The foreign exchange rate has numerous implications in any economy, the case is no different for Nepal. If you invest internationally, study abroad, or simply need to buy a new laptop, the exchange rate will directly or indirectly impact you.
Bank forex sheets are easy to read, but have you ever wondered what goes into determining the exchange rate? What is it that the dollar is 120 times more valuable as the Nepali rupee? In this article, we will talk about the forex policies of Nepal, factors that affect the change, and the effects of it on our economy.
A Crash Course on Foreign Exchange
The exchange rate is the rate at which one currency can be converted into another currency. For instance, a Nepali company may wish to purchase Us dollars. If the company wants 1000 USD, then it would have to purchase it using 120,000 Nepali Rupees (estimate). So, the exchange rate is 120 NPR to the US dollar.
So where is the currency sold, or bought then? Well, economists use the term foreign exchange market to define the space, and a physical manifestation of it could be the central bank of the country or any commercial bank affiliated with it.
How is Exchange Rates Determined?
There is a lot of complicated economics that goes into determining exchange rates. TO understand the gist of it we will first have to delve deeper into the reasons foreign exchange exists in the first place. What creates a demand for foreign currency, and what determines its supply?
Demand and Supply of currency
- International trade is the primary reason. If you need to buy something from the US, you need the currency used in the US, hence creating a demand for the US dollar. Similarly, if you sell something to the US, they will need Nepali currency. To get this, the US will exchange US dollars, which will create a supply for US dollars.
- Investment in Nepal by foreign firms would create demand for Nepali currency. Similarly, if Nepali people want to invest elsewhere, the supply of Nepali currency would increase (from the aforementioned logic).
Factors Affecting Exchange Rates
In simple terms, whenever the supply of something increases, its value decreases. Similarly, when the demand for something increases, its value increases too. If diamonds were available everywhere, its value would not be as high and if no one wanted diamonds, its value would not be as high either. The same stands true for foreign currency, you should regard it as any other product.
For simplicity, let us assume that governments do not exist, and currencies are allowed to flow freely. This system is called the floating exchange rate system. So, in essence, the supply and demand of a currency determine its value.
- If exports increase from Nepal, the value of Nepali currency will increase. This is because the demand for Nepali currency would increase (as explained before), hence increasing its value.
- If imports into Nepal increase, then the value of Nepali currency will decrease, for the same reason.
- If foreigners invest more in the Nepali market, the value of Nepali currency will increase (because investment creates demand).
- If Nepali people invest elsewhere, the value of Nepali currency will decrease.
Speculation and Exchange Rates
This comes under factors that affect the exchange rate but deserves its own subheading because it’s pretty bizarre. When it comes to forex, speculation about a market is a highly influencing factor, especially since there are a lot of floating exchange rates present today. It is estimated that around 96% of foreign exchange transactions from London are done on a speculative basis, making it the single most deterministic factor of the exchange rate (at least in the short term).
This is a common question, for some reason, everyone seems to be buying dollars right now. What is this sudden rush for grabbing dollars? This question is very closely related to how speculation works, I will explain both of these simultaneously.
How Speculation Works
What does speculation mean? Well, let’s assume you have 1 million Nepali rupees and have access to a foreign exchange market. The current hypothetical exchange rate is NPR 100 to the US dollar. If it is speculated that the value of the dollar is set to increase sharply in the next month, you will then want to buy US dollars.
Why? Because if you exchange 1 m NPR now when 100 USD= 1 NPR, you will have USD 10,000. Then a month later, says the prediction is correct, and the value of USD increases determining the exchange rate at 120 NPR= 1 USD. If you exchange back your currency now, you will have NPR 1.2m, earning a total of 200,000 out of nowhere.
So, when people assume that the value of a currency is set to increase, they start buying more of that currency. This creates a loop effect because the speculation of growth results in more demand, accelerating the growth of the value of a currency.
Why people invest to buy dollars
Going back to our previous question, with the onset of the pandemic, the value of the dollar started rising rapidly. The reason for this is beyond the scope of the article, but the effect is relevant. Since the value of the dollar is rising, people speculate that it will continue to rise. From the aforementioned example, you can see how this would mean more people buying the dollar, they can practically grow money from nowhere. This rapid increase in demand, in turn, pushes the value of the dollar even further, creating a loop. Hence, people are set on buying dollars.
Forex After Government Intervention
In reality, forex isn’t as simple as mentioned above, governments intervene a lot in the foreign exchange market to achieve national economic interests through monetary policies. This results in a lot of abnormalities that are not in line with what I discussed above, raising a lot of questions. I will try to address these questions while explaining government intervention.
Why is NPR 100 always equal to INR 160?
This is the first question that comes to mind when thinking of forex in Nepal. If the rate of NPR changes with other countries, why is it always the same with India?
To answer this, let me introduce you to a fixed exchange rate system. In this system, the government intervenes to keep the value currency of the home country pegged to a certain value of the foreign currency. Fixing a currency helps it stay stable and underappreciated especially when imports are much higher than stable (as is the case in Nepal). This is done especially by developing nations to avoid acute depreciation of the national currency and is usually done with the closest trading partner.
In Nepal’s case, around 80% of overall international trade is done with India. And since the Indian rupee is relatively more powerful than the Nepali rupee, the government of Nepal decided to peg it back in 19, and 56continues to do so. If it weren’t pegged, and NPR was allowed to float freely, data shows that 1 INR would be equal to 3.9 NPR (as opposed to 1.6). This means that the Nepali currency would be grossly depreciated in value, and the economy would suffer.
Why is NPR worth more than some developed nations’ currencies?
There are some nations which have very depreciated currencies despite their economic performance. The most prominent example is South Korea, whose currency is significantly lower than NPR (NPR 1= SKW 9.67). This has to do with the South Korean currency itself. After the Korean war in 1950s, the won depreciated a lot in value, and never quite recovered. This, along with possible government measures to keep the currency stable, is probably why the won’s value remains so low.
This is a great example to show the complications behind forex rates. A “stronger” currency is not necessarily the currency with the highest exchange rate. What nations aim for is a “stable currency”. If currency remains stable, it attracts investors and increases economic value for the nation. Hence, even though South Korea is much more developed than Nepal, its currency remains low. However, in terms of strength, Korean won is still much stronger and more valued than NPR in international market.
Economics Effects of Forex Rates
The same way the economy affects the forex rate, the vice versa is also true. Here are some of the obvious effects of forex rates on the economy.
When a country’s currency is depreciated, imports become more and more expensive. For example, if a laptop from the US costs USD 1000, at ER USD 1 = NPR 100, it would cost 100,000 in Nepal. But if Nepal’s currency depreciates to USD1 = 120 NPR, the price of the laptop will increase by 20 thousand to 120,000. In the case of currency appreciation, the opposite would happen.
Balance of payment
But at the same time, a depreciated exchange rate can help incentivize exports, because while imports become more expensive, exports become cheaper. In the previous example, something that costs NPR 100 at USD 1 = NPR 100 would cost USD 1. But after depreciation, at USD 1= NPR 120, the same item would cost USD 0.83 in the US. This would result in more sales of Nepali products and firms would lean towards exporting more.
Aiming for a stable currency
Hence, in some cases, depreciation of a currency can help reduce its foreign debt, and help to recover its balance of payments by increasing exports. But at the same time, it can also lead to inflation back home because of increase in price of foreign products. The implications are numerous, and I cannot possibly explain them in one article. But in general, as I mentioned before, a “stable” exchange rate is what nations aim for. In the long run, this will help keep inflation down and attract more investors, which automatically decreases the national debt and increases economic performance. A currency that fluctuates often, regardless of how powerful it is, is a sign of a failed economy.
I have tried my best to lay out the basics of foreign exchange, the determining factors behind it, and the implications of it in this article. I have taken the Nepali market as a reference point, but the ideas in this are relevant to any economy around the world. As complicated as forex can get, it remains quite relevant in everyday life, and having more information on it will certainly help you make better business and personal choices.
Related Topic: Foreign Currency Exchange in Nepal