The main objective of this paper is to investigate the relationship between balance of payments and macroeconomic variables in Nepal. It has considered four macroeconomic variables such as real gross domestic product, inflation, exchange rate with US dollar and broad money supply M2. Net foreign asset (NFA) is taken as balance of payment. It has covered time series data from 1975 to 2022 A.D. the study is based on secondary data which are abstracted from the publications of NRB and Ministry of Finance, Government of Nepal. Error Correction Model has been applied to examine their interlinked. The paper concludes that there is long run positive relationship between money supply and balance of payment in Nepal. So, monetary policy works in the long run to address the problem of balance of payment in the country. Similarly, there is positive relationship of balance of payment to exchange rate, it might be the result of lack of full convertibility of capital account in case of Nepal. The findings of the study are mixed.
Key words: Net foreign assets, ECM, Balance of payments, Exchange rate, Money supply etc.
1. Background of the study
One of the most important and widely used source of information about a country’s international economic position is its balance of payments situation. It is a summary statement of all the transactions between the residents of one country and the rest of the world. It covers a given period of time, usually one year. Maintaining favorable balance of payments is a prime objective of a country. It shows economic strength and weakness of a country which is linked with other macroeconomic variables or a country.
The balance of payment accounts consists mainly following two accounts.
i. Current Account and
ii. Capital and Financial Account
The current account is a part of the balance of payments that considered both visible and invisible trade of a country to the rest of the world. Visible imports and exports consist of physical merchandise of all kinds, whereas the invisible imports and exports are services, transfers and interest, profit and dividends. When, X denotes the exports and M imports then in monetary term current account balance of payments equation can be expressed as;
B = X – M ——————————- (1)
If X > M, B > O, the case of current account surplus or favorable.
If X > M, B < O, the case of current account deficit or unfavorable.
If X = M, B = O, the case of current account is balanced.
Similarly, capital and financial account is a part of the balance of payment that records long term and short-term capital movements among the countries. Capital and financial account of the balance of payments is divided into two main categories as the capital accountandthe financial account. The capital account consists all transactions that involve the receipt or payment of capital transfersand acquisition or disposal of non-produced and nonfinancial assets. Financial account covers all transactions related with changes of ownership in the foreign financial assets and liabilities a country. Such changes include the creation and liquidation of claims on, or by, the rest of the world. The main basis for the classification of the financial account is functional category i.e., direct investment, portfolio investment, other investment, and reserve assets while the SNA classification is primarily by type of instrument: monetary gold, currency and deposits, loans, etc. The capital account indicates capital transfers receivable and payable between residents and nonresidents, and the acquisition and disposal of nonproduced, nonfinancial items.
The structure of the capital and financial account also is generally compatible with other statistical systems of the International Monetary Fund and is consistent with the classification of related income components of the current account and with the international investment position. The capital account has also two parts: capital transfers and acquisition or disposal of nonproduced, nonfinancial assets. In former editions of the IMF manual, capital transfers were included indistinguishably with current transfers in the current account.
In equation (1), when B ≠ O i.e. unbalance it is needed to correct and when B < O, serious problem arises that indicates unfavorable. In this case the balance of payments is in deficit. Now, appropriate action should be taken by the concerned authority to control a persistent payments imbalance. There are three main possible policy measures;
i. Demand management policies.
ii. Import controls.
iii. Exchange rate to change.
Normally, currency depreciation is applied to correct a both trade and balance of payments problems. Depreciation will immediately affect the relative prices of traded goods. The foreign price of exports will fall and the domestic price of imports from foreign countries will rise. Such price changes will intern cause a rise in the demand for exports and a fall in the demand for imports. So long as these demand changes can be realized, it will affect the country’s balance of payments and improve the scenario. However, the price effect of depreciation does not tell in the complete change because it may affect national income of the country. This change in income will bring change in the demand for imports and this will insert a further influence on the trade balance. At the same time, the inflationary impact of devaluation may come through various channels in an economy. The consequences of such inflation may erode the impact of the devaluation. Thus, to reduce inflationary impact of devaluation it is considered to be used the real exchange rate, then the nominal.
i. It examines the transaction of all the exports and imports of goods and services for a given period.
ii. It helps the government to evaluate the potential of a particular industry export growth and formulate policy to support for attaining growth.
iii. It provides the government a broad perspective on a different range of import and export tariffs. Then, government can take suitable measures to change the tax policy to discourage import and encourage export, respectively, and be self-sufficient.
iv. If the economy needs support in the mode of import, the government plans according to the statement of balance of payments, and distract cash flow and technology to the unfavorable sector of the economy, and pursue future growth.
v. It also designates the government to detect the state of the economy, and planning.
vi. Monetary and fiscal measures are established on the basis of balance of payment status of the country etc.
2. Statement of the Problem and research question
In the context of Nepal, external sector stability is being a frequently raise issue and problem for macroeconomic stability. Trade deficit is increasing over the year whereas country is suffering by the problem of balance of payments time and again. Foreign currency reserve is declined in early 1980’s, 2018, after COVID-19 and problem in Europe and middle east. it is the result of excessive import in the country. Therefore, it is necessary to evaluate the nexus among macroeconomic variables. Basically, external sector includes foreign trade, balance of payment, foreign exchange reserve etc. To explore the determinants of external sector problems i.e. BoP, following four variables such as price level, exchange rate with US dollar, money supply and economic growth (GDP) have been chosen. The country’s external sector position is likely to worsen in the fiscal year 2018/19 as Nepal Rastra Bank (NRB) has focused on supporting the growth target rather than the stability of price and balance of payment.
When balance of payments records to deficit, the central bank has introduced expansionary monetary policy which has further exacerbated the problem. Lowering the target for foreign exchange, cutting the policy rates, and increasing private sector credit growth target are some of the key examples of the expansionary monetary policy stance. Central bank should have tightened the monetary policy at a time when the economy has been grown up rapidly over six percent annually for last three years after a prolonged period of tepid growth. The economic expansion above the historical average has also put a substantial pressure on the domestic economy and the position of current account. Instead of addressing the challenges that the growth could put on the external sector stability through the monetary policy. The central bank opted for measures which will further compound the risks (NRB economic review, 2019).
Whenever Nepal handled a balance of payment deficit, NRB adopted a tighter monetary policy stance in the past. However, in the monetary policy of 2019/20 stance has been exceptional; making a historic departure in its choice of growth objective in the face of a huge size of BOP deficit. Nepal had faced the problem of BOP deficits seven times after the establishment of the central bank in 1956 A.D. The country had approached to the International Monetary Fund (IMF) three times to address the problem. Against the expectations that the NRB has tighten its monetary policy to limit the backlog of financial sector and external sector risks, the central bank came up with a too reconciling monetary policy.
NRB (2019) stated that BoP surplus declined into a deficit of Rs 90.83 billion in the first eleven months of the last fiscal year 2018/19 compared to a deficit of Rs 4.34 billion in the same period of the previous year. The monetary policy also comes against the recommendation of a tighter policy by the IMF. To manage fiscal and external-sector pressures and promote a more durable economic expansion, the IMF team’s assessment is that a measured tightening of policies is warranted higher interest rates, tighter macroprudential policies, and a smaller fiscal deficit than currently budgeted would be more suited to the current economic circumstances. These adjustments would reduce pressure on the current account by constraining import growth and foster a pace of expansion more consistent with the economy’s current domestic productive capacity. Measured adjustments to policies today could pay dividends in terms of more stable and higher future growth. The central bank, too, has admitted that the external sector will face pressure in the current fiscal year. It has projected that the foreign exchange reserve will be adequate to finance the imports of commodities and services of seven months in the current fiscal year, down from the projection of eight months in the last fiscal.
However, the central bank has not put its key objective of BOP stability in its policy. The target of the forex reserve is to keep sufficient reserve to manage external sector stability. It is not in comfortable position now. There is shortage of foreign exchange in the market. The value of dollar is rising over the time in terms of Nepalese rupees. NRB has made several provisions that will help to increase our cushion of foreign exchange and improve the external sector position.
The main aim of the study is to investigate the relationship between balance of payments and macroeconomic variables in Nepal. Balance of payments covers several components like foreign trade, remittance, foreign direct investment etc. So, the paper has set research questions as:
3. Research Objective
The main objective of the study is to assess the linkage between balance of payment and macroeconomic variables of Nepal. Therefore, the objective of this paper is:
- To assess the relationship between balance of payment and macroeconomic variables in Nepal.
4. Rationale of the Study
This paper tried to investigate the relationship between balance of payment and macroeconomic variables in the context of Nepal. There is noteworthy relationship between economic performance of a country and balance of payment. It is related with economic performance of the economy. So, balance of payment problem is one of the debatable issues in the arena of external sector problem in the country. There is volatility in balance of payments situation in Nepal. In the field of economics, the relationship between balance of payment and macroeconomic variables always matters. There are various theories concerned with the relation between balance of payments and economic performance of the country. Change in economic condition directly affect production and through which price level, balance of trade and balance of payment. Nepal recorded a balance of payments (BOP) deficit for the second consecutive month in the current fiscal year 2017 A.D. as outflow of money from the economy surpassed inflows. The outflow of money from Nepal’s economy surpassed inflows by Rs5.9 billion in the second months of the fiscal year ended mid-September, as remittance income growth rate petered out while imports continued to increase, shows the latest Macroeconomic Report of the Nepal Rastra Bank. Balance of payment deficit of Rs5.9 billion indicates Nepal needs to find more ways to earn foreign currency, otherwise foreign exchange reserve will come under pressure. One of the main sources of foreign currency for Nepal has been money sent by Nepalis working abroad (NRB,2017).
There is significant contribution of remittance on BOP whereas contribution trade is negative. Country should not trust on remittance only for generating foreign currency. Policy reforms and reviews are essential for correcting trade deficit. One of the theorical conclusion for improvement in export is devaluation of currency. It is not being effective in case of Nepal. So, it is a time for revisiting and rethinking our export, exchange rate and balance of payments situation of the country.
This study will be beneficial for policy makers as well as future researchers to examining the relationship between balance of payments and macroeconomic variables of the country. It helps to make policy change. The study enquiries and investigates short term and long-term relationship between stated variables. It also gives insights to the future researchers and helps for regulatory authority while preparing, analyzing and evaluating their exchange rate and other related policy. Exchange rate system and its impact on external sector is one of the prominent issues in the macroeconomic analysis of Nepalese economy.
5. Literature review
There are lots of research and study in the field if balance of payments. For the long period, Keynesian and monetarist theories have dominated macro-economics in general and balance of payments theories in particular. There have been many short-run tests of the monetary approach to the balance of payments and the evidence has been used to support the monetary approach. Basically, the study is based on monetary approach to examine the linked among the macroeconomic variables.
Mundel (1971) developed BOP adjustment model and tried to link with other macro variables such as rate of inflation, rate of credit creation and money stock. The model shows that money can have a direct effect on the BOP through its immediate impact on expenditure, part of which inevitably falls on imported goods. The study has suggested that authorities should keep in mind that bank’s credit expansion rate should be more or less equal to growth rate of the economy. It states that for a given rate of credit creation the BOP is determined by the growth rate of transactions and output of the goods and services. In most cases domestic credit creation is a positive function of the domestic growth rates.
Bhatia (1980) conducted a study to examine the BoP and monetary policy of India for the fixed exchange rate regime. This study had used prices income, money multiplier and the domestic credit as explanatory variables and found that the coefficient of these variables were close to unity and were significant at 5 percent level of significance. There was positive impact of the growth rate of income and price level on foreign reserve flow. And an increase in interest rate, money multiplier and domestic credit expansion had a negative impact on foreign reserve flow.
Mainly (1989) tried to find out significant factors causing balance of payment problem in Nepal. This study has used Johnson’s small country model and Aghevli Khan Model to analyze the data for the period of 1964-1980. The study shows that domestic credit creation can be used effectively to influence surplus or deficit in the balance of payment. This study also shows that an increase in income increases the overall balance of payment. It has found that the use of exchange rate as a policy variable will not help to correct the balance of payment problem. The study reveals that the monetary approach to the balance of payment is an efficient tool to study the balance of payment problem of Nepal.
Khatiwada (1992) tested the impacts of different economic variables on the balance of payments of Nepal for the period of 1965-1990. It has found that nearly one to one negative association between changes in net domestic credit and NFA of the monetary authority. Money multiplier and required reserves were found significant factors affecting NFA negatively and positively respectively. In his findings, real income and domestic prices were found significant positive effect on NFA. The coefficient of foreign prices was found less significant indicating that Nepal does not have a perfectly open economy, i.e. domestic price is not determined by international prices alone. Results of his test show that changes in exchange rate have no impact on foreign assets flow. It is because the variable was found insignificant in his study. Furthermore, it states that exchange rate adjustment should be viewed as a tool to stabilize price rather than the balance of payments.
Ardalan (2005) reviewed three alternative theories of balance of payments adjustments. They are the elasticity and absorption approaches (associated with Keynesian theory), and the monetary approach. In the elasticities and absorption approaches the focus of attention is on the trade balance with unemployed resources. The elasticities approach emphasizes the role of the relative prices (or exchange rate) in balance of payments adjustments by considering imports and exports as being dependent on relative prices (through the exchange rate). The absorption approach emphasizes the role of income (or expenditure) in balance of payments adjustments by considering the change in expenditure relative to income resulting from a change in exports and/or imports. In the monetary approach, on the other hand, the focus of attention is on the balance of payments (or the money account) with full employment. The monetary approach emphasizes the role of the demand for and supply of money in the economy. Ardalan (2003, 2005a) has comprehensively reviewed the relevant empirical work dealing with the monetary approach. Empirical work on the monetary approach to the balance of payments can be divided into two different approaches; one tests the theory in long-run equilibrium, the other considers the adjustment mechanism and the channels through which equilibrium is reached.
The first approach is based on the reserve flow equation developed by Johnson (1972). Testing was undertaken by Zecher (1976) and others (See Ardalan, 2005a). The second approach is based on theoretical work of Prais (1977), with corresponding empirical work undertaken by Rhomberg (1977) and others (See Ardalan, 2003). The Monetary Approach to BOP” published in 1977, Johnson says that in a growing economy a deficit will develop if domestic credit expands more rapidly and sufficiently than real output or the growth rate of international reserves. According to him, domestic credit is the only effective, efficient and reliable long run policy to get rid of the BOP problem, which is within the control of the international policy making authorities. He believes that implementing the policies such as devaluation, import restriction or export subsidization may create surplus in BOP. But it is temporary.
Adhikari (2020) stated that major challenge to the Nepalese economy is the persistence disequilibrium in the balance of payments. This is a general economic phenomenon in most developing countries. This paper has analyzed the balance of payments for Nepal using a monetary approach using an annual data set from FY 1990/91-FY 2015/16. The main objective of this paper is to find whether the monetary variables that are money supply, income, price level, interest rate and net domestic assets are responsible to produce fluctuations in the balance of payment of Nepal or not. To achieve this objective, the paper applies a multiple regression model for time series data. The finding of the study is that monetary approach to the balance of payments is an appropriate tool to study BOP problem of Nepal. And, at present, to solve the BOP problem of Nepal effectively, the monetary measures should be applied. The domestic credit which is very much influential among the four variables exerts negative impact on the NFA of the country. Thus, domestic credit must be taken as the policy variable and controlled to correct BOP in Nepal. This study has considered only five macroeconomic variables such as money supply, income, inflation, interest and net domestic assets. Additional study should be performed in future including more variables as well as further econometric models and econometric test.
There are very few issues raised and discussed by the researchers relating to balance of payments constraints and its relationship with macroeconomic variables in Nepal.it has not been inquired in depth after the study of Khatiwada (1992). From the long period of time there is no depth study undern the issue even being huge political and economic changes made in the country. As per change in political system, various policy changes have been made which have definitely affect the economic system and macroeconomic variables in an economy. Time and again BoP is being a prominent issue in Nepal. So, the study ties to bridge the gap.
6. Methodology
This section primarily shows the major analytical framework that is adopted in this study. It covers the data source and specification of model applied to identify the relationship between balance of payments and macroeconomic variables such as gross domestic product, inflation, money supply, and exchange rate in USD of Nepal by covering the period from 1975 to 2022 A.D. The selection of variables is based on the theoretical and conceptual foundation develop by former researchers. Basically, it has followed monetary approach of balance of payments. On the basis of previous studies, four major variables are taken that influence balance of payments of a country.
Data Sources
This study employs time series data covering the period from 1975 to 2022A.D. All the necessary data are obtained from various issues of Economic Surveys, the Ministry of Finance, Quarterly Economic Bulletins od Nepal Rastra Bank and publications of the World Bank.
Model Specification
The study employs following model in logarithmic form to examine the relationship between balance of payment and macroeconomic variables in Nepal.
LNNFA = β0 + β1 LNRGDP + β2 LNM2 + β3 LNINF + β4LNEXUSD + Ut………(2)
Where,
NFA = Net Foreign Assets
RGDP = Real Gross Domestic Product
M2 = Broad money
INF = Inflation
EXUSD = US exchange rate
Ut = Error term
It is deceptive that the time series econometric analysis would be incomplete without conformation of stationary test of the variables used in the model. In addition to this, Regression run on non-stationary time series variables is casual as it produces spurious results due to high R2 and low DW value. Hence it is essential to ensure that variables are stationary. This exhibits that ‘a stationary time series has three characteristics: they are finite mean, variance and auto-covariance overtime (Gujrati, 2004). There are mainly two tests available to examine whether the time series variables are stationary or not. They are correlogram method and unit root method. The unit root test is widely used as formal statistical tests than correlogram. Dicky-Fuller (DF) and Augmented Dicky-Fuller (ADF) are extensively used tests. For the use of the unit root tests, the following equation is developed.
Yt=a+p Yt-1………………………………………………………………………(3)
The time series Y is considered stationary if p lies between -1 to 1. On the other hand, if p equals or greater than one then the time series is non-stationary. The value of p must be less than one in time series for stationary. Hence, a unit root of the time series indicates the null hypothesis of unit root test. Symbolically, H0 =1
Alternatively, the unit root test measures the following process.
ΔYt=a+δYt-1 +Ut………………………………………………………………….(4)
Where, δ = p-1
Δ = Difference operator.
In this context, the null hypothesis is that δ has zero value. Symbolically,
Ho: δ = 0
δ will be zero in case of the value of p equals to 1 and δ will be positive and greater than zero in case of the value p exceeds 1. When the value of p exceeds one, then the time series becomes volatile. It is obvious that the value of p should not exceed one for the time series to be stationary which means that the coefficient of δ must be negative with the corresponding negative ADF t- statistics and MacKinnon critical values.
Co-integration Test
Co-integration test is used to find out to test whether two or more variables are co-integrated or not. It is useful for establishing a long-run relationship between time series macroeconomic variables, as most of the macroeconomic variables, are non-stationary in their levels, trend over time and seem to follow random walk. Co-integration technique provides a tool to avoid the non-stationary time series generated spurious regressions. To examine whether any long run equilibrium relationship would exist among the variables, Engle – Granger two steps had to be followed. The Engle and Granger suggest co-integration test, which contains two steps. The first step is concerned with the estimation of Co-integration regression by using OLS, obtaining the residual Ut, while the second step involves performing unit root test for Ut. To determine an equilibrium situation, they suggest testing the null hypothesis that the value should be unit root against the alternative hypothesis that must be a root less than unity. Since Ut are estimated, new response surface critical values need to be tabulated.
ut= ρ + ut-1 + εt…………………………………………………………………………….(5)
With εt~i.i.d.(0, σ2)
One could assume three possibilities, that ρ is smaller, equal or higher than one.
If | ρ ˆ | > 1: yt ~ I(1) and xt~ I(1) then ut~ I(2),
If | ρ ˆ | = 1: yt ~ I(1) and xt ~ I(1) then ut~ I(1),
If | ρ ˆ | = 1: yt ~ I(1) and xt ~ I(1) then ut~ I(0),
Only if | ρ ˆ | < 1, a co-integration relationship exists.
Error Correction Model
Co-integration is concerned with restoration of equilibrium of the variable in long run if there is deviation in the short run, the error correction model is applied that is specified below:
DLnNFAPt = α0 + α1ECT(-1) + α2DLnRGDPt + α3DLnM2t + α4DLnINFt + α5 DLnEXUSDt + Ut…..….(6)
Where,
ECT (-1) = One Year Lag of Error Correction Term
D = First Difference
7. Empirical Analysis
The results and analysis of the study have been carried out by adopting Engle Granger two step procedure. It is presented below:
Table 1: Stationary Test: Unit Root Test
| Variables | ADF Test Statistic | t- statistic |
| 1% | 5% | 10% | |
| LNNFA (None) | -2.6162 | -1.9481 | -1.6123 | 3.2148 |
| LNNFA with C | -3.5812 | -2.9266 | -2.6014 | -0.5145 |
| LNNFA with C and T | -4.1706 | -3.5107 | -3.1855 | -1.9298 |
| DLNNFA with C | -3.5847 | -2.9281 | -2.6022 | -3.5642 |
| DLNINF(None) | -2.6173 | -1.9483 | -1.6122 | -9.7424 |
| DLNM2(None) | -2.6174 | -1.9483 | -1.6122 | -1.0319 |
| DLNM2 with C and T | -4.1756 | -3.5130 | -3.1868 | -3.6697 |
| ECT-1(None) | -2.6198 | -1.9487 | -1.6120 | -2.9709 |
| DLNRGDP(None) | -2.6173 | -1.9483 | 1.6122 | -0.7208 |
| DLNRGDP with C | -3.5847 | -2.9281 | -2.6022 | -3.8973 |
| LNEXUSD(None) | -2.6173 | -1.9483 | -1.6122 | -2.7300 |
LNNFA = -40.95172 + 3.6873LNRGDP -0.08058 LNM2 + 0.0606 LNINF + 0.5273LNEXUSD ………(7)
R2 = 0.98, DW= 0.56
The equation 7 shows the long run relationship between net foreign asset with other explanatory variables such as real gross domestic product, money supply, inflation rate and exchange rate in UD dollar. There is positive relationship between GDP, inflation and exchange rate in US dollar with NFA and negative relationship with broad money supply during the long run. The value of R2 is too high and DW value is low and very weak. The result is spurious for cointegration test.
Table 2: Engle – Granger Co-integration Test
| Variables | ADF t- statistic | Response Surface Estimates of Critical Values |
| ECT (none) | -4.6052 | -5.416* |
| ECT with C | -4.5880 | -4.700** |
| ECT with C and T | -4.5385 | -4.348*** |
* Indicates level of significance at 1 percent or less
**Indicates level of significance at 5 percent or less
*** Indicates level of significance at 10 percent or less
The estimated results show that the ADF test statistic is greater than the response surface estimates of critical values at less than 10 percent,5 percent and 1 percent. Hence, the study accepts H1 and makes concluding observation that series is co-integrated. The results confirm the presence of long-run relationship between the NFA and the explanatory variables incorporated in the model.
Error Correction Model
The output from the Error Correction Model is expressed as:
DLnNFAPt = 0.0056 – 0.1816ECT(-1) – 0.3924DLnRGDPt + 8951DLnM2t + 0.0253DLnINFt + 0.9259DLnEXUSDt …….(8)
R2= 0.38 DW = 1.71
The result of error correction model reveals that the coefficient of the lagged residual is negative but statistically significant at 5 percent level. It implies that around 18 percent of the deviation is corrected in short run so as to obtain the original equilibrium. It expresses short term relationship between dependent variable and explanatory variables. However, all the explanatory variables real gross domestic product and inflation are statistically found insignificant for net foreign assets of Nepal. However, the results are mixed with the theoretical foundation. The interesting finding is that money supply has positive impact on NFA. Even exchange rate with USD has also positive impact on NFA.
8. Conclusion, Discussion and Implications
The study concludes that there is long run positive relationship between money supply and balance of payment in Nepal. Thus, monetary policy works in the long run to address the problem of balance of payment in the country. Similarly, there is positive association between balance of payment to exchange rate. The result if contradictory with the findings of Mainaly (1989) and in some variables similar findings with Khatiwada (1992). Money supply, inflation and exchange rate have positive impact on net foreign assets. During the short run inflation may have inducement effect on growth via investment. High exchange rate of US dollar may have reduced import and reduced outflow of currency. It might be the result of lack of full convertibility of capital account in case of Nepal. The study guides the policy makers to make necessary initiative for achieving the goal of maintaining external sector stability in the country. Unstable balance of payment situation is the main external sector problem in Nepal. It is always in top priority of macroeconomic policies of Nepal. Therefore, the study helps to address the problem by making necessary corrections by changing demand side and supply side variables in an economy.
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