A few weeks ago, Nepal Rastra Bank (NRB) published its monthly macroeconomic report for June, the penultimate month of the current fiscal year. The latest report shows a significant increase in the country’s foreign exchange (forex) reserve for the first time in 15 months. Such a consistently negative growth of the reserve is a remarkably rare occurrence, and it has brought into light the country’s vulnerability to a dire economic crisis.
 

Why is the forex reserve important?

Forex reserve, the stock of foreign-denominated cash or assets held by a country’s monetary authority, expands with activities that bring foreign currency to the country (e.g., exports, remittance, foreign grants) and shrinks with activities like imports and external debt servicing. In a global order guided by economic integration through trade and financial transactions, all countries hold foreign currency. But for Nepal, a small import-oriented economy amidst a global melt-down, having a sound forex reserve is especially important.

Nepal is a country that relies on imports for the availability of most essential and intermediate goods. Since importers pay in foreign currency, the forex reserve indicates a country’s ability to finance imports. Moreover, the majority of Nepal’s imports comes from India (around 70% according to the latest NRB report), and a fixed exchange rate with the Indian currency has historically fostered eased trade and price stability. However, without a sizable reserve of foreign currency, the central bank is unable to maintain the market’s confidence that it will exchange Nepali currency for a foreign currency at the given/fixed rate. As such, the country’s foreign exchange reserve is also instrumental in adding credibility to the currency regime.
 

Understanding the decline in forex reserves

The decline in Nepal’s forex reserve is an amalgam of many factors. On one hand, channels of foreign currency injection have been fairly stagnant. Workers’ remittance, the largest source of foreign currency, was Rs. 897 billion in the eleven months of 2021/22, just a 3.65% increase from the previous fiscal year. Likewise, foreign grants decreased from Rs. 23 billion to Rs. 6.4 billion, whereas net foreign direct investment increased by 7% to Rs. 17 billion.
In contrast, an outflow of foreign currency, mainly through imports, is increasing. The trade deficit, already on an increasing trend since August 2020, showed a 25% growth in the latest NRB report.

Rising prices and USD’s appreciation are the main factors pushing up the cost of imports and exacerbating trade deficit – the value of the country’s top import, petroleum products, increased by 89% this fiscal year compared to the previous year.

Inflation, which had been surging globally since 2020 due to supply chain disruptions induced by COVID, has been further intensified by the conflict in Ukraine. Rising prices in the international market has persisted for much longer than anticipated and continues to reach record-high levels in emerging as well as advanced economies. Kristalina Georgieva, chair and managing director of the International Monetary Fund, in a recent blog post, recognized the prolonged threat of global inflation and projected a downturn in global economic growth for 2022 and 2023.

NRB’s report does not necessarily suggest alarm for a crisis though. As economies recover from the pandemic, tourist arrivals are picking up and Nepal’s tourism sector is growing. Likewise, the number of migrant workers going abroad increased by over 400% this fiscal year compared to the previous – we can expect increased remittance income in the future.

Regardless, the forex reserve is expected to be in a crunch in the coming future as only last month, NRB reported that the reserve was enough to finance merchandise and services imports for a record low of 6.6 months. Further, citing lack of improvement in the reserve, the government extended its 81-day ban on the import of certain goods by one and a half months.
 

Policy and way forward

Policymakers are unable to control the international market, but they can respond by pacifying domestic demand. Likewise, the outflow of foreign currency can be reduced by “cooling down” the economy through austerity measures. Central banks globally raising interest rates to incentivize people against domestic consumption to slow demand is an example of this.

The recently published monetary policy by NRB too employs contractionary tools to reel in domestic demand. For example, the policy interest rates, the rates used by the central bank to influence other banks and financial institutions’ (BFI) interest rates, have all been raised by 1.5%. As BFIs follow and increase lending rates, the public is incentivized to save more and reduce consumption, thus slowing demand. This consequently refers to a reduction in the demand for imports, relieving trade deficit and forex reserve.

Georgieva’s blog urged that fiscal policies should support and not hinder Central Banks’ efforts during these trying times. The expansionary fiscal budget proposed for the next fiscal year, amid increased expenditures for federal and provincial elections, poses a challenge to the monetary policy. Further, with the Finance Minister having resigned and NRB’s Governor being pressured to do the same following allegations raised against them, policymakers’ diligence and impartiality is under question.

While Nepal’s foreign exchange reserve does not face immediate adversity, without appropriate policies and coordination between government authorities, the economy remains vulnerable to a crisis.