There has been a long history of ‘exchange’ in the course of human civilization. The exchange in modern civilization dates back to the barter system where countries used to exchange the surplus product for shortage product with each other. Countries with surplus agriculture products would exchange such products for other shortage products like minerals i.e., gold, silver and others.
Roman soldiers used to barter their services for the exchange of salt. Similarly, the colonists in America used this system for goods and services in exchange. However, due to several limitations of this system, it was replaced by money or currency. This development in money made countries to have their own currency. The introduction of currency led to the introduction of the exchange rate. Exchange rate provided a fair value for the goods and services that were traded from one country to another. With several evolution, countries used several methods for the exchange and among few, pegged exchange rate is one.
Pegged Exchange Rate
Pegged Exchange Rate, Fixed Exchange rate or Pegged Currency all are synonyms to each other. This system of currency rate exists when a country maintains a fixed exchange rate of its currency with that of another. There are several for countries to peg their currency with others. Generally, a developing country ties their currency with that of other stable nations. For example, more than 60 countries have pegged their currencies with dollars. The major reason for such currency peg is to make the international trade smooth and lower the exchange rate fluctuations.
Exchange rate depends on demand and supply of the currency in the international market. If there is excessive demand or supply, it affects the exchange rate and fluctuates it. Therefore, countries peg with those who are developed so that the domestic businesses can access more markets with significantly less risk.
Nepalese Currency and Pegged Exchange Rate
In the similar manner, Nepal has pegged its currency with that of India. The exchange rate between India and Nepal has been changed several times. Prior to 1994, the exchange rate was adjusted at 1.45. This means every 1 INR was equivalent to 1.45 NPR. However, it has changed to 1.6 INR since 1994. Since then, it has been fixed at Rs 160 NPR is equal to Rs 100 INR. The important reason for the country to fix the exchange rate was to bring stability in the currency of Nepal. Indian INR has been a powerful and stable currency for a long time. Thus, pegging with it would bring stability in the fluctuating Nepalese exchange rate.
In addition, the major reason for Nepal to peg NPR with INR was the increasing amount of trade between the countries. Nepal shares a physical border with India on three sides and both are dependent upon each other for trade of several products and services. Thus, trading on large volumes would increase the demand of INR causing the exchange rate to rise. Thus, to solve this problem, the exchange was pegged with INR at NPR 160. Now, to maintain the exchange rate at NPR 160= 100 INR, Nepal needs to maintain the steady flow of INR in its foreign reserve. There have been several implications and debates about the pegged exchange rate with India. Let’s explore some of the advantages and disadvantages of Nepal’s pegged exchange rate with India.
Advantages of Pegged Exchange Rate
- Stability in the price due to peg exchange boosts confidence in people to trade without any speculation.
- Same stability in price also boosts confidence of investors to invest in Nepal through foreign direct investment (FDI).
Disadvantages of Pegged Exchange Rate
- Along with import of different goods and services, Nepal directly imports the inflation from India. Since Nepal is heavily dependent on India, imports of inflated goods and services bring carried inflation to Nepal thereby increasing prices here.
- If India suffers from any international shocks related to trade or exchange, Nepal also suffers the shocks. Being tied up to India, the carryover effect can be seen on Nepal’s exchange value with other currencies. Recent example is the depreciation of the depreciating Nepalese currency against the US dollar. The exchange rose from about Rs. 102 to Rs 119 from last year’s December to this year’s October. The fall in the currency is associated with the fall of Indian INR against the USD.
- The pegged exchange rate is detrimental to the macroeconomic policy of Nepal. One of the major objectives of macroeconomic policy is price stability i.e., curbing inflation. However, Nepal directly imports inflation along with the goods and services. Thus, the macroeconomic policies made to combat inflation in Nepal do not work.