Reassessing the Nepal-India Currency Peg: Macroeconomic Stability in a Multipolar World

With a new government in place, Nepal now has an important opportunity to review its core macroeconomic policies. This includes the fixed exchange rate of 160 Nepalese Rupees to 100 Indian Rupees, set in 1993. As India grows as a global economic force and leads the BRICS group, it also pushes for wider use of the INR. Nepal’s close economic ties with India are coming under new pressure.

This report offers a detailed, scenario based look at the currency peg. The main conclusion is that Nepal should keep the current peg for now. While the NPR is structurally overvalued, Nepal lacks strong exports, solid reserves, and flexible markets. These are needed for a safe currency change. Changing the peg now would bring serious economic shocks and would not boost exports.

Key Policy Recommendations:

• Maintain the 1.6 Nominal Peg: Anchor domestic inflation and preserve stability in the primary trade and remittance corridors with India.
• Focus on "Internal Devaluation": Rather than devaluing the currency (reducing the NPR's official value relative to the INR), make exports more competitive by cutting business costs, removing red tape, and using domestic hydropower to lower industrial energy prices. Internal devaluation means improving competitiveness by lowering domestic costs, not by changing the currency's value.
• Set up a Long-Term Basket Peg Taskforce: Ask the NRB (Nepal Rastra Bank, Nepal's central bank) to create a 10 year plan for moving to a trade-weighted managed float. A managed float is an exchange rate system in which the currency is allowed to fluctuate within a range set by the authorities, typically using a basket of currencies such as INR (Indian Rupee), USD (US Dollar), and CNY (Chinese Yuan). This plan would be activated once Nepal’s exports reach 15% of GDP.
• Diversify Reserves: Move part of the NRB’s reserves into gold and Chinese Yuan (CNY) to hedge against BRICS financial shifts.
• Improve Digital Financial Links: Strengthen ties with India’s Unified Payments Interface (UPI, a digital payment system that allows instant money transfers between banks in India) to make cross border payments easier and reduce the need for large cash reserves.

Historical Evidence & Case Studies:

 History shows that changing fixed exchange rates can have severe consequences. Adjusting a peg is not just financial it triggers major economic changes.

Devaluation & Floating Crises.

• India (1991): Facing a severe Balance of Payments crisis (a situation in which a country cannot pay for essential imports or service its foreign debt), India devalued the Rupee and dismantled the "License Raj" (India's complex regulatory system that required many government approvals for businesses to operate). Lesson: Devaluation only works when paired with massive, immediate structural deregulation that unleashes suppressed industrial capacity.

• Argentina (2001-2002): Argentina abandoned its 1:1 peg to the US Dollar during deep economic stagnation. (A peg is a fixed exchange rate between two currencies.) The immediate result was chaos: the peso lost 70% of its value, inflation soared, and poverty doubled. Exports eventually recovered, but the country entered a period of chronic inflation and sovereign defaults (when a country fails to pay back its debts). Lesson: Dropping a peg without fiscal discipline causes ongoing instability.

• Sri Lanka (2022): Sri Lanka attempted a managed float, in which the central bank allows the currency to fluctuate within a set band while still intervening as needed, while also running large fiscal deficits and facing depleted foreign reserves. The currency collapsed, triggering hyperinflation (extremely rapid price increases), sovereign default, and the government's fall. Lesson: Do not float a currency without sufficient foreign exchange reserves to defend against capital flight (large outflows of money from the country).
• Zimbabwe: Abandoned domestic monetary discipline entirely, which means it stopped controlling the amount of money in the economy responsibly, leading to hyperinflation (extremely high and fast price increases) and the eventual forced adoption of foreign currencies. Lesson: A peg fixing the currency often forces discipline on weak governments; removing it can lead to unchecked money printing.

Appreciation & Strong Peg Successes

• Bhutan (Ngultrum pegged to INR): Bhutan’s 1:1 exchange rate peg (where one Bhutanese Ngultrum always equals one Indian Rupee) with India is successful due to deep economic integration, mainly via state backed hydropower exports. Lesson: A peg works best when trade is integrated and lucrative a model for Nepal's hydropower sector.
• Hong Kong (HKD pegged to USD): Hong Kong operates a currency board (a monetary authority that issues domestic currency only when it has equivalent foreign reserves to back it, so the money supply is directly linked to those reserves). To withstand shocks, Hong Kong depends on flexible domestic wages and property prices. When the USD rises, HK wages and prices fall to stay competitive. Lesson: A firm peg demands a highly flexible economy a flexibility Nepal’s rigid labor market lacks.
• Switzerland (2015): The Swiss National Bank suddenly removed its cap a fixed upper limit on the Franc's exchange rate against the Euro. The CHF (Swiss Franc) appreciated rapidly. While it temporarily hurt Swiss exporters, the economy absorbed the shock because Swiss exports (such as pharmaceuticals and luxury watches) are highly inelastic (demand falls little when prices rise) and high-value (not very price sensitive). Lesson: Appreciation is only sustainable if your exports compete on supreme quality, not price.

Macroeconomic Scenario Analysis:

To assess Nepal’s options, we must examine how changing the peg could work.
(Note on terminology: In economics, if the NPR (Nepalese Rupee) goes from 160 per 100 INR to 170 per 100 INR, the NPR has depreciated or devalued (lost value compared to the INR). If it goes from 160 to 150, the NPR has appreciated (gained value). Depreciation makes goods from abroad more expensive, while appreciation makes them cheaper.

• Scenario A: Devaluation of the NPR (e.g., 100 INR = 175 NPR) this scenario, the NRB would intentionally devalue the Nepali currency to address its "overvaluation" and boost exports.

• Imports & Inflation (Immediate Shock): Devaluation means reducing the value of the NPR compared to the INR. Nepal imports about 60% of its goods from India, including fuel, machinery, and agricultural staples. A devaluation makes all these goods instantly more expensive. For example, a tractor that cost 1,600,000 NPR would now cost 1,750,000 NPR. Inflation, the general rise in prices would spike dramatically, creating an immediate cost-of-living crisis.
• Export Competitiveness (The Theoretical Benefit): Theoretically, a weaker NPR makes Nepali goods cheaper for Indian buyers. However, Nepal faces severe supply side constraints, such as a lack of infrastructure, unreliable power, and insufficient raw materials. The Marshall Lerner condition, which states that devaluation improves the trade balance only if demand for exports and imports is price sensitive, indicates that Nepal's exports are unresponsive (inelastic). Increased export price competitiveness won't result in a large boost in export volumes because Nepal cannot increase production quickly.
• Debt Servicing: Paying back foreign loans (even those from the World Bank or ADB) would take up a larger share of the national budget.

• Devaluation: Devaluation would cause stagflation, meaning slow growth and rising prices. Nepal would face higher costs without seeing much benefit from exports.

• Scenario B: Appreciation of the NPR (e.g., 100 INR = 145 NPR) Here, the NRB would strengthen the Nepali currency, citing high remittances as support.
• Imports & Inflation (Short-term Relief): Indian imports become cheaper. Living costs and fuel prices drop, offering brief relief and populist deflation.
• Domestic Industry (Total Collapse): Cheaper Indian imports would flood the Nepali market. Domestic manufacturers and farmers, already struggling against Indian economies of scale (cost advantages as production increases), would be completely undercut and forced into bankruptcy.
• Remittances (Income Shock): Millions depend on money sent from workers abroad. If the NPR appreciates, remitted funds convert to fewer Rupees, destroying wealth, shrinking consumption, and hurting the poorest.
• Trade Balance: The trade deficit when a country imports more goods and services than it exports would widen dramatically as exports become too expensive for foreign buyers and imports become irresistible to domestic consumers.
• Conclusion: Strengthening the NPR would turn Nepal into a consumption-based economy, destroying local industry and remittance value.

Trade and Structural Implications:

People often mistake the 1.6 peg as the main problem, when it’s really a sign of deeper issues. Changing the exchange rate alone won’t solve Nepal’s trade imbalance (when the value of a country's imports and exports is not equal).

Nepal's economy runs on an "import-and-remit" cycle: youth leave for work, remittances come in, and these remittances buy imported goods.

• The Competitiveness Illusion: Some believe that changing the peg will help Nepal compete, but the real problems are about productivity, which refers to how efficiently goods and services are produced, not just prices. Bad roads, high transport costs, slow bureaucracy, and not enough raw materials are the real obstacles.
• Role of Hydropower: Hydropower is Nepal’s only sector that could improve the trade balance, but it needs Indian investment. A stable peg reduces currency risk for these investors. If Nepal allows its currency to float or devalues, investment risk rises, and the sector could stall.
• Internal Devaluation: Instead of changing the exchange rate, the government must pursue internal devaluation. This means cutting actual production costs by subsidizing electricity, modernizing customs, and creating special economic zones.

Geopolitical and Diplomatic Risks:

Currency policy is always political. The choices Nepal makes about its currency affect its relationships with neighbours like India and China, and these pressures shape Nepal’s decisions.

• India’s Rise and BRICS: India is actively pushing to internationalize the INR and settle bilateral trade in local currencies, bypassing the US Dollar and SWIFT. If India succeeds in making the INR a regional reserve currency, sticking to the peg is a strategic advantage for Nepal. It provides easy access to a powerful, globally recognized financial system. Unpegging just as the INR gains global weight would be a massive strategic mistake.
• The China Factor: Nepal wishes to balance its economic reliance on India by increasing trade with China. While pegging to a basket that includes the Chinese Yuan (CNY) makes long-term economic sense, doing so abruptly would trigger severe diplomatic anxiety in New Delhi. This could potentially lead to non tariff trade barriers at the southern border.
• Sovereign Credibility: The NRB’s defence of the 1.6 peg is the single most credible institutional policy in modern Nepali history. International bodies (the IMF and the World Bank) and foreign investors view the peg as proof of Nepal's macroeconomic discipline. Abandoning it without a bulletproof alternative would severely downgrade Nepal’s sovereign credibility and deter foreign aid and investment.

Evidence-Based Policy Recommendations:

 The roadmap below gives clear, step by step strategies for the Ministry of Finance and NRB.

Phase 1: Short-Term (0–3 Years) - Fortify and Reform

• Maintain the 1.6 Peg: Unequivocally signal to markets that the peg remains secure.
• Carry out supply-side reforms: Start a strong push to lower industrial costs. Use excess hydropower to support local manufacturing rather than just exporting it.
• Digital Integration: Make cross-border digital payments (like UPI) fully work. This will make trade cheaper and reduce the need for large cash reserves.

Phase 2: Term (3–7 Years) - Diversify and Build Capacity:

• Diversify Foreign Reserves: The NRB should gradually change its foreign currency holdings. Right now, most are in USD and INR, but Nepal should start buying gold and CNY to protect against BRICS currency changes and future currency swings.
• Establish a Stabilization Fund: Channel a mandatory percentage of future hydropower export revenue. Put a set share of future hydropower export earnings into a national fund. This fund will help protect the currency if Nepal moves to a floating exchange rate later.

Phase 3: Long Term (7-15 Years) – The Transition to a Basket

• Trigger Conditions: Nepal should only consider abandoning the strict INR peg when two conditions are met:
•  Exports consistently exceed 15% of GDP.
• FX reserves sustainably cover 12+ months of imports.
• The Target System: Move from just pegging to the INR to using a basket of currencies (INR, USD, and CNY). This will help control inflation from other countries and maintain stable trade with key partners.

Conclusion:

This analysis gives a clear recommendation: Nepal should keep the fixed exchange rate of NPR 160 to INR 100 for now. Changing the peg now would be the wrong diagnosis for Nepal’s economic problems. The peg does not cause the trade deficit; it simply shows Nepal’s weak industrial base. Devaluing would cause inflation that people cannot handle, while making the currency stronger would destroy what is left of the local industry.

Nepal's future depends on real economic changes, not just changing its currency policy. The government should use the stability provided by the peg to build energy infrastructure, improve logistics, and attract foreign investment. Nepal will be ready to float its currency only when it shifts from import based to export-based growth. Until then, the peg is Nepal’s most important economic anchor.