reserves). With low saving rate, high consumption rate, restrictive capital account, and remittance-fueled forex reserves to the tune of Rs 263 billion (imports from India alone was Rs 262 billion in 2010/11), Nepal is not in a position to fulfill these conditions right now.
[6] Sapkota and Kummer (2010) argue that at present devaluation is “definitely a better case than revaluation but a weaker case than status quo”, i.e. staying the course with IRs 1 = NRs 1.60. Specifically, devaluation could increase inflation in a highly import-dependent economy and could spur currency speculation as the market would want to hold stronger currency against weaker currency of a nation with waning industrial base for fear of repeated devaluation to keep up with further weakening of economic fundamentals.
[7] The top imports from India such as petroleum and coal products; ferrous metals; chemical, rubber and plastic; mineral products; and machinery and equipments do not have substituting industries in Nepal and hence the demand for these products will see marginal impact even if the peg is devalued right now to make them expensive in terms of domestic currency.