Exchange Rates & Int'l Macroeconomics: Determinants, Systems & Policy

TAKEAWAYS:

• Exchange rates adjust via supply/demand in floating systems (e.g., NPR/USD) or are fixed by central banks (e.g., China’s yuan peg).
• Balance of payments (BoP) links current account (trade), capital account (investment), and official reserves—deficits/surpluses drive exchange rate movements.
• Purchasing Power Parity (PPP) explains long-term exchange rates via price levels (e.g., why a Big Mac costs more in Kathmandu than in Delhi).
• Government interventions (devaluation, tariffs, capital controls) can stabilize rates but may distort trade (e.g., Nepal’s 2023 NPR devaluation).
• Speculation and carry trade by firms (e.g., Daraz borrowing in USD to invest in NPR) amplify volatility.
• International macro policies (fiscal/monetary coordination) matter for small open economies like Nepal, where remittances (30% of GDP) dominate forex flows.

1. What Is an Exchange Rate?

An exchange rate is the price of one currency in terms of another (e.g., NPR 150/USD). It determines:

• Cost of imports (e.g., Daraz’s US products for Nepali buyers).
• Revenue from exports (e.g., Nepal’s carpets, hydropower).
• Real-world link: When NPR weakens (depreciates), Nepali tourists find Dubai cheaper, but importers like Pathao pay more for foreign tech.

How Exchange Rates Work: Supply and Demand

• Supply of NPR: Increases when Nepalis sell NPR to buy USD (e.g., remittance recipients converting USD to NPR).
• Demand for NPR: Increases when foreigners buy Nepali goods/services (e.g., Indian tourists spending in Pokhara) or invest (e.g., Daraz’s USD loans converted to NPR).
• Equilibrium: Where supply = demand (e.g., NPR 150/USD in 2023).

2. Exchange Rate Systems: Fixed vs. Floating

Real-world tie-in:

• Nepal’s NPR: Officially floating but managed by Nepal Rastra Bank (NRB), which intervenes to curb volatility (e.g., buying USD when NPR falls below 150/USD).
• China’s yuan: Fixed to USD at 7.0/USD, helping exports but requiring massive USD reserves ($3.2 trillion in 2023).

3. Determinants of Exchange Rates

A. Economic Fundamentals (Long-Term)

1. Interest Rate Differential:

   • Higher interest rates attract foreign capital (e.g., Ncell’s USD bonds offer 8% vs. US 2% → demand for NPR rises).
   • Formula: $\text{Exchange Rate}\propto \frac{1+r_{\text{foreign}}}{1+r_{\text{domestic}}}$
   • Example: If Nepal raises repo rate to 8% (from 6%), NPR appreciates as investors seek higher yields.

2. Inflation Rates (PPP Theory):

   • Countries with higher inflation see currency depreciation (e.g., Nepal’s 8% inflation in 2023 vs. US 3% → NPR weakens).
   • PPP Example: A Big Mac costs $5 in the US and NPR 800 in Nepal → PPP-implied rate = 800/5 = 160 NPR/USD (actual rate: ~150, so NPR is slightly undervalued).

3. Economic Growth:

   • Faster growth increases demand for imports (e.g., Nepal’s 5% GDP growth in 2023 → higher USD demand → NPR depreciation).

B. Market Psychology (Short-Term)

• Speculation: Traders bet on future rates (e.g., selling NPR in 2022 expecting a devaluation).
• Carry Trade: Borrowing in low-interest currencies (e.g., USD) to invest in high-yielding assets (e.g., Nepali bonds) → increases NPR supply.
• Risk Sentiment: Global crises (e.g., 2020 COVID-19) cause "flight to safety" (USD demand rises → NPR falls).

4. Balance of Payments (BoP) and Exchange Rates

BoP has 3 accounts:

1. Current Account:
   • Trade balance (exports - imports).
   • Net income (remittances, dividends).
   • Nepal’s 2023: Trade deficit ($10bn) but surplus from remittances ($11bn) → current account surplus.
2. Capital Account:
   • Foreign investment (e.g., Daraz’s USD loans).
   • Nepal’s 2023: FDI inflows (~$1bn) but outflows for education/tourism.
3. Financial Account:
   • Central bank reserves (e.g., NRB’s USD holdings).

How BoP Affects Exchange Rates:

• Current Account Surplus → Excess NPR supply → depreciation (e.g., 2023 NPR fell as remittances surged).
• Capital Inflows → Demand for NPR rises → appreciation (e.g., 2021 when FDI in hydropower boomed).

Worked Example: Nepal’s 2023 BoP

• Data:
  • Exports: $12bn | Imports: $22bn → Trade deficit: -$10bn.
  • Remittances: $11bn → Current account surplus: +$1bn.
  • FDI: $1bn | Portfolio outflows: $500m → Net capital inflow: +$500m.
• Effect: Surplus current account + capital inflows → NPR should appreciate, but NRB sold USD to curb volatility → managed float.

5. Government Policies Affecting Exchange Rates

Real-world case: Daraz’s forex risk

• Daraz borrows USD at 3% (global markets) and lends NPR at 12% (Nepal).
• If NPR depreciates from 150→160/USD, Daraz’s NPR revenue rises (good), but USD debt becomes costlier (bad).
• Solution: Daraz hedges by locking in exchange rates via forward contracts.

6. Exchange Rate Pass-Through (ERPT)

How much imported price changes reflect exchange rate changes.

• High ERPT: Imports become expensive quickly (e.g., oil prices in Nepal rise 1:1 with USD/NPR).
• Low ERPT: Firms absorb costs (e.g., Daraz keeps app prices stable despite NPR depreciation).

Formula: $$\text{ERPT}=\frac{\text{Change in Import Price}}{\text{Change in Exchange Rate}}$$

Example:

• USD/NPR moves from 150→160 (+6.7%).
• Oil price in USD rises from $100→$110 (+10%), but in NPR: 15,000→17,600 (+17.3%).
• ERPT = 17.3% / 6.7% ≈ 2.6 (high pass-through).

7. International Macroeconomic Linkages

A. Monetary Policy Spillovers

• US Fed hikes rates → USD strengthens → NPR depreciates → Nepal’s imports costlier.
• Example: 2022 Fed hike → NPR fell from 120→140/USD → Nepal’s inflation rose to 8%.

B. Fiscal Policy Coordination

• IMF/World Bank loans often require Nepal to:
  • Reduce fiscal deficit (e.g., cut subsidies on fuel).
  • Defend NPR via forex reserves.
• 2023 Case: Nepal’s $1bn IMF loan tied to maintaining NPR stability.

C. Currency Unions

• Eurozone: Shared currency (EUR) eliminates exchange risk but requires fiscal discipline.
• Nepal’s challenge: No currency union with India/Bangladesh, so trade relies on NPR/INR fluctuations.

In the Real World

1. eSewa and Khalti (Digital Payments)

   • Idea: Exchange rate risk in remittances.
   • How: When Nepalis abroad send USD via Wise/Remitly, eSewa/Khalti converts to NPR at the interbank rate + 1-2% (e.g., 152 NPR/USD vs. market 150).
   • Impact: Higher fees during NPR depreciation (e.g., 2023 fees rose as NPR fell).

2. Daraz (E-Commerce)

   • Idea: Carry trade and hedging.
   • How: Daraz borrows USD at low rates (e.g., 3% from global banks) and lends to Nepali sellers at 12% NPR. To hedge, it uses forward contracts to lock in NPR/USD rates 6 months ahead.
   • Example: In 2022, Daraz secured NPR 155/USD for 2023 deliveries, avoiding losses when NPR hit 160.

3. NTC (Telecom) and USD Debt

   • Idea: Sovereign risk and currency mismatch.
   • How: NTC’s USD-denominated bonds (e.g., $500m in 2021) must be repaid in USD. If NPR depreciates, NTC’s NPR revenue buys fewer USD → higher repayment burden.
   • 2023 Crisis: NPR fell 20% in a year → NTC’s USD debt became 20% costlier in NPR terms.

4. Nepal’s Hydropower Exports

   • Idea: Exchange rate and terms of trade.
   • How: Nepal sells electricity to India at INR 0.3/kWh (~NPR 3.5/kWh). If NPR depreciates to 160/USD (from 150), revenue in USD terms falls:
     • 2022: 150 NPR = $1 → 3.5 NPR = $0.023/kWh.
     • 2023: 160 NPR = $1 → 3.5 NPR = $0.022/kWh (-4% in USD).
   • Solution: NRB encourages INR-denominated sales to reduce forex risk.

5. NEPSE (Stock Market)

   • Idea: Capital flight and currency substitution.
   • How: When NPR weakens, Nepali investors shift to USD-denominated assets (e.g., US ETFs, gold). In 2023, NEPSE saw $200m capital outflows as NPR fell, reducing liquidity.

Exam Tip

1. Diagrams Are Mandatory:

   • Always draw supply-demand for forex (label shifts for remittances, tourism, BoP).
   • Show BoP accounts as a T-account (debits = inflows, credits = outflows).

2. Link Theory to Nepal:

   • Questions often ask: "How would a 10% NPR depreciation affect Nepal’s inflation?"
     • Answer: Higher import costs (oil, electronics) → demand-pull inflation (AD shift right).
     • Use the AD-AS model (draw it!) to show inflation rising from 8%→10%.

3. Policy Evaluation:

   • If asked about NRB’s forex intervention, structure your answer:
     1. Tool: Buying/selling USD.
     2. Short-term effect: Stabilizes NPR but reduces reserves.
     3. Long-term risk: Speculative attacks if reserves run low (e.g., 2008 global crisis).

4. Numerical Questions:

   • For PPP: Use the formula $\text{ER}=\frac{P_{\text{foreign}}}{P_{\text{domestic}}}$.
     • Example: If a laptop costs $500 in the US and NPR 75,000 in Nepal, PPP rate = 75,000/500 = 150 NPR/USD.
   • For BoP: Calculate trade balance = Exports - Imports, then link to NPR movement.

5. Common Pitfalls:

   • ❌ Confusing devaluation (official change in peg) with depreciation (market-driven).
   • ❌ Ignoring capital account in BoP analysis (e.g., FDI inflows can offset current account deficits).
   • ❌ Forgetting speculation as a short-term driver (e.g., "hot money" flows in/out of NPR).

Past Exam Pattern:

• Short Answer (5 marks): Define "managed float" or explain PPP.
• Long Answer (10 marks): "Analyze how Nepal’s current account deficit affects NPR and suggest policies."
• Numerical (15 marks): Given BoP data, compute NPR movement or inflation impact.

Visual Summary:

mindmap
  root((Exchange Rates in Nepal))
    Determinants
      Supply: Remittances, Exports
      Demand: Imports, Tourism, FDI
    Systems
      Floating: NPR (managed)
      Fixed: China (yuan)
    Policies
      Devaluation: 2023 NPR move
      Tariffs: On Chinese goods
    Impacts
      Imports: Oil, Electronics
      Exports: Hydropower, Carpets
      Firms: Daraz, NTC