Nepal’s monetary policy
Interesting—seemingly encouraged by Guna Raj Bhatta and Rabindra ji’s publication on rule-based monetary policy—the article, without adequately assessing the facts, appears carried away by a misguided belief that sustaining the fixed peg system for more than three decades is something no other country can match.
Taking the core functions of a central bank and the intricacies of managing monetary policy, Robert Mundell and Marcus Fleming in 1960 developed a theory, famously known and used worldwide as the theory of the Impossible Trinity or Trilemma, showing the trade-offs among three core functions of a central bank. These are represented as the three corners of a triangle: a fixed exchange rate, free capital mobility and independent monetary policy. The theory stipulates the impossibility of achieving all three simultaneously.
In practice, Nepal, along with many others, has adhered to this framework with some modification for policy convenience by making all three corners partially flexible. For example, it has made 70% (trade-weighted) of its currency fixed with the Indian rupee but keeps 30% freely floating, albeit in accordance with India’s managed float, resolving issues of arbitrage. On capital movements, it controls short-term speculative flows but allows medium- to long-term non-speculative FDI and unofficial short-term capital movement from border areas. On liquidity management, it adopts an interest rate corridor and policy rates as tools, keeping an eye on RBI rates. Nepal relies on this system at a huge cost, both direct and indirect, damaging its growth potential.
The write-up continues without checking the facts, making a false argument in favour of the fixed peg system—that any adjustment would destabilise the economy and create uncertainty, along with bigger losses for Nepalis working in India. Besides, under the pretext of a price anchor, the IMF, World Bank and ADB have made it a taboo and recommended not touching it. I remember that during the 1992 policy reform workout, IMF officials did not agree to adjust the exchange rate to 1.60 from 1.45, nor with the reform package, but Nepal proceeded as it clearly saw merit in steering the economy in that direction.
The fact is that Nepal has not only a large and increasing trade deficit with India but also a deficit in its current account and balance of payments. Nepal pays more to Indian workers in Nepal and spends more on travel in India for study, medical services, religious visits, etc., than it earns from Nepalis working in India, including Gorkha pensions and other receipts. That is why its current account and BoP are always in deficit, for which it spends annually around US$4–5 billion or more to purchase Indian rupees to settle its accounts. Nepal may take comfort in rising forex reserves contributed by increasing migration. One may wonder what the consequences would be if, for some reason, those reserves recede.
The continuation of the fixed peg for such a long period has not only eroded competitiveness and shrunk the domestic market for local products but also encouraged trading over industrialisation among potential investors. The consequences include rising unemployment, increasing overseas migration for jobs leading to labour shortages, declining factor productivity and capital accumulation, narrowing fiscal space due to stagnation in domestic economic activities, increasing rural-urban disconnection, and issues relating to population growth.
Rule-based monetary policy does not function properly as long as a fixed exchange rate system is maintained. Interest rates and prices are heavily affected by the rates of the pegged country, and monetary policy has to be devised with reference to them, losing independence. Although considered expansionary, Nepal adopts an interest rate corridor as the best available policy tool for determining domestic interest rates, while keeping an eye on the pegged country’s policy rates and interest rate structure.
To conclude, with swelling reserves and a low price level, this is the right time to adjust and move to a crawling peg system that will inject fresh energy into the economy and raise investor confidence. If this is accompanied by a simple, open and forward-looking business policy, a lower tax system encouraging imports of capital equipment, and improved access to subsidised credit supported by R&D in agriculture-related activities, it could create enough employment opportunities to change the narrative from “kehi pani hundaina” to “Nepal ma thulo avasar cha, je pani garna sakincha.”
Prithvi Raj Ligal, Former Vice-Chairperson of the National Planning Commission