Article by Reyan Kumar Sapkota
Have you ever thought about why the exchange rate of the Nepalese rupee is fixed at 1.6 Indian Rupees? Why does the Nepalese currency not fluctuate with respect to the Indian Currency?
The answer is simple: Pegged Exchange Rate.
Pegged Exchange Rate is a type of exchange rate regime where the currency’s value is fixed against another powerful and stable currency or an asset. The exchange rate of a pegged currency is fixed to another country’s currency or any stable asset like Gold and Silver. But, why does such provision exist?
Let’s understand the simple economics of currency establishment. Before the advent of paper money, goods were traded using standard valuable metals: Gold and Silver in most cases. Gold, being a valuable metal, was trusted by the people in the market. Soon, widespread circulation of gold forced the central banks to issue a security equivalent to the value of the gold. This security is the paper-based currency and the currency issued with respect to the value of Gold is called Gold Standard currency.
In 1821, the United Kingdom became the first country to adopt the Gold Standard. Under this system, the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as its official reserve asset.
During the gold standard period (1879–1914), the U.S. dollar was defined as 1.49 grams of pure gold. It can be inferred that 1 dollar bill was equivalent to 1.49 grams of gold. Exchanging dollar bills was equivalent to exchanging Gold. The paper made circulation more convenient. Post World War II, the US dollar emerged as the most stable currency in comparison to the war-ravaged European economy and its currency. Under the Bretton Woods agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies to the dollar, which was pegged to Gold.
In short, fixing the value of a currency to a stable asset is called the currency peg. US dollar was pegged to gold to maintain a fixed exchange rate and avoid volatility.
Now, let’s come back to the original question.
Why does the Nepalese currency not fluctuate with respect to the Indian Currency? Nepalese rupee is pegged to the Indian Rupee. Between 1857 and 1930, the Nepalese rupee was fixed at 1.28 per Indian rupee. After this period, its value fluctuated against the Indian rupee, falling to रु1.60 = ₹1 in 1939, rising to रु0.60 = ₹1 during the Second World War and falling again afterward. In 1952, the government of Nepal officially pegged the Nepalese rupee at रु1.28 = ₹1, although the market rate remained at रु1.60 = ₹1.
Between 1955 and 1957, there was a series of soft peg revaluations that started at रु1.755 = ₹1 and appreciated to रु1.305 = ₹1 by 1957.
A hard peg of रु1.60 = ₹1 was instituted in 1960, which was revalued to रु1.0155 = ₹1 when the Indian rupee was sharply devalued on 6 June 1966.
From 1967 to 1975, the government pegged the Nepalese rupee against the Indian rupee, the US dollar, and gold, starting at रु1.35 = ₹1, रु10.125 = US$1 and रु1 = 0.08777g gold.
By the time the gold standard was removed in 1978 by President Richard Nixon, the exchange rate was रु1.39075 = रु1, रु12.50 = $1 and रु1 = 0.0808408g gold.
In 1983, the Nepali rupee's anchor was changed to a trade-weighted basket of currencies, which in practice amounted to a hard peg against the Indian rupee. This remained until 1993 when the peg was officially set at रु1.60 = रु1.
Indian Rupee is more stable and powerful than the Nepalese rupee. The considerably higher supply and demand of the Indian Rupee in the global market make it a stable currency. Before the Economic Liberalisation by the then Indian Finance Minister Manmohan Singh in 1990, Indian Rupee was pegged to the Currency Basket of major trading partners, which means the Indian Rupee’s value was fixed to the value of that currency basket.
After the Liberalisation, Indian Rupee became a free-floating currency, which means the currency is not primarily backed by any fixed assets (gold, foreign reserves). The currency’s exchange rate is determined by the supply and demand in global trade. Its acceptance in the global market determines its price. It’s somewhat similar to the price fluctuations of Stocks. Since the Indian rupee holds a considerably strong spot in global trade than Nepal and Bhutan, Nepalese and Bhutanese currencies are pegged to the Indian Rupee.
Pegging our currency to a much stronger Indian Rupee prevents volatility and inflation. If Nepali Rupee existed as a free-floating currency, it would experience extreme volatility and inflation because Nepal does not hold a prominent spot in the global trade (like the US dollar, Indian rupee). The demand for Nepalese currency is significantly low, which will devalue its independent free-floating price. This leads to uncontrolled inflation: increased prices in foreign import goods and extremely low export prices.
Let’s take an example.
The Iranian rial is a free-floating currency. Currently, Iran is under Economic sanctions by the US. After President Trump pulled the United States out from the Iran Nuclear Deal in 2018 and restored the Economic Sanction on them, the Iranian rial experienced an inflation rate of up to 30.22% in 2018; a sharp increase from the already worrying 9.05% inflation rate in 2017 (prior the deal and the sanctions). United States’ sanctions halted Iran’s global trade, which in turn devalued its currency (Iranian rial’s decrease in demand led to its devaluation).
Such is the disadvantage of a free-floating currency for a country with no substantial economic influence (like Nepal). So, pegging the currency to an established and stable currency becomes a safe option for a country like Nepal and Bhutan. There are 66 currencies pegged to the US dollar and 12 currencies pegged to the Euro. Currencies of weaker economies are pegged to the stronger currencies.
That’s why Nepal maintains a fixed exchange rate of रु 1.60 = ₹ 1 (buy rate) and रु 1.6015 = ₹ 1 (sell rate).
Article by Reyan Kumar Sapkota. The author plans to publish his upcoming articles also in the INSIDEOUT series, where he intends to explore finance and capital market concepts. This is the second article of the series.
First Article: INSIDEOUT: Cryptocurrencies