Wednesday, December 21, 2016

Impact of demonetization of Indian notes in Nepal

It was published in The Kathmandu Post, 20 December 2016. 

The surprise decision to withdraw the two highest denomination Indian currency notes by Indian Prime Minister Narendra Modi on 8 November has led to confusion and uncertainty not only in India, but also in neighbouring countries where Indian currency is freely used as a medium of exchange. The administrative unpreparedness and the ensuing management mess in India have put Nepali policymakers, traders and ordinary people, who use the Indian currency for various purposes, in a terrible fix.

The close economic integration between the Nepali and the Indian economy, especially in trade, employment, remittance inflows, tourism and investment, means that the demonetisation drive in India is having ripple effects on the Nepali economy as well. Unfortunately, the Nepali monetary and fiscal authorities cannot do much to mitigate its direct impact as the shock is entirely exogenous and its fallout poorly managed.

Economic ties

Almost all macroeconomic indicators in Nepal are influenced by the fiscal and monetary changes in India. Imports from India accounted for about 62 percent of total imports in 2016. The total value of imported goods—ranging from petroleum products and vehicle parts to chemical fertilisers and agricultural goods—from India is equivalent to about 23 percent of gross domestic product (GDP). Similarly, exports to India accounted for about 56 percent of total exports. The two countries have a trade and transit treaty—although it was knocked sideways during the four-and-half-month-long crippling supplies blockade—that cuts deeper than any other multilateral and regional trade agreements. Investment commitment and tourist inflows (recreational as well as religious) have also been the highest from India. Nepal has pegged its currency to the Indian rupee at a rate of NRs1.6 to IRe1 since 1993, partially contributing to macroeconomic stability even in times of tumultuous politics. Furthermore, the Indian market is a stable employment destination for seasonal Nepali migrant workers.

Against this backdrop, the ripple effects of any changes to fiscal or monetary policies in India are bound to be felt in Nepal too. In the demonetisation case, the transmission mechanism would most likely be more pronounced through depleted savings (although transient in nature) of seasonal workers, setbacks to informal trade flows and investment in small and medium enterprises, and lower spending by Indian tourists. For Nepali citizens using services in India, such as students, pilgrims and medical patients, it would be a nightmare to implement their plans without Indian currency in hand.

Persistent effect

The effect of these factors will most likely be gradual, yet persistent, resulting in downward pressures on economic growth.

First, India is a popular employment destination for seasonal workers, who migrate for short-term unskilled work, especially during lean agricultural period. Survey estimates show that India accounts for over 41 percent of the total stock of Nepali overseas migrants and they send about 20 percent of total remittance inflows. A unique feature about the Indian market is that it provides unhindered seasonal employment to a large number of unskilled Nepali workers compared to other employment destinations such as the Gulf countries and Malaysia. An open labour market, language familiarity and low cost of migration may be the most important factors for such a trend. Furthermore, members of the poorest households across Nepal, especially from the plains and the mid-hills, tend to migrate to India for short-term work. They include members of households affected by last year’s earthquakes.

Note that this group of unskilled migrant workers earn a stipulated daily wage in cash, which they usually save in higher denomination notes that are easier to carry back home. The demonetisation shock has made this group of people, many of whom do not have a bank account, the most vulnerable and hapless. Their cash savings are on the verge of being worthless, and they cannot afford to queue outside banks for hours. Worse, they are probably not paid for the daily work they are doing due to the lack of cash in their employer’s vault. The remittance income of this group of migrant workers normally constitutes one the strongest pillars of the consumption-based local economic activities back in their villages. This is now at risk.

Second, recent estimates show that just 29 percent of total imports from India are transacted through letter of credit, that is through the formal banking system. It means a substantial portion of imports is settled in cash or other means such as bank drafts or travellers’ checks to mainly avoid taxes and bureaucratic hassles. Also, surveys on informal trade show that informal agricultural imports from India account for about 15 percent of total formal imports. The total informal merchandise imports from India may well be over 30 percent of total imports. As these are mostly settled in cash by small- and medium-scale traders, a shock to this process will generate a slow but persistent impact on the Nepali economy.

Third, small-scale investments—in retail and wholesale trade, agro and manufacturing enterprises—along the border areas do not flow through the formal banking process. They are transacted locally in cash. We will continue witnessing a slowdown there as well. Additionally, there is a real possibility of a decline in the number of Indian tourists and their spending capacity in Nepal. Tourism related purchases are settled in cash, especially by Indian tourists who drive into Nepal for a short vacation over a weekend.

Now what?

These are a few potential transmission channels through which the demonetisation shock will have a downward effect on economic activities in Nepal. That said, there still is much uncertainty over the stability of the Indian currency market and the normalisation of administrative mess to match demand for and supply of new notes.

Nepal cannot do much directly, but that does not mean that the central bank and government should stay idle and wait for a response from their Indian counterparts. The amount of higher denomination Indian rupee in circulation in Nepal is far higher than the paltry IRs34 million said to be in the banking system. India will not be paying much attention to our troubles when its own administrative and banking capacities are deficient to deal effectively with the ensuing chaos.

Our government and the central bank cannot turn their back on the poor seasonal migrant workers, general public and traders, and point to the evolving perplexity in India. They need to work proactively to address the troubles faced by the public and small- and medium-scale traders. Furthermore, local economic activities need to be closely monitored, especially in areas with high seasonal migration to India.