Making monetary policy work
Amid a structural liquidity crisis in the banking sector, increasing pressure on foreign exchange reserves, growing trade deficit and inflation, Nepal faces a huge challenge to maintain harmony. between its fiscal and monetary policies. In this difficult situation, an expansionary budget set the target of an economic growth rate of 8% and an inflation rate of 7% for the financial year 2022-23. Following an unnatural fiscal policy, the importance of monetary policy and the credibility of the central bank should not be compromised. Nepal Rastra Bank introduced a flexible policy last year, with various relief programs to ease the economic impact of the Covid-19 outbreak. A tight monetary policy for FY 2022-23 aims to maintain financial stability, external sector stability, and price stability.
The main challenges in the banking sector are liquidity and credit risks. An increase in the credit to deposit ratio stands at 86.22%, which is below the upper threshold of 90% prescribed by the Nepal Rastra Bank. The interbank rate exceeded its upper limit and rose to 7%, indicating continued pressure on bank funds as it will be difficult for them to provide loans immediately. The current liquidity crisis is distinct since it resulted from the inability of banks to meet borrowers’ demand for funds when economic activity increased after the pandemic. Monetary policy for FY 2022-23 calls for growth in broad money supply and private sector lending of 12 and 12.6 percent respectively. This is the first time in many years that the target for credit and money supply growth has been kept at such a low level.
The cash reserve ratio, a percentage of cash that must be kept in reserve relative to the bank’s total deposits, will increase from 3% to 4% from mid-August this year. While the statutory liquidity ratio, which is the minimum amount of deposits the bank must keep in the form of cash, gold or other securities, will be raised from 10% to 12% by mid-January next year. The central bank aims to limit refinancing facilities to the productive sector such as agriculture, energy, transport and exports. In mid-June 2022, the NEPSE index stood at 1996.3, compared to 3025.8 in mid-June 2021. A tightening of the money supply is likely to have a negative impact on stock prices. If most of the credit goes to the productive sector, a credit growth rate of 12-15% is enough to achieve a high economic growth rate. Credit flows consistent with deposit growth should be concentrated in areas that can directly support economic growth over the next decade.
External sector stability
The country is in urgent need of structural transformation. As the challenge is structural, short-term solutions must be devised through structural reforms. In terms of short-term solution, it is necessary to manage credit expansion and sectoral distribution, control high imports and increase remittances through formal channels to ease the pressure on the external sector by realizing savings on the balance of payments. Central bank officials have repeatedly acknowledged that the majority of credit was used to finance imports, which contributed to widening the balance of payments deficit and depressing foreign exchange reserves. In the current situation, monetary policy should encourage the private and banking sectors to be more responsible and accountable when using credit. The private sector no longer benefits from the ease of importing with loans as in the past. The private sector should be responsible and play an active role in import substitution (increase domestic production instead of imports). With supportive government policies, the private and banking sectors should work together to increase domestic production.
The Russian-Ukrainian war and supply chain bottlenecks have crippled the global economy. These exogenous factors have driven up the price of energy, food and other basic necessities as the global economy is still recovering from the Covid-19 pandemic. According to the latest report on the macroeconomic and financial situation of Nepal Rastra Bank, consumer price inflation (CPI) reached 8.56% in the first 11 months of the financial year 2021-22, against 4, 19% the previous year. India’s CPI stood at 7.01% in June 2022. Therefore, inflation in Nepal is likely to rise. Consumption had increased dramatically in Nepal and money was being paid to pay for imported goods, reducing foreign currency reserves. The rapid depreciation of the Indian rupee against the US dollar continues to be a significant concern. Since the beginning of 2022, the Indian rupee has lost more than 6% of its value. The Nepalese rupee had depreciated against the dollar by 6.64% by mid-July 2022, compared to a year ago. Since the central bank alone cannot control inflation, tight monetary and supportive fiscal policies, combined with prudent measures, should help keep inflation under control.
The practice of intervention in monetary policy matters by ruling political parties is a serious departure from good governance. Such an approach institutionalizes the wrong culture and pushes the economy in the wrong direction. Nepal Rastra Bank should be independent and work within its system to find solutions to monetary policy issues.
The International Monetary Fund (IMF) has urged Nepal to tighten monetary policy to maintain macroeconomic stability. International financial institutions have expressed concern over the low level of non-performing assets in Nepal. Considering that banks’ non-performing assets are an important criterion for assessing the financial health of the banking sector, a higher concentration of these assets in the banking sector poses systemic risk and significantly slows credit expansion. At the end of the current fiscal year, the countercyclical buffer, a macroprudential tool designed to mitigate potential cyclical systemic risks among banks, will be put in place. This policy tool was suspended last year in an effort to improve credit flow during the Covid-19 pandemic. Banks will need to raise capital in order to stimulate the flow of loans when the countercyclical buffer clause is reinstated. The Macro Stress Testing Framework should regulate the banking sector more effectively by improving its health and the quality of its assets. Finally, the central bank should use macroprudential instruments to reduce volatility and vulnerabilities in the financial system and maintain macroeconomic stability.