Foreign Exchange Rate Determination and Management in Nepal

1. Introduction

Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a country's currency is valued according to the laws of supply and demand. It is the price at which one currency can be converted into another. It represents the rate at which a firm may exchange one currency for another. Thus, the exchange rate is simply the amount of a nation’s currency that can be bought at a given time for a specified amount of the currency of another country.

According to Foreign Exchange (Regulation) Act, 2019: "Foreign exchange" means a foreign currency, deposits, credits and balances of all types which are paid or received in a foreign currency, foreign securities and cheques, drafts, travelers cheques, electronic fund transfers, credit cards, letters of credit, bills of exchange and promissory notes which are in international circulation and are or can be paid in a foreign currency, and this term also includes any other such monetary instruments.

So, exchange rate is the price of foreign currency as (a) consumer price is the price of goods and services (b) wage rate is the price of labor, and (c) interest rate is the price of capital.

Factors that determines the exchange rate of Nepali currency

A.     Demand for foreign exchange

a.       Import of merchandise and services (education, health, travel abroad, cost of diplomatic missions abroad

b.      Amortization of principal and interest on foreign loans

 

B.     Supply of foreign exchange

a.       Workers’ remittances and pensions

b.      Exports of goods and services (incl. tourism)

c.       Expenses in Nepal by foreign diplomatic missions, INGOs and charity organizations

d.       Foreign Aid

e.       Interest on investment abroad

f.        FDI’s

 

 

 

 

 

                                        2. Types of Exchange Rate Determination

 

A.    PURCHASING POWER PARITY (PPP)

·         The Purchasing Power Parity (PPP) model or else the “law of one price” estimates the adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.

Assumption

PPP assumes that if there are no barriers to free trade the price of the same commodities must be the same everywhere in the world. Based on that assumption, the exchange rate between two economies must fluctuate towards a long-term value that ensures the equilibrium of commodity pricing.

Key Points regarding the PPP Analysis:

·         PPP analysis is based on several assumptions, including homogeneous products and absence of trade restrictions

·         PPP analysis can be used only for tradeable goods and not for non-tradeable goods such as services

·         In reality, only the prices of internationally traded goods tend to balance out

·         PPP analysis is useful for long-term currency valuation

·         There can significant divergences between currency valuations and PPP, especially in the short-term

·         PPP analysis is particularly useful for corporations, carry traders, and other long-term thinkers

·         PPP analysis is useless for short-term currency traders

Calculating the PPP

Basically, the price parity between two countries is formulated as:

■ e = Pd / Pf

This can be also expressed as:

■ Pd = e x Pf

Where:

e = The PPP equilibrium exchange rate value

Pd = Domestic price level of a commodity

Pf = Foreign price level of a commodity

 

 

B.     THE PORTFOLIO BALANCE APPROACH

·         The Portfolio Balance approach is a modern theory based on the relationship between the relative price of bonds and exchange rates.

·         The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds. According to this approach, any change in the economic conditions of a country will have a direct impact on the demand and supply for the domestic and the foreign bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between the domestic and foreign economies.

·         The key advantage of the portfolio approach when compared to traditional approaches is that the financial assets tend to adjust considerably faster to news economic conditions than tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange rates.

 

C.    THE INTEREST RATE APPROACH & THE FISHER EFFECT

 

·         The connection between currency exchange rates and interest rate differentials appeared after the end of the Bretton Woods agreement in 1970-1972.

·         The interest-rate models assume that the global capital enjoys perfect mobility and that it will immediately take advantage of any interest rate differentials. A situation which is known as ‘Covered Interest Rate Arbitrage’

·         Covered Interest Rate Arbitrage

o   According to covered interest rate arbitrage theory, the interest-rate arbitrage is always active and ensures the covered interest rate parity worldwide.

 

·         Interest Rate Parity (IRP)

Interest Rate Parity (IRP) assumes that the interest rate differential between two countries remains always equal to the differential calculated by using the forward exchange rate and the spot exchange rate. In other words, an exchange rate’s forward premium/discount equals its interest rate differential:

■ Forward premium/discount (%) = interest rate differential (%)

This creates an equilibrium based on the relationship between exchange rates and interest rates.

D.    THE MONETARY APPROACH

 

·         The Monetary Approach focuses on the monetary policies of two countries in order to determine their currency exchange rate. The Monetary Approach uses two dynamics to determine an exchange rate, the price dynamics and the interest rates dynamics.

·         A change in the domestic money supply leads to a change in the level of prices and a change in the level of prices leads to a change in the exchange rate

·         The Monetary Policies

o   In general, a monetary policy focuses on the money supply of an economy. The available money supply is determined by:

(a) The amount of money in circulation, and

(b) The level of interest rates.

·         Countries that apply expansionary monetary policies in order to increase the amount of money in circulation will face inflationary pressures. This usually leads to a devaluation of the currency exchange rate. On the contrary, countries that apply tight monetary policies decrease the amount of money in circulation and see their currencies appreciate.

 

E.     THE BALANCE OF PAYMENTS APPROACH

·         According to the Balance of Payments theory, changes in a country’s national income affect the country’s current account. Consequently, the exchange rate is adjusting in a new level in order to achieve a new balance of payments equilibrium.

 

                                        3. Policy, Practice and Management Techniques

 

       I.            Policy:

a.      NRB Act 2002 Section 4, one of the main objectives of the bank is, "to formulate necessary monetary and foreign exchange policies in order to maintain the stability of price and BOP for sustainable development of economy and manage it.

a.      Foreign exchange Regulation Act: "The inflow, outflow and transaction of foreign exchange within the country are managed by the foreign exchange regulation act." Foreign exchange acquisition, sale of foreign exchange, FDI provision to buy, sale, holding, regulation, license restrictions foreign exchange transaction are guided by this act.

b.      Monetary Policy Provision as foreign ex management : The transaction of foreign exchange and limit has been set in every year in MP issued by NRB  

 

    II.            Practices and Regulations

 

 

v  According to Ch 7 of NRB Act 2002, Foreign Exchange Policy, Regulation and Reserve

 

Foreign Exchange Policy: The Bank shall have full authority to formulate &implement foreign exchange policy and cause to implement of Foreign Exchange policy of Nepal.

 

 

 III.            Management of foreign exchange:

The Bank shall have the following powers for such management.

 

 

·         To issue license under this Act or any other prevailing laws to the persons willing to deal in foreign exchange transaction

·         To frame Rules and Bye laws and to issue necessary order, directives or circulars in order to regulate dealings in the foreign exchange transaction by the foreign exchange dealer

·         To insect, supervise and monitor the foreign exchange dealer

·         To set the bases, limitations and terms and conditions for the transaction of foreign exchange dealer

·         To prescribe the system of determining the foreign exchange rates of the Nepalese currency

·         The Bank shall cause the license-holder to submit to the Bank the detailed particular of exchange of foreign currency and of the transaction relating to it. The duration for submitting such particulars, the format and other documents relating to it shall be as prescribed by Bank from time to time

·         Dealing in Foreign Exchanges

o   May purchase and sell foreign exchange

o   Fixing its buying and selling rates

·         The Bank shall mobilize the foreign exchanges reserve. Such reserve shall be denominated in the respective foreign exchange and such reserve shall consist of the following assets

o   Gold reserve, foreign currency reserve, SDR held by the Bank at IMF,

·         Issuance of Debt Bond against Gold and Foreign Currency

·         Deal with International Clearing and Payment Agreements

o   The Bank may, either for its own account or for government account and by the order of Government of Nepal, enter into clearing and payment agreements with public or private central clearing unions domiciled abroad


                                                4. Conclusion

The foreign exchange market is a global decentralized market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock. The foreign exchange market determines the relative values of different currencies. So, the best regime is the one that stabilizes macroeconomic performance minimizes fluctuation in output, consumption, the domestic price level or some other macroeconomic variables.

  

                                                        5. References

·            Nepal Rastra Bank Act, 2058(2002). Retrieved from  

http://www.lawcommission.gov.np/en/archives/14807

·            Foreign Exchange Act, 2019. Retrieved from

https://www.tepc.gov.np/assets/upload/acts/1Foreign_Exchange_Act,_20191616.pdf

·      Acharya, Keshav. (2012). Foreign Exchange Management, Regulation and External Payment     Processes in Nepal. Retrieved from

http://www.sawtee.org/presentations/ForeignExchange_Keshav.pdf


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