Exchange rate of NRs vs IRs: Stay the Course

I co-authored my latest piece with Adnan. It is about the issues surrounding balance of payments deficit and the pegged exchange rate between Nepali rupee (NRs) and Indian rupee (IRs). Looking at the options available to the Nepali central bank, neither revaluation is good nor devaluation is good. Given the dire state of the Nepali economy, sticking with the existing peg is the best option. Here is an additional blog post on the issue.

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Exchange rate: Stay the course

ADNAN KUMMER and CHANDAN SAPKOTA

There are rumors about potential change in exchange rate of Nepali rupee (NRs) with Indian rupee (IRs), with which Nepal has pegged its currency at a rate of NRs 1.60 equal to IRs 1.00 since 1993. While some analysts are wondering why Nepal’s currency cannot be changed, or appropriately revalued, others are calling for devaluation at the rate of NRs 2.00 equal to IRs 1.00. Some people say that change in exchange rate is essential because the existing peg set almost two decades ago does not reflect changing trading environment and widening productivity gap undergone by these economies. Others point out a little more convincing situation relating to soaring trade deficit with India and the need to contain it.

The rumors about possible change in exchange rate picked up much steam since the economy experienced approximately Rs 20 billion hole in the balance of payments (BOP) in the first half of this fiscal year. To douse potential speculative attack on the currency, the finance secretary and the finance minister had to put out statements saying that exchange rate will not change as of now. Even the central bank is being pressured to come up with a formal statement. Given the state of our economy right now, staying the course, i.e. sticking with the existing exchange rate peg, seems to be the best option.

The most pressing macroeconomic problem right now is to find ways to narrow current account deficit and close the hole in BOP. The surge in imports and decline in remittances and exports have triggered this unfortunate situation. A revaluation of the currency is out of question because it would not address the core problems. In fact, it would widen current account deficit as imports from India become relatively cheaper to domestic consumers. Meanwhile, imports of Nepali items by Indian consumers would become expensive. It makes sense to revalue Nepali rupee against the Indian rupee if the demand of Nepali export items by Indian consumers is inelastic, i.e. no matter by how much prices change, Indian consumers would demand Nepali items. This is clearly not the case. In fact, the Indian market already has close substitutes of almost all the items Nepal exports.

Devaluation seems to be the most favored option among analysts of the Nepali economy. At present, it is definitely a better case than revaluation but a weaker case than status quo. There are short-term gains and long-term dangers associated with devaluation. Devaluation – a deliberate downward adjustment in the official exchange rate – will reduce the currency’s value. By making exports less expensive, and discouraging imports, devaluation can indeed help reduce current account deficit. If things turn out this way, then devaluation is not bad for the Nepali economy.

However, once the monetary and trade engines set in motion, it does not stop there; devaluation is not devoid of dire economic consequences. First, by increasing the price of imports and stimulating demand for exports, devaluation potentially increases economic activity but aggravates inflation. But, high inflation rate will force government to raise interest rates to control spiraling price rises, which is already hovering around 12 percent in Nepal.

As a consequence, the higher interest rates will cause a slower rate of economic growth by discouraging consumption and reducing investment by firms. Moreover, once the inflation genie is out of the bottle, we will have to let go a lot of economic growth before inflation can be contained again. The story of inflation is a little more complicated than what some are arguing simply that devaluation will result in a short-term high-inflation, but a long-run low-inflation. Economists and policymakers would have a simpler life if it was this straight-forward.

It makes sense to revalue Nepali rupee against the Indian rupee if the demand of Nepali export items by Indian consumers is inelastic, i.e. no matter by how much prices change, Indian consumers would demand Nepali items. This is clearly not the case.

There are a number of factors that affect inflation. We need to figure out what will be the greater source of inflation after devaluation: Demand-pull or cost-push inflation. Given such a high rate of unemployment and excess capacity in the economy, it is unlikely that inflation will come from the demand side. Moreover, if the demand is relatively inelastic in the export sector—which seems to be the case if we look at the level of exports to India in the past several years—the increase in volume of exports will be rather small. Instead, a greater fall will occur in the total value of exports. This avails no effective solution in addressing the pressing macroeconomic challenge.

A greater likelihood is that more inflation will creep into the economy from the supply side, both imported and domestic. Though it has changed a little bit recent years, historically, inflation in Nepali economy has followed the inflation pattern in the Indian economy. The increase in the price of imported goods and domestic supply constraints—both production-related and nonproduction related—will cause cost-push inflation. Note that Nepal imports almost 60 percent of total imports from India. According to NRB, the wholesale price inflation increased by almost 19 percent compared to 10.1 percent a year ago. Moreover, the exporting firms, for their part, now will have less incentive to cut their costs as devaluation will make their products more competitive in the export sector. Hence, in the long-run, both costs and inflation will increase. Inflation coming in from the supply side is sure to have long-term effects, and not just short-term. This will also undermine investor confidence in Nepal’s economy and diminish the ability to attract foreign investment.

With reserves to fund more than six months of imports, the central bank can comfortably sterilize pressure on the Nepali rupee. Generally, the IMF recommends reserves that can fund three months of imports. Right now, we are better off staying the course, i.e. no change in the exchange rate.

To address the current account deficit, which has deteriorated by around 245 percent in the first half of this fiscal year, Nepal should aim to “grow” itself out of this crisis rather than through currency manipulation. How? For the short term, one possible way is to make Nepal Tourism Year 2011 a success and generate substantial foreign exchange to ward off the pressure from surging imports and receding exports. Also, increasing price and quality competitiveness of Nepali goods will help increase exports. Meanwhile, increasing remittances inflow would provide a badly needed band aid to the economy.

The central bank has a very difficult task ahead. It has to rein in rumors about change in exchange rate, tame double-digit inflation, tighten liquidity in the real estate and ease in productive sectors, and effectively sterilize any pressure on the Nepali rupee. It has to take very cautious and pragmatic steps. In terms of NRs exchange rate with IRs, staying the course is the best option for now.

(Kummer is a graduate student at Johns Hopkins School of Advanced International Studies & Sapkota is a Junior Fellow at Carnegie Endowment for International Peace.)

[Published in Republica, March 23, 2010, pp.6]

Robert Wade on Industrial Policy

Duncan Green summarizes Wade's argument on industrial policy, particularly the distinction between 'leading the market' and 'following the market':

Leading the market is South Korean style picking winners – we want a steel or chip industry, so we’re going to spend big time and just make it happen. That worked in the Korean case, but has failed in many others. Following the market, on the other hand, is a much less risky form of industrial policy, based on systematically ‘nudging’ firms to upgrade their technologies through incentives, performance requirements, or the state playing a brokering role putting firms in touch with foreign investors. Robert saw this as a third way (sorry) between the command and control of South Korea, and the passive laissez faire of the traditional World Bank view that governments should stick to sorting out the ‘enabling environment’ of property rights and keeping the bureaucracy in check. Robert held up Taiwan as a model of successful following-the-market type industrial policy.

Barry Eichengreen on the next MD of the IMF

Barry Eichengreen argues that selection of the next managing director of the IMF should be based on merits, not geographic location.

The obvious choice is Asia, home to the most dynamic emerging markets. It is the region to which the world’s economic center of gravity is shifting. If you ask Asian leaders what would make them consider again approaching the Fund after their traumatic experience with IMF “assistance” in 1997-1998, they will answer: an Asian managing director.

In fact, this is precisely the wrong way to think about the problem. The IMF’s problem in the past has been parochialism and lack of accountability. The best way to ensure that the Fund remains open to new ideas is by selecting the person with the best ideas to lead it. The best way to ensure that the IMF’s management is accountable to all of its governmental shareholders is to prevent the top job from becoming the sinecure of any region, whether Europe or Asia.

The next managing director should be selected on the merits, not on the basis of nationality. There should be an open competition, in which the best candidate wins on the basis of his or her ideas.

The next managing director should be selected on the merits, not on the basis of nationality. There should be an open competition, in which the best candidate wins on the basis of his or her ideas.

Asia has plenty of competent economic officials who might be considered as the next managing director of the IMF. But just because they are Asian is not reason enough to select them.

R.I.P. GPK!

Girija Prasad Koirala: A very important Nepali statesman who became prime minister for four times, supported for free press and liberal economic policies, convinced the Maoists to join democratic process thus playing a crucial role in ending the decade long civil war, staunchly opposed the Royal coup, lead the country during the immediate transition from autocratic Royal regime to a republic secular nation, and so on… passed away yesterday. R.I.P. GPK!

Obituaries here, here, here, here, here and here. Here is a piece about economic reforms during GPK’s time. His life in pictures here.

List of RTAs in the World (as of 2010-3-20)

 

Download it from here (PDF). I compiled it from the WTO website.

Daron Acemoglu profiled in F&D magazine

An interesting profile of Daron Acemoglu in IMF's Finance & Development magazine:

Governments are often barriers to the functioning of markets, but if you really want markets to function you need governments to support them—with law and order, regulation, and public services.

“We have done a lot of empirical work that shows a very clear causal link between inclusive economic institutions—those that encourage participation by a broad cross section of society, enforce property rights, prevent expropriation—and economic growth,” Acemoglu asserts. “The link to growth from democratic political institutions is not as clear.”

The textbook contends there was no sustained growth before 1800, first, because no society before that date had invested in human capital, allowed new firms to bring new technology, and generally unleashed the powers of creative destruction; and second, because all societies before 1800 lived under authoritarian political regimes. And economic takeoff started in western Europe because international trade rose after the discovery of the New World and the opening of new sea routes. The trade uptick boosted commercial activity and vested more economic and political power in a new group of merchants, traders, and industrialists, who then began to operate independently from European monarchies.

There will be three obstacles to growth under authoritarian regimes: there are always incentives for such regimes to be even more authoritarian; these regimes tend to use their power to halt Schumpeterian creative destruction, which is key to sustaining growth; and there is always infighting for control of authoritarian regimes, which causes instability and uncertainty.

“Dysfunctional societies degenerate into failed states,” asserts Acemoglu, “but we can do something about it. We can build states with infrastructure and law and order in which people are confident and comfortable going into business and relying on public services, but there is no political will to do that. You would not need armies to implement such a scheme—just a functioning bureaucracy to lay down the institutional foundations of markets.”

Hunger in the developing world after the crisis

Food and economic crises increased the number of hungry people to one billion in 2009.

Reasons: people's inability to afford food due to high prices and a slightly low harvests

 

Solutions:

In the medium and long term, the structural solution to hunger lies in increasing agricultural productivity to increase incomes and produce food at lower cost, especially in poor countries. The importance of longer-term measures is evidenced by the unacceptably high number of people who did not get enough to eat before the crises and are likely to remain hungry even after the food and economic crises have passed. In addition, these measures must be coupled with better governance and institutions at all levels.