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Benefits of the Pegging Arrangement Between Nepali and Indian Currencies

Hari Bansh Jha was ICCR Fellow at the Institute for Defence Studies and Analyses, New Delhi.
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  • July 21, 2011

    In Nepal, both the Nepali and Indian rupees were legal tender until 1956. Each day the exchange rate between the two currencies used to be determined by the private money changers on the basis of demand and supply. Sufficiency of Indian rupees or their lack resulted in the swings in exchange rates. However, the change in the exchange rate on a day-to-day basis was an irritant for the people. Quite often, it affected trade and other economic activities between the two countries.

    Therefore, as soon as the Nepal Rastra Bank, the central bank of the country, was established in 1956, it began to work towards making the Nepali rupee the sole legal tender and tried to do away with the existing dual-currency system in Nepal. Accordingly, the dual currency system was abolished under Nepal Currency Circulation and Expansion Act of 1957. A new single currency regime was established under which the Nepal Rastra Bank pegged the Nepali rupee to the Indian rupee and fixed the exchange rate at 160 Nepali rupees for Indian 100 rupees. Such a provision entailed that the Nepal Rastra Bank could buy and sell any amount of Indian rupees at the given exchange rate. Therefore many exchange counters were opened in different parts of the country to provide this service. Also, the banking institutions in Nepal were authorised to facilitate the exchange of these currencies at the fixed exchange rate.

    Significantly, on June 6, 1966, the Indian government substantially devalued its currency. Nepal on its part had to do little as the Nepali rupee had already been pegged to the Indian rupee. But the end result was that the Nepali currency automatically appreciated vis-à-vis the Indian currency on account of the pegging factor. As such, the new exchange rate between the two currencies was established at Nepali rupees 101 equivalent to Indian rupees 100.

    The last adjustment that was made between the two currencies was on February 1, 1993, 1 when the earlier exchange rate of Nepali rupees 160 equivalent to Indian rupees 100 was revived. Thus, for quite a long time the exchange rate between the Nepali and Indian rupees has been largely the same, despite the fact that the Foreign Exchange Regulation Act 1962 allowed the convertibility of Nepali rupees with all other currencies. 2

    But in certain quarters the rationality of the pegging of Nepali rupee with the Indian rupee is questioned. An impression is being created that the pegging of the Nepali rupee with the Indian rupee is not in Nepal's national interest. So several efforts have been made to remove this provision.

    As is well known, the only alternative to the pegged currency regime is the introduction of a floating exchange rate system between the Nepali and Indian rupees. Under this regime, the exchange rate between the Nepali and the Indian rupee would be determined each day on the basis of the demand and supply of the respective currencies as it happens in determining the exchange rate of Nepali currency with all other currencies, including the Euro and the US dollar.

    But the central bank in Nepal does not dare to follow the floating exchange rate regime though it is free to do that. It is feared that any attempt to do so on a day-to-day basis would increase the instability in Nepal’s economy.

    Besides other things, it would further erode people’s confidence in the Nepali currency as well as in the banking and financial institutions. Already, the people’s faith in such institutions is at an all-time low. This is the reason why many people do not like to deposit their money in the banks and financial institutions. As a result, a severe liquidity problem has erupted among these institutions.

    On the other side of the border, India has emerged as the world's second fastest growing economy with an annual rate of economic growth of around 9 per cent. In the international market, the value of the Indian rupee is increasing due to the growing strength of the economy. But in Nepal the Nepali rupee has been losing its value on account of the poor economic growth of 3.4 per cent. If there was a floating exchange rate arrangement between the Nepali and Indian rupees in the place of the existing fixed exchange rate, the value of the Nepali currency would be far lower than what is it is today. Perhaps, this could have a more adverse impact on Nepal’s economy.

    Moreover, a floating exchange rate does not appear to be practical for Nepal as the central bank of the country is not fully equipped to run an independent monetary policy because of its own limitations. It can do very little to control inflation through its monetary policy. Until inflation is controlled in India, the central banking authority can do little about it in Nepal. Worse still, the central bank has not been able to do anything concrete to check the shrinking circulation of Nepali currency in the country.

    The economic instability in Nepal is being kept within manageable limits since the Nepali rupee is pegged to the Indian rupee. Realising this fact, Yuva Raj Khatiwada, the governor of Nepal Rastra Bank, said that the Nepali currency is strengthening only because it is pegged to the Indian currency. Khatiwada’s counterpart, D. Subbarao, the governor of India’s central bank, the Reserve Bank of India, also said, “For now, we do not have any plan to adjust the exchange rate. It is possible if both Nepali and Indian governments feel necessary.” 3

    In the existing situation, any effort to do away with the pegging arrangement would further invite capital flight from Nepal and thus affect business, trade and other economic activities. Besides, it would also bring about hyper-inflation in the country. Hence, it will be a mere waste of time and energy to even consider doing away with the pegging arrangement between the Nepali and Indian currencies. There are more important things that Nepal’s central bank and other institutions need to concentrate upon; including restoring the people’s confidence in the country’s banking and financial institutions in order to ensure economic stability which is at its lowest at present.

    Hari Bansh Jha is ICCR Fellow based at IDSA.