Exchange Rate Misalignment in Nepal

Nepal has a large and persistently growing trade deficit with India and an overall negative trade balance. Its economy is growing slowly relative to India’s, while the exchange rate is pegged with India at a parity that is believed to be overvalued. In this article, possible misalignment of Nepal’s real effective exchange rate is considered by estimating a behavioural equilibrium exchange rate, using a set of fundamentals for the period 1975–2008. The estimates from the Johansen (1988) cointegrated vector autoregression (VAR) model as well as a single-equation bounds-testing approach to cointegration suggest that Nepal’s trade-weighted real exchange rate was overvalued in the last decade-and-a-half.