Possible (Economic) Impacts of Floating Exchange Rate in Nepal

Nepali capital market, money market and foreign exchange market is not developed and not automated that prevents maintaining real exchange rate ultimately impacting trade and investment in Nepal. Implementing a floating exchange rate system between Nepal and India could have several economic impacts. Here are the possible positive and negative effects:

Positive impacts:

1. Automatic exchange rate adjustment
2. Monetary Policy Autonomy: Nepal would have greater control over its monetary policy, allowing it to address domestic economic conditions more effectively.
3. Shock Absorption: A floating exchange rate can act as a shock absorber, allowing the currency to depreciate during economic downturns, which can help stabilize the economy by making exports cheaper and imports more expensive.
4. Competitiveness: Fluctuations in the exchange rate could make Nepali goods and services more competitive internationally if the currency depreciates relative to the Indian Rupee.
5. Foreign Exchange Reserves: Nepal may need to hold fewer foreign exchange reserves compared to a fixed exchange rate system, as there is no need to maintain a pegged rate.

Negative Impacts:

1. Impacts on Trade and Balance of Payment
   1. Nepal’s Comparative and Competitive abilities are relatively weak that depreciates NPR
   2. Depreciated NPR will make imports dearer
   3. Volume of import will skyrocket
   4. Weak internal production ability creates further pressure on export
   5. Challenges on border area business
   6. Ultimately raising domestic price level
2. Impacts on Monetary Autonomy
   1. Volatility in exchange rate deteriorates faith to NPR
   2. Promotes INR usage and demand
3. Impact on Capital/Investment Market
   1. Deteriorates investment environment
   2. Promotes repatriation/outflow of existing Foreign Investment
   3. Promotes Capital Flight
      Such impact further weakens NPR
4. Impacts on Economic Development
   1. Increased development project cost
   2. Uncertainties on investment
   3. Adverse effect in economic development
   4. Increased workflow movements towards India/abroad
   5. Challenges in operating Industries
5. Impacts on Speculative investments
   1. Encourages INR holding
   2. Increased gray/black market

In conclusion, while a floating exchange rate system can provide flexibility and autonomy, it also introduces volatility and uncertainty, which could have significant implications for Nepal’s economy, particularly given its close economic ties with India. Careful consideration and strategic planning would be essential to manage the transition and mitigate potential negative impacts.