In an unusual development, the Nepali PM sacked the head of its central bank accusing him of leaking sensitive information and for failing to perform his duties.

What is the news?

• Nepal’s forex reserves have plummeted by 18.5% to $9.58 billion in March from $11.75 billion in July 2021.
• The current forex reserves are not enough to pay the government’s import bills beyond the next seven months or so.
• Nepal’s central bank recently announced a ban on the import of vehicles and other luxury items, citing liquidity crunch and declining foreign exchange reserves.
• It is rumoured that the Nepali economy will go into a crisis like Sri Lanka.

Why have Nepal’s forex reserves fallen?

• Nepal’s forex reserves situation appears healthy as of now as the country, unlike Sri Lanka, is not burdened by external debt.
• There are, however, concerns that the lower middle-income economy is being battered repeatedly by external factors and that may precipitate a crisis sometime soon.
• Nepal which is blessed with one of the finest tourism sectors in South Asia, because of the Himalayan mountain range, suffered during the COVID-19 pandemic as global tourist flow fell.
• This is followed by the global energy crisis caused by Russia’s invasion of Ukraine.
• This has put extraordinary inflationary pressure on the economy.

How bad is the situation?

• Nepal’s economy is highly dependent on imports as the country buys a range of merchandise goods apart from fuel.
• The prevailing weak economic indicators mean that Nepal is spending from its forex reserves faster than it can save.
• Economists contend that Nepal will soon have double-digit inflation. All economic indicators are declining.
• The real shortfall in forex reserves is because of the decline in foreign remittances which suffered during the pandemic when the Nepalese workforce abroad suffered job losses.

Can the energy scene in Nepal escalate economic woes?

• Nepal’s history shows that any uncertainty regarding fuel can trigger serious internal problems as was visible during the 2015-16 blockade when disruption of fuel supply from India.
• Nepal’s primary supplier of energy is Indian Oil Corporation (IOC).
• Nepal Oil Corporation (NOC) pays IOC in two installments every month, on the 8th and the 23rd.
• The NOC has been in crisis for months as high global prices depleted the company’s savings, prompting it to approach the government for a lifeline.
• The Government of Nepal has agreed to provide NOC the necessary amount to continue supplies from IOC.
• NOC’s financial status makes it unattractive for banks and as a result the public sector company does not enjoy confidence in the market.

Paradoxical situation

• The government is in a paradoxical situation: It has to control imports of products from which it earns the highest amount of tax revenue.
• Luxury items are the country’s major source of revenue.
• If revenue shrinks, an economic crisis could be imminent.

Impact on elections

• Nepal will hold local level polls next month which will be followed by general elections towards the end of the year.
• The election process requires considerable financial allocation and Nepal has received support in the past for elections from international donors like the USAID.
• These donors help in carrying out pre-election staff training and logistics that are part of any democratic process.
• But there are uncertainties considering the bleak financial situation.
• It will require at least 10 billion Nepali rupees for the election process and that will mean diversion of a large amount of resources for the democratic process.

Quick recap: Sri Lankan Crisis

• Like Nepal, Sri Lanka is a country with a small economy. The Sri Lankan economy is around 1.5 times bigger than Nepal’s.
• Sri Lanka’s economic crisis was in the making since it suffered a terrorist attack in 2019 which hit its tourism industry, a major contributor to the GDP.
• Then came the pandemic, which further wiped out tourism incomes. Then there were debt burdens in dollars.
• The political leadership failed to act to address the looming crisis.
• The Rajapaksha dynasty made some wrong moves—it cut taxes and started printing money, hugely devaluing the currency.
• In what looked like a well-intentioned move towards organic farming, the county banned imports of chemical fertilisers. Paddy production failed. The country ran out of money to pay its bills.

Is Nepal really going the way of Sri Lanka?

• In Nepal, the situation is not as bleak.
• Nepal’s current forex reserves are enough to pay for imports of goods and services for about seven and a half months.
• Tourism, one of the major foreign currency earners, was hit hard by the pandemic, but its gradual revival has given a glimmer of hope.
• Since Nepal’s currency is pegged to the Indian rupee, a massive devaluation shock is unlikely. Tourism is also rebounding, giving a fillip to foreign currency reserves.

Back2Basics: Foreign Exchange Reserves

• Foreign exchange reserves are important assets held by the central bank in foreign currencies as reserves.
• They are commonly used to support the exchange rate and set monetary policy.
• In India’s case, foreign reserves include Gold, Dollars, and the IMF’s quota for Special Drawing Rights.
• Most of the reserves are usually held in US dollars, given the currency’s importance in the international financial and trading system.
• Some central banks keep reserves in Euros, British pounds, Japanese yen, or Chinese yuan, in addition to their US dollar reserves.

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