For millions of Nepalis, the act of crossing the border into India for employment, trade, or tourism is an essential part of their lives. This ease of movement is made possible by a subtle yet highly successful economic strategy: The ‘fixed’ currency exchange rate. Since 1993, the Nepalese Rupee (NPR) has been tied to the Indian Rupee (INR) at a rate of 1.6, which has its roots in 1960. Although this policy has ensured a stable environment for Nepal’s extremely trade-dependent economy, a pressing question arises as Nepal works towards realising its graduation from Least Developed Country (LDC) status by 2026: Is this long-standing policy still a force for good in the country’s economy or has it become an economic burden? The political environment is already witnessing a shift to counter this problem. The Rastriya Swatantra Party (RSP) has already committed to reviewing the ‘fixed’ peg in its election manifesto, which shows that this ‘sensitive’ topic is finally being brought into the mainstream policy debate.

Economic lifeline

The peg is an essential element in Nepal’s stability. India contributes more than 60 percent of Nepal’s total trade and is its main source of foreign direct investment. For several decades, the fixed exchange rate has removed exchange rate uncertainty, providing the basis for trade between the two countries. The importers can calculate the costs precisely, and Indian investors bear no currency risk when investing in essential infrastructure like hydropower projects.

The most visible benefit has been to the Nepali people. Remittances are the engine driving the Nepali economy. The latest fiscal statistics from Nepal Rastra Bank (NRB) show that remittances have broken all previous records, and the foreign exchange reserves of the country have reached record highs of over $22.47 billion, enough to pay for about 18.1 months of expected imports. Since a substantial amount of remittances comes from Nepali nationals working in India, the peg ensures that these remittances reach the Nepali economy without the exchange risk premium that a floating exchange rate would entail. This is helping to ensure the purchasing power of families and also acting as a social safety net.

In addition, Nepal has effectively adopted the monetary prudence of the Reserve Bank of India (RBI). This has been a historical practice that has ensured that the inflation levels of Nepal remain in a manner of balance with its southern neighbour, thus offering a cushion against the domestic economic mismanagement.

Monetary dilemma

An anchor that prevents a ship in an ocean from drifting away can also make it difficult for the ship to move. The inflexibility of the peg system comes with structural costs that are increasingly difficult to ignore, especially the loss of monetary sovereignty. Because of the peg, the NRB cannot independently set interest rates to promote local growth in times of economic downturns, nor can it aggressively pursue local inflation without undermining the exchange rate. Monetary policies, therefore, should follow the Indian model, which ineluctably causes the Nepali people to import both the instability and stability from Indiaty.

Furthermore, one of the main causes of the decline in export competitiveness is this rigidity. The NPR may be overpriced in real effective terms, according to economic analyses from respectable institutions like the International Monetary Fund (IMF). The Nepalis are severely disadvantaged even though Indian imports are less expensive due to the overpriced currency. It becomes extremely difficult for Nepali producers to compete internationally or even domestically with cheaper Indian imports, resulting in a huge trade deficit.

Lastly, the fixed exchange rate makes Nepal extremely vulnerable to economic contagion. As they say, Nepal bears the consequences when the Indian economy struggles. Whether it was abrupt global inflation spikes or the 2016 demonetisation that seriously disrupted border liquidity, Nepal's lack of an independent currency buffer makes India-centric shocks worse and leaves its domestic economy vulnerable to forces that are mostly out of its control.

Global lessons

The currency pegs are complex and delicate operations as shown by the historical records, and Nepal can learn a great deal from the tactics used by other countries in similar circumstances. For example, Bhutan has a 1:1 peg to the INR, similar to Nepal’s policy, and this has brought about great stability. However, Bhutan offsets its import dependence by exporting large amounts of hydropower to India. This is a natural economic hedge and source of foreign exchange inflows that Nepal does not have to the same extent. The example of Hong Kong is another successful but highly specific case. Hong Kong has achieved worldwide success with its peg to the US Dollar, but this is only possible because of Hong Kong’s status as a major international financial centre. Hong Kong has foreign reserves in the hundreds of billions of dollars, allowing it to strongly support the peg against speculators.

Conversely, the Argentine experience provides a cautionary tale about the effects of a currency’s loss of alignment with economic fundamentals. The Argentinean rigid peg to the USD suffered a catastrophic breakdown in 2001 due to the erosion of the country’s export competitiveness. For Nepal, this provides a warning about the risks of maintaining a fixed exchange rate that may no longer be in line with the country’s economic reality.

Ahead and beyond

Nepal has moved from an agricultural economy in the 1960s to a service economy. As it readies itself to move out of its LDC status, it is time to reassess the policies of the past. The fact that the RSP’s manifesto includes a review of currency policy shows that the next generation of leaders in Nepal is ready to challenge the economics of the past.

It would be foolhardy to change the peg policy immediately, which could result in inflation, outflows of capital, and panic remittance-sending households. However, to continue with the status quo would mean that the industrialisation in Nepal could be hindered indefinitely. The best course of action is to move forward slowly. The government should begin to investigate the possibility of a managed float or a trade-weighted basket peg (linking the NPR to a basket of currencies of its main trading partners, instead of the current peg to the Indian Rupee).

Despite all the political and economic unrest that Nepal has undergone over the years, the exchange rate of 1.6 has served as a stabilising element. However, a nation must be adaptable to be deemed economically resilient. Nepal might want to consider delinking its currency to allow its economy to expand in global markets.