Long read | How Nepal can avoid its impending foreign exchange reserves crisis

It's time to take the concrete, maybe unpleasant, steps if necessary to avoid what Sri Lanka has been through. Both fiscal and monetary sides should come together to take coordinated bold steps.

Dr Bamadev Paudel

  • Read Time 12 min.

Lately, Nepal’s foreign exchange reserves have begun to plummet. This has led to widespread speculation that we may be heading toward a severe currency crisis and potentially toward the troubling situation Sri Lanka is confronted with now. A combination of factors are attributed to this situation but many argue that rapid credit expansion through expansionary economic policies in the past is where the problem brewed which triggered a massive amount of imports leading to a rapid depletion of foreign exchange reserves.

Before talking about what precautionary measures we can take to avoid the risk of an impending currency crisis, let me take you to a simple structural understanding of how the system of foreign exchange reserves operates in a country. To understand this, one needs to look at the country’s balance of payments (BOP) account which shows how a country receives foreign currency and how it spends it, in exchange for buying and selling Nepali currency. BOP account, one of the largest accounts of the whole country showing the economic interaction with the rest of the world, records all items in terms of receipts and payments—the former being an inflow of foreign exchange and the latter being the outflow of it. The BOP account consists of three accounts known as the current account, the capital account, and the financial account. The BOP account stands as an interactive map, like a TV screen in front of us, showing the country’s strength of financial position relative to the rest of the world. Closely related to the BOP situation is the foreign exchange reserve situation, usually used to demonstrate how many months of a country’s imports the reserve can afford.

Going a bit in detail, the current account section of the BOP shows the movement of Nepali and foreign currencies as a result of the buying and selling of goods and services internationally as well as the flow of incomes between Nepal and the rest of the world which are short-term transactions in nature in terms of money flow. For example, if an American would want to buy a piece of handicraft from Nepal, he must buy Nepali rupees in the international money market in the first place, usually in banks, by selling his dollar which goes to Nepal’s foreign exchange reserves, and creates demand for Nepali currency and supply of US dollar in the international money market. Likewise, when a consultant comes into Nepal to offer service for a bank restructuring project, his income is taken away from Nepal in terms of foreign currency which depletes our foreign currency reserves with an increase in the supply of Nepali currency and demand for the US dollar in the money market. One of the major items under the current account for Nepal’s case is workers’ remittances coming into Nepal which contributes to increasing foreign exchange reserves.

The capital account, on the other hand, summarizes the transfer of ownership of intangible assets such as patents, copyrights, trademarks, debt forgiveness, migrant asset transfers, and so forth, which tends to be a very small amount for Nepal which is NRs 8 billion as per latest data available. The financial account, on the other hand, summarizes all foreign transactions of financial assets involving Nepali rupees and foreign currency which includes three types of transactions with the rest of the world: Portfolio investment which is the investment in financial assets such as bonds and shares; a direct investment which is a financial investment that gives the buyer controlling equity interest; and other financial investments that are linked to day-to-day fluctuations in foreign currency bank deposits.

After bringing all these accounts together, and doing some adjustments for errors and omissions in recordings and embedding it under statistical discrepancy, a complete BOP account pops up to show the country’s financial condition with other countries. The balance in this account is also the major determinant of domestic currency’s exchange rate against foreign currency, given the country is pursuing a flexible exchange rate system, because the transactions in this account create fluctuations in demand and supply of domestic currency.

Going by the latest data published by Nepal Rastra Bank, the BOP balance is negative with US$2.3 billion (NRs 289 billion) as per 10 months’ data of the FY 2021/22. It is taking nosedive since the pre-pandemic situation with a positive US$ 2.4 billion in mid-July 2020 and a positive only US$ 10.3 million in mid-July 2021. The negative balance in the current account is widening lately, especially owing to rising imports, whereas the financial account has long been offsetting the negative balance in the current account but of late it is also narrowing down. Capital account balance has remained relatively flat with a positive balance but it is the very number hovering around NRs 8 billion. In terms of foreign exchange reserves’ affordability of imports, gross foreign exchange reserves could afford 12.7 months of merchandise and services imports in mid-July 2020 which has plummeted down to nearly half by 6.7 months in mid-May 2022. Looking into the trajectory of all these indicators, one can easily deduce that the future doesn’t seem to be great.

With this basic understanding of how a country acquires and/or spends foreign exchange reserves and what the current situation is, let me walk you through how we can tackle the impending crisis so that we won’t have the situation like that of Sri Lanka where lately the government says the country has only 55 million worth of foreign reserves, the number alarmingly low for a whole country that led to the situation of the bailout for which the IMF has just landed in the country to discuss the matter.

Time for concrete steps

It’s time to take the concrete, maybe unpleasant, steps if necessary to avoid what Sri Lanka has been through. Keeping the blame game aside, both fiscal and monetary sides should come together to take coordinated bold steps. This is not the time to point fingers to each other but to sit together to discuss the matter seriously. It is good to hear that the finance minister and governor are coming closer to discuss the matter but it should have happened earlier. One example of conflict in policies in the past is that Nepal Rastra Bank seems to target imports to cut them down which goes against what the government has gone through in its recent budget aiming at raising tax revenue from imports, which seems to be counterintuitive by any standard.

No doubt, our focus now should rest on the short-term solution based on the urgency of the situation, while eyeing long-term measures at the same. As stated above, short-term items are listed under the current account and this should be the target. While some steps have already been taken to curtail imports of some items in the current account, such as vehicles, it is time to expand the list. Those who are in charge of making decisions on this matter should dive deeply into each import and export item, particularly the top 20 items, and announce measures to cut imports and expand exports. Looking into 10-month statistics under the current account of BOP, we have NRs 1.4 trillion of trade deficits and imports are over nine times more than exports, which is not at all a good situation putting the country on shaky ground when it comes to managing foreign exchange reserves. To reverse the trend is a hell of a challenge for the government in the context of the remittance-led consumption boom that’s happening now but there is no other way around owing to the urgency of the situation.

Enhancing foreign exchange earnings from tourism is another area to focus on. The post-Covid world is jubilant about traveling. Nepal should take steps to tap this opportunity. 

Out of the top twenty import items, petroleum products stand first with 16 percent share in total imports and holding growth of 81 percent in ten months of the current fiscal year. The first target should be in this item. Think about Sri Lanka again. Sri Lanka has stopped selling petrol and diesel to the private sector saying they have little oil left for emergency needs such as for public transportation and vehicles providing medical services. Prevention is better than cure so as not to be in a situation where we couldn’t run our bikes and cars at all. Two-day holiday in a week was the right policy in this regard and the government can consider reinstating it. A cheap oil bargain, if needed, with Russia, is also another viable option available.

The second-largest import item is transport equipment, vehicle and vehicle parts which take seven percent in total imports. Kudos to the government policy to curtail this import, the recent policy announcement reduced import growth down to 1.8 percent in 10 months of this fiscal year. This policy should continue. Medicine stands in the fourth position with alarmingly high growth in the last 10 months of this fiscal year (124 percent) but we probably can’t touch this item as being a necessity but measures can be taken, such as searching for cheap import sources, directing medical doctors not to prescribe non-urgent medications, and so forth. Another item being heavily imported is crude palm oil (growth of 529 percent) in which the brake pedal can be hard-pressed. Gold and coal also fall under the top 20 import products, which could otherwise be curtailed as well. In Thailand, people were heard of selling their jewelry during the 1997 financial crisis to support the government in paying the debt. Nepalis have that big heart as well when the government seriously begs for support to cut the gold purchase. Coal, on the other hand, as such, isn’t good for the environment and many developed countries have already reduced their consumption. It is the right time for Nepal to do so as well.

When it comes to exports, India is still Nepal’s dominant export destination (79.1 percent of total exports as of the latest data). So the focus should rest on the Indian market. Soybean oil exports to India has been the top item with 34 percent of total exports to India and its growth is also 27 percent in the last ten months of this fiscal year, which needs to be promoted further, potentially considering providing subsidies in it. Tanned skin (99 percent), herbs (72 percent), and handicrafts (71 percent) are some of the top items with high export growth rates. Similar promotional measures can be taken for these items as well.

As far as remittance is concerned, this is a lifeline of our economy when it comes to foreign exchange reserve management. No country has become rich with remittance earnings but as a temporary solution for foreign exchange reserves, this must be on prime focus. With a weak export base of the country, it wouldn’t be unfair to say that migrant workers are the savior of our economy. We have long heard about hundi transactions happening in remittance inflows. The government, particularly the central bank, can brainstorm on this to bring remittances from formal banking channels. One example could be that the central bank can allow banks to open remittance accounts for migrant workers and banks offer a special line of credit facility based on the average money transfer in the account which will motivate migrant workers to send money via banks. 

Enhancing foreign exchange earnings from tourism is another area to focus on. Given that the pandemic seems to be gone now, the post-Covid world is jubilant about traveling and Nepal should take steps to tap this opportunity. Economic diplomacy can play a significant role in this regard.

Going to other parts of the BOP account, the government should not hesitate to ask for assistance from the IMF for emergency bridging loans in case the crisis worsens. If asked to raise interest rates and taxes as the IMF usually does in situations like this, the government should be ready for it. It is because the people’s plight that emerged from the currency crisis is far more severe than the pain people can have from higher interest rates and taxes. See what happened in Venezuela earlier—a mass exodus from the country where living was almost impossible due to hyperinflation and worthless currency. Most of the crises in the world have been tackled by foreign assistance despite a few exceptions like Malaysia in the 1997 East-Asian crisis. Besides the IMF, extending hands for help with other international organizations such as the World Bank and even individual countries may be needed. Sometimes foreign exchange depletion is so rapid that it goes out of control and timely action is needed. Think about Sri Lanka again where foreign exchange reserves declined by 99 percent within the past three years, perhaps faster than anyone would have thought!

Restructuring the debt

Another important point around this issue is the debt restructuring ability of the country.  The government needs to be very careful about debt default because when this happens foreign direct investment or receiving loans becomes extremely difficult pushing the country further on the edge. Worse yet, debt defaults have prolonged effects. It takes years, if not decades, to bring the country’s image in the international financial market back on track. The time is now to pay utmost attention to an overview of our loan portfolio and accordingly prioritize the payments to prevent further challenges to roll out.

Economic diplomacy is also an important area to focus on. This is needed when it comes to enhancing tourism and receiving financial assistance from individual countries and international organizations. In so doing, our diplomats residing abroad have to have robust negotiation ability and convincing power to foreign governments and officials in international organizations. We have to be honest with the fact that our economic diplomacy isn’t so strong. Currently, developed countries aren’t in a position to lend out money because they are also marred by uncertainty hovering around due to inflationary pressure, and it is for this reason that robust economic diplomacy is warranted.

These are just a few examples. The need of the moment is that policy-makers should fathom the problem deeply and prioritize the actions. Impending monetary policy should not hesitate to take bold steps.

Dealing with currency crisis: International experience

It is also good to look into what other countries did when they had a currency crisis. The East Asian crisis of 1997 is a famous one. The ultimate solution was to bail out from international organizations such as the IMF. Malaysia, which opposed IMF support, imposed a curfew on capital flight during the time, even enforcing a forced peg of ringgit against the US dollar when currency devaluation went unabated. It also made the ringgit invalid abroad to stop speculation on the currency.

As recently as six years ago, Venezuela faced a severe currency crisis that is still going on. In 2018, the country used its own currency Petro backed by oil but it doesn’t seem to have any success with widespread rumors around it. The country even changed its currency denominations eliminating six zeros. Banks forced withdrawal limits on cash to limit inflation which Nepal can consider when inflation rises rapidly.

It is time to take robust policy measures to avoid a potential currency crisis before it inflicts huge casualties on our economy. We are now at a crossroads.

The Argentinian peso crisis in the early 2000s is another famous case. Of many reasons, the lack of fiscal discipline was one of the major reasons. The government’s focus on tax revenue from imports and unrealistic target of tax revenue could be a precursor to the crisis.

Turkey’s currency crisis in 2018-2022 was due to an excessive current account deficit. Foreign-currency denominated private debt was another reason but it is not the case for Nepal. Debt defaults that occurred owing to waves of major depreciation of the currency over time could be a lesson to learn for Nepal. 

Coming back to Sri Lanka again, the newly appointed prime minister of Sri Lanka is heard saying the government is going to print money to pay salaries but nobody knows how its impact is going to be on inflation which is already soaring above 40 percent. Modern Monetary Theory (MMT) allows countries to print money by paying the national debt and collecting tax in domestic currency, but the crisis is related to foreign exchange reserves and the crisis doesn’t seem to be internally viable. Policy-makers in Sri Lanka are now in the condition of throwing a dart in the dark and seeing if it hits the target, which seems like the outcome of a ‘do or die’ situation. While MMT is taking hold in international economic debates, the understanding of its precise impact on the economy is far less certain. The government in Nepal may be tempted to do this when a crisis begins to worsen and the situation arises where there won’t be money to pay salaries for government employees but the government must be cautious about how damaging it could be in inflation by printing money and maybe it could be a colossal suicidal mistake.

Like many countries do during a crisis time, the government should be ready to form many task forces. The good news is that the government has set up one task force already to deal with the situation but setting up only one task force isn’t enough. To activate measures in all potential crisis areas, separate task forces for each area bringing experts from all walks of life is necessary at the moment. Examples include Debt Restructuring Task Force, Economic Diplomacy Task Force, Bank Recapitalization Task Force, Remittance Promotion Task Force, and Policies Coordination Task Force, to name a few.

While implementing policies, the government should be very careful about the counterintuitive effects the policies can trigger. Take the example of Sri Lanka again. In early 2021, Sri Lanka banned imports of chemical fertilizer to curtail imports and asked farmers to use local organic fertilizers instead but it backfired by heavy crop failure and thereby adding pressure on food imports as well as a reduction in tea and rubber exports, worsening further foreign currency reserve position of the country than before.

Despite the current focus on short-term solutions, the fervent belief in Nepali society is that long-term solutions are the need of the country. Export-oriented production is key to successful management of foreign exchange reserves which is a slow but certain solution. Take a simple example. If you go across the Indian border in Birgunj, our currency becomes worthless. We can’t even buy a piece of fabric with our money unless businesses accept it hoping it can be converted into Indian currency later. How can we buy so many things from other countries if we don’t have a permanent source of foreign currencies that are accepted? In this context, we must earn foreign reserves, and in order to do that, raising exports is necessary. No country in the world has ever become rich without selling its products to other countries and Nepal must realize it timely.

When added all up, it is time to take robust policy measures to avoid a potential currency crisis before it inflicts huge casualties in our economy. We are now at a crossroads of which way to go, and the current focus of the government is to pay attention to short-term solutions targeting export, import, remittance, tourism, and so forth. Another immediate need is to form various task forces to deal with the crisis on a piecemeal basis. A longer-term solution should also be on agenda besides avoiding short-term crises. We can’t afford delay. 

Dr Bamadev Paudel is a Professor of Economics at Sheridan College, Canada. He can be reached at [email protected]