Remittance Shock, Reserves and the India Peg
Seven months into the fiscal year, Nepal's remittance inflows are down 6.5% year-on-year, imports are NPR 1,260 billion, exports NPR 180 billion, and the current account deficit is NPR 120 billion. FDI is NPR 15 billion and external loan disbursements are NPR 25 billion. Gross foreign exchange reserves are NPR 1,350 billion. The exchange rate is pegged to the Indian rupee at NPR 1.60 = INR 1. Indian CPI inflation is 5.0%, Nepal's CPI inflation is 6.5%, the Reserve Bank of India's policy repo rate is 6.50%, and Nepal's policy rate is 5.00%. The finance ministry wants to fund a large capital budget by borrowing from domestic banks, and the central bank governor is asked whether to defend the peg by raising rates. Tourist arrivals are recovering but remain below pre-pandemic levels.
1. Compute the import cover and the current account financing gap. Assess reserve adequacy and the direction of travel.
Read the worked answer
Monthly imports = 1,260/7 = NPR 180 billion. Import cover = 1,350/180 = 7.5 months. That is above the conventional six-month benchmark, so the reserve level is not immediately critical. Current account deficit = NPR 120 billion. Identified financing = FDI 15 + external loans 25 = NPR 40 billion. The financing gap is 120 - 40 = NPR 80 billion, which must be met from reserves or other inflows. Reserves can cover the gap, but the direction of travel matters: remittances are falling 6.5%, the trade deficit is large, and tourism is below potential. A 7.5-month cover can deteriorate quickly if remittances continue to decline and the capital budget is financed by imports. The assessment should therefore be 'adequate but weakening', not 'comfortable'.
2. Analyze the interest rate differential with India under the peg. Should Nepal raise its policy rate to defend the peg? Consider inflation, credit conditions and the fiscal stance.
Read the worked answer
Nepal's policy rate is 5.00% against India's 6.50%, a negative differential of 1.50 percentage points. With a credible peg, very low domestic rates can encourage outward placement of funds, import frontloading and speculative pressure on reserves. But raising the policy rate mechanically to 6.50% is not automatically right. Nepal's inflation is 6.5%, so real rates are near zero; some tightening may be justified. However, higher rates would raise the cost of the finance ministry's domestic borrowing and could crowd out private credit. A better approach is a modest tightening plus macroprudential measures on import-intensive credit, while fiscal policy reduces the deficit. The peg should be defended with reserves, fiscal discipline and structural export/remittance measures, not with a single rate hike that may choke growth.
3. The finance ministry proposes domestic bank borrowing for a large capital budget. Evaluate this financing choice in light of the external imbalance and recommend a policy mix.
Read the worked answer
Domestic borrowing by the government absorbs bank liquidity and can crowd out private credit, but it does not directly worsen the external current account unless it finances imports. A large capital budget with high import content would raise imports and pressure reserves. The policy mix should therefore have three parts. First, fiscal: prioritize projects with low import content and quick foreign exchange earnings, and improve expenditure execution rather than simply increasing borrowing. Second, monetary: keep liquidity adequate for private credit but use macroprudential limits on import-heavy lending; do not finance the deficit by central bank credit. Third, external: encourage remittances through formal channels, promote tourism and export diversification, and maintain a reserve buffer above the import-cover benchmark. Defending the peg 'at all costs' is not a strategy; the peg needs fiscal credibility and reserve adequacy.