Causes and remedies for negative balance of payment in Nepalese economy Dipesh Karki dipeshkarki510@hotmail.

com

Introduction: Balance of Payment is an accounting record of all the monetary transaction between a country and the rest of the world. It actually tracks the amount of money going out of country in form of payment for imports of goods and services, repatriation of income by foreigners and purchase of foreign assets etc called Debit and flow of money into the country in form of revenue from exports of goods and services, income from selling foreign assets, foreign aid, remittance and selling of foreign or domestic assets to foreigners etc called Credit. Just like in general accounting these two sides Debit and Credit must balance with each other. According to IMF The balance of payment (BOP) is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. Transactions, for the most part between residents and non residents, consist of those involving goods, services, and income; those involving financial claims on, and liabilities to the rest of the world; and those (such as gifts) classified as transfer, which involve offsetting entries to balance in accounting sense one-sided transaction Overall Balance= credits debits Since every transaction is entered twice, once in credit and other in debit the overall balance of payment always balanced in an accounting sense. Balance of Payment again comprises of following components: a) Current Account: This represents flow part of BOP which includes money flow due to trade, income from assets and unilateral transfers (remittances and foreign aid). It is represented by the Net Export. Net Export (NX) = Export - Import Capital Account: This represents the stock part of BOP which includes transfer of money due to purchase and sales of assets that can be both financial and nonfinancial through foreign direct investment or portfolio investment. It is represented by Net Capital Outflow. Net Capital Outflow (NCO)= Purchase of foreign assets by domestic residents Purchase of domestic assets by foreigners

b)

The most essential feature of interaction between these two accounts is that Net Export is always equal to Net Capital Outflow. Therefore following two scenarios occurs in general 1 When a country is running a trade surplus that is NX >0 (Export > Import) it is selling more goods and services to foreigners than it is buying from them. The foreign currency it receives from this net sales must be used in buying foreign assets thus Net Capital Outflow of country NCO >0.

Principles of Macroeconomics (Mankiw)

When a nation is running a trade deficit ( NX <0) , it is buying more goods and services from foreigners than it is selling to them. The financing of purchase of goods and services by selling its foreign assets thus Capital is flowing into the country (NCO < 0).

Reason for BOP disequilibrium

As discussed in introduction section it is apparent that BOP should always balance because of accounting principle and inherent nature of Net Export balancing the Net Capital outflow. But still attainment of balanced BOP is theoretical notion and disequilibrium exists because of following reasons: i) ii) iii) Distorted relative price in international trade because of lack of competitiveness. Excessive expenditure relative to output that can be attributed to countries living beyond their means. Internal monetary disequilibrium because of excessive money supply relative to its demand.

According to Thirwall and Gibson the disequilibrium in balance of payment can be mainly attributed to the pegged regime of exchange rate. If the exchange rate were absolutely free floating then there would be no change in international reserves at all hence there would be no BOP disequilibria.

Current Balance of Payment Situation of Nepal Nepal is one of the Least Developed Countries in the world with quarter of population living below poverty line2. Being landlocked country Nepal has to depend on the neighboring countries especially India for its trade. Further it has very small economy of around $ 35.81 billion GDP that constitute 40% agriculture, 20% industry and remaining 40% service sector. Even though 80% of population is involved in agricultural sector it is still at subsistence level and more over the economy is mainly consumer driven. Besides because of the lack of primary industry and zero production of petroleum, Nepal has to depend entirely on India for fuel and raw materials. This has caused large strain on Nepals current account which has been further exacerbated by rising price of crude oil in international market. Moreover the export of Nepal constitutes items such as carpet, clothing and leather goods whose demand is falling in international market that has eventually resulted in falling export. Political turmoil, minimum wage law, natural disaster and frequent strikes have made matter even worst. All these negativities have culminated into adverse Balance of Payment situation in the country. According to Nepal Rastra Banks recent macroeconomic bulletin3 in the first ten month of Fiscal Year 2010/11 the exports to India rose by 8.1% and to other countries by 0.8% compared to last year. On the other hand import form India in same period rose by 23.9% while import from other country plummeted by 20.5%. Thus overall trade deficit went up by 4.6% to Rs. 268.14 billion. Compared to FY 2009/11 there has been deceleration in growth of trade deficit but it hasnt been arrested as a result the Balance of Payment recorded overall deficit of Rs. 11.67 billion in deficit. The main revenue source during the period has been remittance that accounted for Rs. 206.66 billion but its growth was just 10.8% far less than the growth few years back. The growth of remittance has been stagnant

2 3

CIA country fact sheet www.nrb.org.np

because of global economic crisis owing to housing bubble burst in US since 2008. This has caused low demand of labor overseas thus arresting the foreign employment opportunity that has eventually contracted the remiitance.

The plot below shows how trade balance, current account balance and remittance are behaving in Nepal for past ten years.

The entire picture thus looks very grim and hence major policy shift needs to be placed in order to bring BOP at even par.

Possible Correction for BOP of Nepal: Theoretical and practical perspective

i)

Devaluation of Nepalese Currency (Elasticity approach): Nepalese Currency has been pegged with Indian Currency at Nrs 1.60= IRs 1 since 1993. But the economic situation has drastically changed since then. During that time Indian currency was devalued owing to gulf war and adoption of economic liberal policy set my Manmohan and Rao model. And Nepal was also witnessing spurt of growth due to reinstatement of democracy. But since then India has developed leaps and bounds with its GDP growth at around 8% per year. But Nepal has been languishing at bottom of economic development owing to decade long insurgency and political turmoil. In this situation as IRs has grown strong with other currencies due to pegging of the NRs it too has become unrealistically strong with other currencies. This unnaturalness must be rectified and hence many economists embracing the traditional school of Elasticity Approach of Devaluation are advocating the devaluation of Nrs by removing the peg with Indian currency. Their argument is that by devaluating the Nepalese currency Nepalese product will be more attractive in international market shooting up its demand thus increasing the export and eventual correction of BOP. This approach is based on following assumptions: Trade (exports and imports) goods are perfectly elastic in supply Product ( non-trade) price are determined (fixed) in home currency Domestic money wage is fixed

According to it devaluation should be adopted if following Marshall & Lerner inequality holds

.i) Where , = Elasticity demand for export = Elasticity demand for import The logic is devaluation squeezes the price of exports in terms of foreign currency and thereby high volume of exports. But by how much volume the export will increase depends upon demand elasticity for export ( ). Similarly devaluation increases the prices of imports in terms of home currency and thereby lower imports. But its magnitude also depends on the elasticity of demand for import ( In context of Nepal notion of gaining competitive advantage through devaluation of Nrs is extremely presumptuous because though Nepal exports mainly finished products such as carpets, leather and clothing whose demand is elastic in foreign market still the volume of production is very small. And whatever gain obtained through export will be entirely offset by the import of raw material whose demand elasticity of import is highly inelastic. As a result the price of raw material and fuel shoots up thus creating pressure on supply side that will eventually create supply side driven inflation. Therefore devaluing Nepalese Rupees and returning to real exchange rate will not be solution in context of Nepal which itself is reliant on import of large variety of goods. ii) Monetary Approach: According to monetary approach4 BOP is always and everywhere a monetary phenomenon governed by the supply and demand of money. This approach was developed by Johnson in 1977 from the classical approach Price Speciies-Flow mechanism introduced by David Hume in 19th century. Under this approach deficit of Balance of Payment can be defined as the excess of money supply in comparison to money demand Deficit BOP= Where, P= Price Level = Permanent Income = opportunity cost elasticity of money demand = expected rate of inflation ..ii)

: Money Demand And = m H= m (NFA +NDA) m= money multiplier H= High Powered Money NFA= Net Foreign Asset in the foreign bank NDA= Net Domestic Assets of the central bank
4

Donald Kemp. A monetary view of Balance of Payment.

Meanwhile the Surplus of BOP can be defined as the excess of money demand over the supply Surplus BOP= iii)

The logic is when Money Supply is greater than Money Demand, people use or exchange their excess money holding for foreign commodities and securities. And this requires central bank to sell foreign currency at given fixed exchange rate in order to eliminate the excess supply of domestic currency. Similarly when the supply of money is low people fulfill their money demand by selling their commodities and securities to foreigner and the central bank has to buy that foreign currency from public at the given fixed exchange rate in order to eliminate the excess demand for domestic currency. Mathematically, monetary approach can be summarized by following equation + Where the stochastic error iv) are coefficients estimated through generalized regression and U is

And expected signs for coefficients are : As Permanent Income increases( foreign exchange and there by surplus BOP. : As expected inflation rises ( , people hold foreign goods and securities and outflow of foreign reserves and thereby deficit BOP. : As Price level (d logP) rises Money demand also increases and inflow of foreign reserve and there by surplus BOP. Q=1 : As money multiplier increases (dlogm) Money Supply increases and outflow of foreign reserves and there by deficit BOP. : As Net Domestic Asset per High Power Money ( reserve and hence the deficit BOP. ) increase there is outflow of foreign , Money demand also increases and inflow of

Monetary approach to BOP is considered as most comprehensive explanation for BOP as it takes account for every little detail in economy such as price level, expected inflation and money supply and demand. In fact this approach has been adopted by International Monetary Fund to assess the BOP situation of its member country. Unlike elasticity approach that categorically advocates the devaluation of domestic currency for the correction of BOP this approach provides wide array of prescription for BOP correction. In context of Nepal the correction of BOP through this means though presumptuous still is plausible. If the Permanent income and moderate rise of price level can be maintained then BOP can move towards the Surplus. But the assumption that by simply rise in money supply actually make people demand for foreign asset increase is bit impractical in Nepalese context because Nepalese Currency is not convertible and Nepal Rastra Bank has imposed restriction in freely exchanging the NRs for foreign

currency which can be done only provided that individual get visa. Besides despite the BOP deficit there is liquidity crisis and capital flight in country as a result

iii)

Capital Movement Approach: Capital flight is another major cause for the disequilibrium in BOP. Capital market can be analyzed in terms of the supply and demand of loan able fund. And this demand hinges into two major factor: a) Interest rate b) Level of risk As a result differential interest rate between two countries and difference in level of risk at two different places can influence the level of capital flight. This condition is more apparent among country with fixed exchange regime. For example if the prevailing interest rate in Nepal is 3% and India is 6% then it is more profitable to transfer capital to India for investment. Similarly if level of risk is high investors are less willing to invest and potential investment move to foreign country. In context of Nepal capital flight is clear and present danger. Due to constant political turmoil and lack of clear cut road map the foreign direct investment has dried up. Further the risk in industrial growth has caused people to seek alternatives and hence money is being sent to India and third countries though unscrupulous means. The dire situation has been further aggravated by open and porous border with India. Also there persist differential interest rate between Nepal and India with India providing high interest rates. Thus all these circumstances has lead up to massive capital flight from the country which is evident from the liquidity crisis that country is currently reeling through. Therefore for controlling capital flight proper strategy must be laid out to make economic environment more investment friendly and interest rate should be maintained

Conclusion Nepal is going through troubled economic time. Even after Constitution Assembly election country hasnt been able meet its political and economic aspiration. Besides because of lack of political will regular budget hasnt been promulgated in time. Therefore every aspects of the economy are in doldrums. In this scenario deficit in balance of Payment has been major problem. And this can be attributed to several factors- viz fixed exchange regime with India, lack of competitive advantage in market place, global economic crisis and monetary problems. To solve these problems following should be done: i) Devaluation though is tempting should not be practiced at present as Nepals export is very weak and it imports highly inelastic products. Hence all advantage that is to be gained will be offset by rising price in raw materials and fuels. Hence it is imperative that Nepal should check its inordinate consumption of raw materials. Money supply should be regulated such that the money demand will be in par with money supply.

ii)

iii)

Economic environment should be made more investor friendly thus obviating possible capital flight.