Image: Prasun Sangroula
Nepal has outsourced monetary policy for six decades, or so the thinking goes. Its fixed exchange rate—1.60 Nepali rupees to one Indian rupee—has survived revolutions, recessions and reforms. Yet its utility is increasingly in question. As economic conditions evolve, so does the case for ending the peg.
The current regime began informally in the 1960s and was fixed at the current rate in 1993. It stabilised prices; anchored expectations; and simplified trade with India. Moreover, for Nepal (with thin capital markets and limited central bank credibility) the peg substituted for trust. Inflation remained contained and volatility low.
But the trade-off is narrowing room for manoeuvre. The Nepal Rastra Bank sets policy rates and conducts open market operations, but its choices are constrained. Any deviation from the Indian interest rate path risks arbitrage or capital flight, as some researchers argue. The peg imports India’s monetary stance wholesale, regardless of local conditions, they add.
The dependency is becoming more costly. The current account has deteriorated thanks to growing imports and stagnant exports. The fixed rate contributes to that imbalance by keeping the rupee stronger than market fundamentals would dictate. Imports stay cheap; exports struggle. Domestic production weakens.
Critics argue the peg suppresses competitiveness. More than 80% of domestic exports go to India, according to latest data, but reliance on a single market has discouraged diversification. The inability to adjust the currency blocks a key policy tool. A managed float, critics contend, would allow for tactical devaluation and enhance shock absorption, as well as incentivise local industry.
Proponents of the peg cite its role in maintaining stability. Inflation has remained within range, aided by India’s inflation targeting. The NRB has retained some flexibility using secondary instruments like liquidity windows and reserve requirements. Floating, they argue, would expose the rupee to speculative pressure and external shocks it is ill-prepared to absorb.
The financial infrastructure is shallow. Reserves are limited. Market instruments to manage currency volatility are underdeveloped. A sudden pivot to a floating regime could provoke instability. The NRB lacks the institutional capacity to manage big and rapid capital flows. Investors may retreat in the face of perceived uncertainty.
The peg also carries geopolitical weight. India and Nepal share an open border and deeply integrated labour and remittance flows. The fixed rate is a symbol of policy coordination. Abandoning it could hint at economic divergence and complicate diplomatic ties, especially amid growing Chinese engagement in Nepal.
Nonetheless, the underlying structure is evolving. Trade with China is rising. Energy self-sufficiency has been met, bar during dry months. Agricultural modernisation and digital services require more targeted, responsive policy. Monetary flexibility may soon become a necessity rather than a preference.
A sudden float would be risky. But so is complacency. Gradual transition is possible. Nepal could build reserves; develop forward markets; as well as widen the trading band incrementally. A shift toward a basket peg or a managed float would retain stability while expanding policy options.
Pegs do not last forever. They persist until market forces overwhelm them. The country’s still serves a function. But that function is diminishing. Economic complexity means monetary tools aligned with national priorities and not foreign cycles.
The rupee rope may hold for now. But it would be prudent to prepare for release: on own terms rather than the market’s. ■
