Balance of Payments: Accounts, Exchange Rates & Nepal’s Trade

TAKEAWAYS:

• The Balance of Payments records all economic transactions between Nepal and the rest of the world, divided into current account (trade, services, income) and capital account (investments, loans).
• A floating exchange rate is determined by supply and demand of foreign currencies, while a fixed exchange rate is set by the central bank (Nepal Rastra Bank).
• Nepal’s trade deficit (imports > exports) affects its foreign exchange reserves and currency depreciation.
• Devaluation (official lowering of currency value) and depreciation (market-driven drop) both weaken the currency but have different causes.
• Exchange rate regimes (fixed, floating, managed float) impact Nepal’s imports, exports, and inflation.
• NEB exam focus: BOP components, causes of trade deficits, effects of exchange rate changes, and Nepal’s foreign trade policies.

---

1. What is Balance of Payments (BOP)?

The Balance of Payments (BOP) is a statistical record of all economic transactions between Nepal and other countries in a given year. It helps us understand:

• How much Nepal earns (exports, remittances, foreign investments).
• How much Nepal spends (imports, loans, foreign aid).
• Whether Nepal has a surplus (more earnings) or deficit (more spending).

Key Features of BOP

• Double-entry bookkeeping: Every transaction has a debit (outflow) and credit (inflow) entry.
• Always balances: Total credits = Total debits (by accounting rules).
• Measured in foreign currency (usually USD).

Components of BOP

The BOP is divided into two main accounts:

Visual: Nepal’s BOP Structure

Why does Nepal have a trade deficit?

• Nepal imports more than it exports (e.g., oil, machinery, medicines).
• Dependence on India for most imports (80% of trade).
• Low industrialization → relies on raw material imports.
• Remittances (from Nepalis abroad) help but are not exports.

Example: If Nepal exports $2 billion in goods and services but imports $3 billion, the trade deficit = $1 billion. This deficit is financed by: ✔ Foreign loans ✔ Foreign investments (e.g., hydropower projects) ✔ Remittances (Nepalis working abroad send money home)

---

2. Types of Balance of Payments

There are three main types of BOP positions:

---

3. Exchange Rates: How Currencies Are Valued

An exchange rate tells us how much one currency can be exchanged for another.

• Nepal’s currency: Nepalese Rupee (NPR)
• Major trading partners: USD, INR (Indian Rupee), EUR

How Exchange Rates Work

Exchange rates are determined by:

1. Supply & Demand (Market forces)
   • If more people want USD, NPR weakens (1 USD = more NPR).
   • If more people want NPR, USD weakens (1 USD = fewer NPR).
2. Government Policies (Nepal Rastra Bank controls supply)
   • Devaluation: Official lowering of NPR value (e.g., from ₹75 to ₹80 per USD).
   • Depreciation: Market-driven drop in NPR value (due to high imports).
3. Economic Factors
   • Inflation: If Nepal’s inflation is high, NPR loses value.
   • Interest Rates: Higher rates attract foreign investment → NPR strengthens.
   • Political Stability: Uncertainty → NPR weakens.

Types of Exchange Rate Systems

---

4. Causes of Exchange Rate Changes in Nepal

A. Demand for NPR Increases (NPR Strengthens)

• More exports (garments, hydropower, tourism).
• Higher foreign investments (FDI in infrastructure).
• Higher interest rates (attracts foreign capital).
• Political stability (investors feel safe).

B. Demand for NPR Decreases (NPR Weakens)

• More imports (oil, machinery, medicines).
• Capital flight (Nepalis send money abroad).
• Low exports (global demand for Nepali goods falls).
• Inflation in Nepal (NPR loses purchasing power).

Example: In 2020, NPR weakened because: ✔ Oil prices rose → Nepal had to import more oil. ✔ Tourism collapsed (COVID-19) → fewer foreign earnings. ✔ Remittances fell → less demand for NPR.

---

5. Effects of Exchange Rate Changes

Example:

• If 1 USD = ₹80 → 1 USD = ₹90 (NPR weakens):
  • Imports (oil, machinery) become more expensive.
  • Exports (garments, hydropower) become cheaper for buyers.
  • Inflation rises (cost of living increases).

---

6. Nepal’s Foreign Exchange Reserves

Foreign exchange reserves are assets held by Nepal Rastra Bank (NRB) in foreign currencies (mostly USD) to:

• Pay for imports.
• Stabilize the exchange rate.
• Service external debt.

Sources of Foreign Exchange Reserves

1. Exports (garments, hydropower, tourism).
2. Remittances (Nepalis working abroad send money home).
3. Foreign investments (FDI in hydropower, infrastructure).
4. Foreign loans & aid (World Bank, ADB grants).
5. Borrowing from IMF (e.g., Nepal took a $250 million loan in 2020).

Uses of Foreign Exchange Reserves

1. Paying for imports (oil, medicines, machinery).
2. Stabilizing NPR (buying/selling USD in the market).
3. Repaying external debt.
4. Emergency funds (natural disasters, economic crises).

Example: If Nepal’s foreign reserves drop below 3 months of import cover, the NPR becomes highly unstable.

---

7. Balance of Payments Adjustment Mechanisms

When Nepal has a BOP deficit, how does it correct itself?

---

8. Nepal’s Balance of Payments: Real-World Example

Let’s analyze Nepal’s BOP for Fiscal Year 2022/23 (based on NRB data):

Problems: ✔ Trade deficit is 7.7 billion USD (worse than 2021). ✔ Remittances dropped due to global economic slowdown. ✔ NPR depreciated (from ₹110 to ₹120 per USD in 2023).

Solutions: ✅ Boost exports (garments, hydropower, tourism). ✅ Reduce oil imports (promote electric vehicles, solar energy). ✅ Attract more FDI (hydropower, infrastructure). ✅ Control inflation (prevent NPR from weakening further).

---

9. Exchange Rate Regimes in Nepal

Nepal follows a managed float system, meaning:

• The market determines the exchange rate.
• The Nepal Rastra Bank (NRB) intervenes when needed.

How NRB Manages Exchange Rates

1. Buying USD → Increases NPR supply → NPR depreciates (if too strong).
2. Selling USD → Increases USD supply → NPR appreciates (if too weak).
3. Setting reserve requirements for banks to control money supply.

Example:

• If NPR is too weak (e.g., ₹120/USD), NRB sells USD to push NPR up.
• If NPR is too strong (e.g., ₹100/USD), NRB buys USD to let NPR weaken slightly.

---

10. NEB Exam Focus: Key Questions & Answers

Short Answer Questions (5–10 marks)

Q1: What is Balance of Payments? Explain its components. Answer: Balance of Payments (BOP) is a record of all economic transactions between Nepal and other countries. It has two main accounts:

1. Current Account (trade in goods & services, income, transfers).
2. Capital Account (investments, loans, foreign aid).

• Always balances (credits = debits).
• Helps analyze trade surplus/deficit and foreign exchange position.

Q2: Differentiate between devaluation and depreciation. Answer:

Q3: Why does Nepal have a trade deficit? What are its effects? Answer: Nepal has a trade deficit because:

1. High imports (oil, machinery, medicines).
2. Low exports (limited industrial base).
3. Dependence on India (80% of trade).
4. Remittances are not exports (they are income, not trade earnings).

Effects: ✔ NPR depreciates (more USD needed to buy imports). ✔ Inflation rises (imported goods become expensive). ✔ Foreign exchange reserves decline. ✔ Debt increases (Nepal borrows more to pay for imports).

---

Long Answer Questions (15–20 marks)

Q4: Explain the determination of exchange rates with reference to Nepal. How does a depreciation of NPR affect the economy? Answer: Exchange rates are determined by:

1. Supply & Demand (market forces).
   • If more people want USD, NPR weakens (1 USD = more NPR).
   • If more people want NPR, USD weakens (1 USD = fewer NPR).
2. Government Policies (NRB interventions).
   • Buying/selling USD to stabilize NPR.
   • Devaluation (official change in rate).

Effects of NPR Depreciation:

Conclusion: While depreciation helps exporters, it hurts importers and increases inflation. Nepal must boost exports (garments, hydropower) and reduce dependency on imports (oil, machinery) to benefit from a weaker NPR.

---

Exam Tip: How to Score Full Marks in NEB Economics (Unit 9)

1. Understand the BOP structure – Always explain current vs. capital account.
2. Differentiate key terms – Devaluation vs. depreciation, surplus vs. deficit.
3. Use real examples – Nepal’s trade deficit, NPR depreciation, remittances.
4. Draw diagrams – BOP table, exchange rate trends, supply-demand graph.
5. Explain effects – For every change (e.g., NPR depreciation), discuss pros and cons.
6. Link to Nepal’s economy – Always relate answers to Nepal’s trade, NRB policies, and inflation.

Common Mistakes to Avoid: ❌ Assuming BOP is only about trade (forget services, income, capital flows). ❌ Confusing devaluation & depreciation (one is official, one is market-driven). ❌ Ignoring NRB’s role (always mention how Nepal Rastra Bank manages exchange rates). ❌ Not discussing real-world examples (NEB loves Nepal-specific cases).

---

Final Thought: Nepal’s BOP and exchange rate are interconnected. A weak NPR helps exporters but hurts importers and inflation. To improve, Nepal must: ✔ Increase exports (garments, hydropower, tourism). ✔ Reduce imports (promote local industries, renewable energy). ✔ Attract foreign investment (FDI in infrastructure). ✔ Manage foreign reserves wisely (avoid running out of USD).

Good luck for your NEB exam! 🚀