Robbie Strom’s Twitter homepage @robbiestrom

Dan Benjamin, Ori Heffetz and I have a team of research assistants to help us in our efforts to develop and demonstrate sound techniques for constructing national well-being indices of the kind discussed in our VoxEu article with Samantha Cunningham and Nichole Szembrot: “Happiness and Satisfaction Are Not Everything: Toward Well Being Indices Based on Stated Preferences.” Robbie Strom is a key member of that team. He shared with me these thought about Nepal, which I suggested he make a guest post on supplysideliberal.com. Here it is:

In the terrible wake of a 7.9 magnitude earthquake, India and the international community have an opportunity to help Nepal rebuild and grow. If we do not act, the economic consequences could reverberate for years to come.

The focus of the media’s intense, often short attention has spurred citizens around the world to contribute to relief efforts in Nepal. If you are reading this, and you haven’t already, please consider donating to an organization such as Educate the Children  that will help respond to the immediate medical needs of disaster victims and the long term rebuilding effort in remote villages as well as larger cities and communities.

These relief efforts are crucial to ensuring disaster victims receive proper medical attention, clean water, shelter and nutrition. They are also crucial to preventing economic calamity.

The Nepal central bank has a fixed exchange rate with the Indian rupee that has hampered its economic growth for years and pushed workers abroad, creating a remittance economy that in 2013 constituted 29% of GDP . This exchange rate policy prevents Nepal from instituting the independent monetary and fiscal policy necessary for economic growth.

The earthquake has disrupted tourism and commerce in Nepal, dwindling inventory and spiking prices, for now. With the disruption of normal economic activity potentially slowing money velocity, and without the capability to enact necessary economic policies, Nepal faces a real danger of deflation, the deadly force at root of economic depression. Because of the fixed exchange rate, only the capital inflow of dollars, euros, yen and renminbi converting into Nepali rupees through foreign aid will prevent a shrinking monetary supply .

When the rate of foreign aid decreases Nepal will have to defend its exchange rate and sell its stockpile of foreign currency reserves.  As this scenario unfolds, Nepal will have to request more foreign aid, borrow money from the IMF with historically unscrupulous terms, partner with other governments to transition away from it’s fixed exchange rate policy or face a run on its currency.

In the long run, sustained foreign aid will exacerbate a vicious cycle that increases agricultural imports and pushes workers abroad. More capital inflow can’t increase the nominal exchange rate so it will increase the real exchange rate. Money has to go somewhere when it flows in, and when it does will raise the cost of land and other inputs.

This cycle explains a striking paradox in Nepal: even as large swathes of fields lay fallow within the country, thousands of workers migrate every year to work in fields in India. When they return, they use their earnings to purchase imported Indian rice. Although agriculture remains the primary economic activity of Nepal, as a country it imports over twice as much agricultural product as it exports. In fact, it imports over forty times as much cereal as it exports.  

We can observe this cycle empirically in the uncanny relationship between current transfers from abroad into Nepal (i.e. foreign aid and remittance) illustrated with the blue line and the Nepal trade deficit illustrated with the red line in Figure 1 . With each increase in current transfers the trade deficit increases in lock step, one for one, because imports are cheaper than domestic goods. In other words, say a migrant worker sends back money to his family to purchase rice. That money will flow right back out of the country because Indian rice is cheaper than Nepali rice, almost as if the migrant worker had worked abroad and imported the rice himself.

The absolute worst option Nepal could consider is to kick the can down the road and subsequently borrow money in a foreign currency from an international organization like the IMF or World Bank to support its exchange rate. Such a loan would come with strings attached. An IMF loan might force Nepal to undergo structural adjustment, restricting Nepal’s public services while servicing the interests of Western governments, corporations and financial institutions.

The only viable option is for Nepal is to make a smooth transition away from its fixed exchange rate by partnering with India. To do so properly could require significant political capital, and the politicians that represent the over 100 peoples, cultures and languages of Nepal must unite to form an effective constitutional government.

The people of Nepal have been rightfully wary of trusting their own government, let alone the governments of their neighboring giants China and India. Yet they have essentially adopted a foreign currency, ceding economic self-efficacy for a sense of false security and trading short-run stability for long-run fragility. The influence of foreign capital has shaped and corrupted this country for too long.

The Reserve Bank of India must allow the Nepal Rastra Bank to set mutually beneficial terms which the IMF, World Bank or another international organization might appropriately oversee and underwrite. These terms should allow a gradual transition away from the fixed exchange rate to a natural, floating exchange rate that facilitates trade and partnership and, most importantly, allows Nepal to institute independent economic policy.

Nepal’s exchange rate with India is, after all, India’s exchange rate with Nepal. It is also in India’s best interest for the exchange rate to gradually adjust toward its natural rate, and for the rate to naturally fluctuate as trade between the two countries grows.

If there is any hope for growth in the aftermath of this calamity, that growth must come through partnership. At the roots of all sustainable economic growth are democratic institutions and governments that represent the interests of smaller communities and citizens. And the fruits of economic growth are only realized through the cross-pollination of countries, organizations and workers.