Factors facilitating for the stability in Nepal's exchange rate vis-a-vis Indian Currency

- Dr. Nephil Matangi Maskay, Patan Multiple Campus, T.U

The exchange rate policy of Nepal vis-a vis IC over the period 1960-1999 has important implications for Nepal in adjusting to disquilibrium in the account of the country's foreign transctions of goods and services and capital that is to say BOP adjustment. At times there arises with economic interaction an imbaalance in the BOP, which requires an adjustment to correct it. The adjustment to correct BOP disequilinrium takes two forms: external adjustment such as, a change in the exchange rate, or internal adjustment such as changes in government monetary or fiscal policy. Nepal's exchaange rate policy vid-a-vis IC has presently eliminaated the possibility of external adjustment, i.e. depreciation or appreciatioon of the NC-IC cxchange rate, to a large extent. This implies that Nepalese adjustment to BOP disequilibrium vis-à-vis IC should be through the changes in Nepal's own montrary or fiscal policy. This should be an internal adjustment rather than a change in the exchange rate. What brought about this adjustment in the Nepalese context? There are three basic characteristics of Nepal-India relations which have gone in to the process of adjustment.

HIGH TRADE OPENNESS

The first stabilizing characteristic is the high trade openness. Trade openness that is to say the measure of the total volume of trade between the two countries (exports and imports) as a ratio to nominal GDP. This statistic suggests that the amount of internal adjustments necessary to correct the imbalances in BOP. Nepal's trade openness with all counties suggest it increased by two third over the last seven years of 1990/91-1996/97 from 26.4% to 44% (Economic Survey). But, the relevant statistics in examining Nepal's exchange rate vis-à-vis IC is Nepal's trade openness to India only. The Economic Survey puts this figure at around 30% for the seven-year period. This is a significant statistics for trade openness. For one thing, despite a decade of trade diversification increaase in trade openness with other countries, no such phenomenon of increases or decrease in trade relations between the two countries was observed. The only factor which appears to have gone into the making the stable relationship is the political changes which occurred during that time.

However this statistic, 30% openness to India , is misleading. It does not capture the heavy compression of valuation particularly of imports. More imoprtantly it only captures official trade figures. It was suggested by Muni in 1992, after examining Nepalese and Indian trade, that the value of goods transacted through unrecorded trade channels between the two countries may be as high as eight to ten times of the officially recorded trade. Many other economists and international trade experts like Blejer aand Szapary (1991), EDERI (1994), ISD (1994a), Rajbahak (1992), Sharma(1997), Uprety (1996) have held the similar view of unrecorded trade between India and Nepal. In other words, given the consideration unofficial trade, the Indian trade may be greater than 50% of the Total Nepalese trade. This statistic suggeset that in South Asian exchange rate regime India may be more important to Nepal. In other cases of successful rigid exchange rate regimes like European or Asian, Germany is not as imortant to Austria (49.8%) or Hong Kong is not as important to USA (15.5%) (Maskay, 1998a) in terms of trade share. All these by implication indication indicate that Nepal presently has a significant trade exposure with India and significant trade ineraction between Nepal and India. These informations implies that for each single NC used for consumption in Nepal, a significant portion of the NC goes towards consumption of foreign Indian goods. The statistic for Nepalese trade openness with India suggests that the marginal propensity to import Indian goods is high. A high MPM in relation to India implies that the neessary internal adjustment necessary to bring about equilibrium in BOP is low (or less costly).

A numerical example using MPM and the CA multiplier will clarify this statement. The CA multiplier shows the necessary change in magitude of government expenditure necessary to bring about a change in the CA. It is given as dCA/dG=-MPM/(MPS+MPM) where dCA/dG is the change in the CA that results from a change in government expenditures, MPM defined as stated above and MPS is the marginal propensity to save (i.e. proportion of income which goes into savings). If we consider MPS to be constant at 0.25, a high consumption for Indian goods is reflected in a high numerical MPM-for this example consider it to be 0.25. Given this scenario and with a hypothetical CA deficit of 200 million NC in the CA the Nepalese government needs to reduce government expenditure by 400 million NC. The reason for this is that a contraction of government expenditures reduces national income. This reductioon in national income carries over as a reduction in individual income, which leads to a reduction of overall consumption, and there in consumption of the Nepalese government expenditures of 400 million NC, in this scenario, is necessary for a CA deficit correction of a 200 million NC.

If we compare this against a scenario where there is a low consumtion of Indian goods, reflected as a low nummerical MPM, a higher contraction in government expenditures is necessary for a CA deficit correction of 200million NC. Consider the same earlier scenario with the only change being that MPM is now only 0.125 (i.e. half of the earlier example). The earlier formula suggests that for a CA deficit correction of a 200 million NC a contraction of 600 million NC is necessary- this mean that the government will have to contract by 200 million NC more!

In othere words, this example has suggested that the high Nepalese MPM with India implies that the necessary internal adjustment to correct for disequilbrium in BOP is less costly. So, this has made the necessary adjustment to BOP disequilibrium easier to implement and has been accepted by the Nepalese government as a sound foreign policy.

HIGH LABOUR MOBILITY

The second stabilizing chracteristic is high labor mobility, that is the ability for individuals to move between Nepal and India to find employment. Unfortunately, for Nepal and India a quantitative analysis of labor mobility is impossible due to the scarcity as well as poor quality of available data. Rather, the open and contiguous border with India as well as the absence of controls on labor movement, as guaranteed by the 1950 Treaty of Trade and Friendship, suggest uncontrolled high movement of labor between the two countries. The conclusions of the report of the Task Force on Migration (1983) and of the Population Monograph of Nepal (1995) support this conclusion.

While direct measurement of labor movements between Nepal and India is difficult, it is possible to measure it indirectly by the social and cultural similarities between the two countries. The similarity of these factors makes for lesser cost of migration and so increased potential for labor movement between the countries. This method of measurement is suggested by Eichengreen (1991) as well aas Carrington, Detragiache and Vishwanath (1996). The border region of the Tarai between Nepal and India is inhabited by the people of society, culture and religion which are common to both countries. The large number of skilled and unskilled workers in the 'Tarai, for example in Birgunj, a border town, speak Hindi, India 's national language. This language is predominantly spoken by the inhabitants of the tarai as also the clothes and method of personal interaction are similar between the Nepalese and Indian living in the border region. This is consistent with Dash (1996,p.109) who states that "of the total immigrants in Nepal's Terai region, more than 97%came from India." Additionally Wilson (1990, p.45) states that "four to five million Nepalese are reported to work permanently in India in addition to 100,000 seasonal Nepali migrants workers who cross the India–Nepal border each year" These information imply that there is high labor movement between Nepal and India. Approximately 850 miles of Nepal's international border is shared with India and approximately 670 miles of the country's international border is shared with Tibetan Autonomous Region of China.

A high labor movement between Nepal and India suggests low cost for internal adjustment to adress disequlibrium in BOP. This adjustment process occurs not only because of the Nepalese government action but also from individuals moving from Nepal to India and vice versa. The critical idea underlying the importance of labor movement is that disequlibrium in the BOP, and thus to disequilibrium in the CCCA, is driven by the process of unemployment (UE). If UE were high then with less people having jobs overall consumption will be low. A lower overall consumption implies, according to the MPM analysis referred to in the preceding paragraph, that a smaller portion of consumption will constitute smaller portion of imports and, given exports as constant, there will consequently be a situation of CA surplus. On the other hand, according to the above analysis, a low UE implies a high CA deficit. Given mobility of labor between the two regions who face a CA deficit situatioon, this implies UE in the regions are dissimilar. Given the incentive of expected income for labor mobility this implies labor mobility will inrease between the regions until there is similarity in UE or there is not further incentive for labor movement. Once this cccurs, with similar consumption patterns the CA, and thus the BOP, disequilibrium will disappear.

In other words, the ability of labor to move between Nepal and India will reduce the necessary cost for adjustment to BOP disequilibrium.

LOW CAPITAL MOVEMENT AND STABILIZING NEPALESE MONETARY POLICY

Officially low capital movement is present between Nepal and India as the individuals in Nepal are unable to immediately transfer funds to India and vice versa and there are restriction for capital movement. This inability is characterized by absence of capital account convertiblity between the countries. The facility of convertibility of NC and IC available in Nepal is not reciprocated by India . This implies that transfer of funds from Nepal to India is not possible through official channels. Additionally, the practical unlimited conversion of NC to IC in Nepal is not without restrictions as converting the amount greater than 20,000 NC to IC will provoke questions by bank officials. The conclusion about the low capital movement is supported by two vital evidences. First, evidence is provided by explict estimation via simultaneous equations to have shown that the offset coefficients are low which means the official capital movement is low (Khatiwada (1994) and Maskay(1998)). Second, there existed interest differentials between Nepal and India for at least a year suggesting low capital movement. Had there been high capital movement then Nepal-India economic activity would have experienced interest rate equalization because of uncovered interest parity."

Low capital mobility has allowed for stabilizing of Nepalese monetary policy only for a short term (at the most a year) but Nepalese and Indian monetary policies need not be similar because of low capital movement. This stabilizing monetary policy is to address the dissimilar temporary real shocks which both economies face (Maskay, 2000a). These dissimilar temporary real shocks are due to the developing structure of both the economies, which significantly relate to agriculture's contribution to national income. In the short term, the economies of Nepal and India are held hostage to the vicissitudes of the weather. Thus, in the short run, a drought in the Himalayas may have a detrimental effect on Nepal but this would be cushioned in India due to the largeness of its size. This implies that while in the long term the economic activity of both economies is similar, in the short term there is some temoprary divergence.

Low capital movement allows the Nepalese monetary authority to pursue expansionary monetary policy to stabilize the economy without the fear of an immediate outflow of capital. Thus the short-term immobility of capital allows the Nepalese monetary authority to play its stabilizing role effectively (Maskay, 1998b). This short term dissimilarity of monetary policy is stabilizing the economy and reduces the cost for following the pegged exchange rate. If capital movement were high then the potential cost for following the pegged exchange rate would be enormous as the Nepalese monetary policy will have to follow Indian monetary policy. If the capital movement were high the Nepalese monetary authority may be forced to follow an expansionary monetary policy to maintain the stability of the pegged exchange rate which may result in destabilizing of the domestic economy.

Headline | 5 Question  | Editorial | 2nd Impression | International | Past |