Excerpt from

24 September 2002

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Yuan and rupee convertibility
The role of the Indian rupee

Raghab D Pant
The Executive Directors of the International Monetary Fund, while discussing the report prepared by its staff on the economy of Nepal, have warned the Nepal Rastra Bank in a very polite manner to confine itself to do only what is appropriate and legal without breaking the consistency among its policy measures. But the tone of both the appreciation and the warning is so technical, and even short, that very few including the Board of Directors of the central bank and its chairman are expected to take the warning seriously. It, according to the news report of the local press including this paper, is as follows: "The exchange rate peg to the Indian rupee remains broadly appropriate given Nepal's close economic links with India, and they endorsed the focus on maintaining monetary conditions consistent with the peg". What, in fact, (i) " the exchange rate peg to the Indian rupee remains broadly appropriate" and (ii) "maintaining monetary conditions consistent with the peg" means?
The meaning and implications of the second observation are not complicated. It means, in effect, that monetary policy, in contrary to current practice of the Nepal Rastra Bank, should be focused to maintain equilibrium in the balance of payments and the current exchange rate practice pegged with Indian currency at Nrs 160=Irs 100. Under such conditions, the central bank will have no power to influence the growth rate of the economy using monetary instruments nor it will have any power to determine domestic rate of inflation. The changes in domestic prices and, hence, the rate of inflation will, overtime, be determined by, and equal to, the rate of inflation in India. As a result, monetary policy and programs announced by the Nepal Rastra Bank for the fiscal year 2002/03, which were not even mentioned in the discussion of the Executive Directors of the Fund, need total revision, a fact that the Nepal Rastra Bank has refused to acknowledge until now.
The implications of the former observation are a bit complicated to explain in plain English without using technical jargon. Two of them, at present, need serious consideration. They are:
(i) It clearly acknowledges the fact that Nepal is now on a Indian currency standard, akin to the gold standard that was in practice in the world until 1914. As a result, monetary conditions at all levels, including the exchange rate must be consistent with the peg. True, Nepal maintains fixed exchange rate with the Indian currency; and the exchange rate with other currencies is fixed by taking into account the exchange rate of that currency with Indian currency. This is sufficient to indicate that Nepal has no independence to fix exchange rate with other currencies in that it has to follow the movement of the Indian currency. If this rule is broken, the cross exchange will be completely broken as it did happen in around 1980 when Nepali currency was maintaing fixed rate simultaneously with two currencies, namely, US dollar and Indian currency. As a result, it was sometimes profitable to convert dollar in Indian currency and then Indian currency into Nepali currency instead of directly converting dollar into Nepali currency.
I was told that Nepal has changed the system after complaints from the IMF.
(ii) The most important question that the Fund observation has pointed out, though implicitly, concerns with the Nepal Rastra Bank's decision in maintaining fixed exchange rate and free convertibility with Chinese currency renminbi (RMB) yuan. Nepal is treating both Indian and Chinese currency at par in that it maintains free convertibility, that is, fixed exchange rate with both the Indian and Chinese currency. This means in practice, in Nepal, that Indian currency is also freely convertible into Chinese currency and vice-versa. This is not allowed in both India and China, but what is not allowed in both countries is freely available in Nepal with Nepali currency playing the intermediary role. What impact it will create in both IC and yuan is not known, specially if the cross rate is broken.
Let me give the numerical example by developing a hypothetical case. Let us assume for simplicity that yuan 100= Nrs 100= Irs 100. Suppose now that the Indian currency is appreciated by 10 percent vis-a- vis US dollar. As Nepali currency is maintaining fixed rate with Indian currency, it also will be appreciated by 10 percent with US dollar. So under the new exchange rate regime yuan 100 will still be equal to Nrs = 100 as there has been no change in US dollar/ yuan exchange rate. The reason is obvious: Exchange rates of yuan against other foreign currencies by the People's Bank of China are calculated by based on the cross rates between yuan against US dollar and US dollar against other currencies in international markets. Now the process to derive profit from the broken cross rate is obvious: a Nepali can convert Irs 90 into Nrs 100 to buy 100 yuan which then can be used to generate Irs100. This means, in effect, in such a system we can buy Irs 100 by just paying Irs 90.
Nepal Rastra Bank can solve the problem only if the exchange rate of yuan vis-a- vis Nepali rupee is determined by taking into account the exchange rate of Irs vis-a- vis, say, US dollar as discussed in the numerical example cited above. At present, one yuan is equivalent to Rs. 9.45 but if Irs is appreciated by 10 percent NC/ yuan exchange rate should be fixed at Nrs 8.42, about 10 percent lower than the earlier rate, notwithstanding yuan/US dollar spot rates fixed by the People's Bank of China.
To avoid broken cross rates, the exchange rate of yuan, in Nepal, with Nepali currency should be determined by the exchange rate movement of Indian currency vis-a - vis US dollar. This will, thanks to the Governor for his foresightedness (?) produce exchange rate system consistent with the peg as recommended by the International Monetary Fund.
Pant, former economist at the IMF, is with the Institute for Development Studies.