Fixed Exchange Rate Regime By Hom Nath Gaire, (Source: New Business Age,February 2012)

Many developed as well as developing countries around the world have adopted the flexible exchange rate regime but Nepal continues to practice fixed exchange rate system with India. The reasons for the fixed exchange rate, from Nepal’s perspective is, to prevent speculation which may arise due to its open border and geographical proximity with India, structure of the Nepali economy and high concentration of its trading volume and pattern with India. The Nepali currency (NPR) has been depreciated against the USD by 21.13 per cent i.e. from NPR 71 to NPR 86 for one USD during the second half of 2011. The depreciation was caused only by the pegged or fixed exchange rate regime between India and Nepal rather than the unfavourable inflation, interest rates or weak performance of the other economic indicators of Nepal.

The Indian currency (INR) has been depreciated against US dollar and other major international currencies due to the volatility in international currency market, euro zone sovereign debt crisis and rising oil prices. At the same time, the repatriation of foreign institutional investors from the Indian capital market, excessive speculation on the USD by Indian banks, widening current account deficit as well as the new provision relating to relaxation of the use of foreign currency in international trade by the Reserve Bank of India (RBI), the central bank of India, are some of the other factors fueling depreciation of the INR. As a result, the INR depreciated by almost 16 per cent against USD i.e. INR 45 to 54 for one USD during the second half of 2011 and the NPR also depreciated at a rate more than that of the INR.

Theoretically, the recent depreciation of NPR should reflect the expansion of export and contraction of import to reduce the trade deficit and improve the balance of payment (BOP) situation. But the Nepali economy has experienced both positive and negative shocks from the recent depreciation of the NPR. The growths in remittance inflow, service account surplus as well as foreign exchange reserve boost and BOP to historic high are some cheering consequences of the recent NPR depreciation. In contrast, prices of various consumer goods, vehicles and electronics have been increased by more than 30 per cent as most of these products are imported from international markets. Even the price of some locally produced goods has increased because their production is based on imported raw materials. At the same time, the servicing of dollar denominated loan of the government of Nepal has also increased due to the appreciation of the USD. In a nutshell, the Nepali government, importers, traders, and customers have severely suffered due to the devaluation of the NPR. In such a situation, the debate on - whether the fixed exchange rate regime between Nepal and India is still relevant or not - articulates the need for a clear policy and academic dialogue on this sensitive issue. Given this background, it is worth mentioning the main views for and against the fixed exchange regime. The fluctuation in the exchange rate between the countries’ currency affects their overall economy in general and the external sector in particular. It is because the countries need to maintain foreign currency reserves at a comfortable level to meet the demand for imported goods for domestic use and maintain the smooth pattern of trade. Advantages of a Fixed Exchange Rate Firstly, a fixed exchange rate reduces transaction costs and exchange rate uncertainty in international trade and thereby stimulates trade. However, it is probable that the impact of such costs can be reduced by enhanced methods for minimising currency risks.

Secondly, a fixed exchange rate can serve as the anchor of monetary policy and increase its transparency. It can also serve as a suitable mechanism for containing imported inflation to some extent as has been the case in Nepal. Thus, if the fixed exchange rate policy itself is credible, it is possible to benefit from the credibility of the area against which the currency is pegged to bring inflation to a comparable level. Thirdly, an imperfect foreign exchange market can cause instability in the economy. Studies suggest that foreign exchange markets are often characterised by herd behaviour and that a currency’s exchange rate does not always reflect the economic fundamentals as it is supposed to. Fixed exchange rates, which rule out internal fluctuations among participating currencies, reduce such behaviour and could have a beneficial impact on the economy. However, a fixed exchange rate policy has various disadvantages too.

Disadvantages of a Fixed Exchange Rate
Firstly, it deprives the central bank’s ability to use monetary policy to respond to peculiar domestic shocks as in the case of Nepal Rastra Bank (NRB), the central bank of the country. Likewise, economic shocks in the country against which the currency is pegged will inevitably be reflected in domestic interest rates. In the event of misalignment in business cycles, this can lead to problems. Secondly, countries with fixed exchange rate regimes become prone to speculation against their currencies. If the fixed exchange rate policy lacks credibility, there is a risk that investors will seek to rid themselves of that currency, forcing the central bank to buy it back on a large scale in order to defend the peg with rising domestic interest rates. This can prove to very expensive and trigger a domestic crisis. Thirdly, a fixed exchange rate policy can reduce the flow of information. A currency’s exchange rate contains important information about the country’s monetary position and the credibility of domestic monetary policy. Fixing the exchange rate can prevent such information from being relayed to the monetary authorities. Even though a fixed exchange rate is an easy target to monitor, it results in a less transparent policy.

This is less of a problem if the exchange rate is allowed to fluctuate within a specific band. Finally, a fixed exchange rate policy can increase the likelihood of a financial crisis if the bulk of domestic liabilities are of short duration or are denominated in foreign currency, as is common among countries with underdeveloped financial markets. Possibility of Crises Under such conditions, debtors’ balance sheets can suffer major shocks when the domestic currency is devalued, if their income is mainly in domestic currency and is not indexed. Bankruptcies and defaults with the banking system could result in sparking a financial crisis through the collapse of the financial system’s intermediating function. A serious economic crisis often follows in such an instance.

Likewise, fixed exchange rate regimes can also encourage greater capital inflows since a stable currency reduces the risks faced by foreign investors. Such an inflow can lead to overheating of the domestic economy, especially when coupled with newfound liberalisation and privatisation in the domestic financial market. A currency crisis arises when a country runs persistent balance of payments deficits while attempting to maintain its fixed exchange rate and is about to deplete its foreign exchange reserves. A crisis can force a country to devalue its currency or move to a floating exchange rate. To postpone the crisis, countries can sometimes borrow money from organisations like the International Monetary Fund (IMF). The anticipation of a BOP crisis occurs when the country is about to run out of foreign exchange reserves because of persistent balance of payments deficits. It can induce investors to sell domestic assets in favour of foreign assets. This is called capital flight and refers to the investors’ purchasing assets abroad in anticipation of an imminent currency devaluation or depreciation, often in the middle of a BOP crisis. Capital flight can worsen a BOP problem and can induce a crisis to occur.

How to Choose a Suitable Exchange Rate?
A decision about a future currency regime should preferably be based on an assessment of the respective costs and gains from a fixed or a stable exchange rate. According to Robert Mundell (1961), who first systematically stated the following conditions that make a fixed exchange rate more attractive than a flexible exchange rate. Firstly, there has to be a sufficient level of external trade for the gain from pegging the exchange rate of the currency to another to make a difference. In addition, import prices weigh more heavily in domestic prices of a relatively open economy than in a closed one. The experience of Mexico and several South-East Asian countries during crisis is a clear example of such a sequence of events. Although a flexible exchange rate could itself cause a similar effect, the probability is smaller. Speculative attacks on a fixed exchange rate regime generally take place because a large and discontinuous fall in the currency occurs much more rapidly than with a more flexible one. Policy Effects with Fixed Exchange Rates Government policies work differently under a system of fixed exchange rates rather than floating rates. Monetary policy can lose its effectiveness whereas fiscal policy can become super effective.

In addition, fixed exchange rates offer another policy option, namely, exchange rate policy. Even though a fixed exchange rate should mean that the country keeps the rate fixed, the countries periodically change their fixed rate. These exchange rate changes are called devaluations (sometimes competitive devaluations) and revaluations. Now let’s discuss how government policies can be used to influence the level of the gross national product (GNP), inflation rate, unemployment rate, interest rates and in an open economy, the effects on exchange rates and current account balances. • A monetary policy i.e. change in money supply has no effect on GNP if the exchange rate is fixed. As such, the trade balance, unemployment, and interest rates all remain the same as well.

• Expansionary fiscal policy i.e. increases in government expenditure through deficit financing, causes an increase in GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment can both be reduced.
• Contractionary fiscal policy, i.e. decrease in government expenditure and rise in tax rate, reduces GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment both rise in such a situation.
• A competitive devaluation lowers the currency’s value and causes an increase in GNP. Unemployment falls, interest rates remain the same, and the trade balance rises.
• A currency revaluation raises the currency’s value and causes a decrease in GNP. Unemployment rises, interest rates remain the same, and the trade balance falls
. • Monetary expansion by the country of reserve currency forces the domestic country to run a BOP surplus to maintain its fixed exchange rate. The resulting money supply increase causes domestic interest rates to fall to maintain equality with the falling foreign interest rates. Domestic GNP remains fixed, as do unemployment and the trade balance.

February 2012