The challenges of the new monetary policy

Nepal Rastra Bank issued a to remark asking for “opinions and suggestions” on the monetary policy going forward for the next fiscal year 2022-23. There is no doubt that Nepal’s economy is going through difficult times due to its chronic and growing vulnerabilities associated with emerging global economic adversities triggered in particular by the protracted Russian-Ukrainian war.

The main economic indicators are already alarming. During the first 10 months of the current financial year, consumer prices inflation (CPI) jumped to 8% from its target of 6.5%. The balance of payments shows a deficit of 2.41 billion dollars. The trade deficit in merchandise imports over the past 11 months has increase by 25% to 1,577.4 billion rupees. The share of exports in total foreign trade remains below 10%. In addition, the services trade deficit also exceeded Rs 90 billion. By the end of this fiscal year (July 15), the total trade deficit, including imports of services, is expected to hit the $20 billion mark.

Workers’ remittances, which remain the main source of foreign currency inflows to offset the deficit, also fell 1.6% to $6.76 billion. Foreign exchange reserves also declined to $9.28 billion from $11.75 billion at the start of the current fiscal year. These indicators show enormous pressure on foreign exchange reserves to cope with the soaring trade deficit on their own.

Expansionary fiscal policy

Despite growing constraints and risks, the government has presented an unsustainable expansionary budget for the next fiscal year 2022-23, with an 8% growth target. The budget speech instructs the central bank to “formulate a monetary policy to contain the inflation rate to less than 7% in order to achieve economic growth and maintain macroeconomic stability”.

The budget proposes 31% deficit financing on its expenditure of Rs 1.794 billion. The biggest challenge for monetary policy is to control inflation while increasing the money supply to meet the government’s plan to raise 256 billion rupees in domestic loans.

Of course, like most central banks around the world, Nepal Rastra Bank also has a dual mandate to facilitate the government’s set economic growth target and control inflation. But when the government conducts an excessively expansionary fiscal policy like the current policy, containing inflation by introducing a restrictive monetary policy becomes a constraint for the monetary authority. There is no doubt that these two objectives, ensuring growth and containing inflation, are competing objectives. But this is precisely where central bank independence, coupled with functional coordination between fiscal and monetary authorities, matters most.

External factors

Several worrisome external economic factors are sure to cast their shadow over the next monetary policy. Nepal is the victim of a sharp rise in the prices of mainly oil and food products, looming food insecurity amid broken supply chains and increased volatility in international financial markets, and it is already feeling the heat. of these developments. For fuel, Nepal depends entirely on imports. Nearly a third of Nepal’s total imports consist of agricultural and animal products. The strict peg of the Nepalese rupee to the Indian rupee has generally provided a much-needed cushion for economic stability; but during times of such global economic crises, this arrangement forces us to borrow against both inflation and currency depreciation, regardless of our economic resilience, if any.

Inflation in the Eurozone (the group of 19 countries that use the euro as their common currency) is already the highest ever, at 8.6%. In the USA, the prices were raised at the same level last year, the largest increase since 1981. Consumer price inflation in India was 7.04% in May, mainly due to reductions in excise duties on petroleum products. But fast depreciation of the Indian rupee against the US dollar remains a significant concern. It has lost more than 6% of its value since the start of 2022, including almost 2% in June, hovering at INR 79 per dollar.

As mentioned above, the political tandem and functional coordination between the country’s fiscal and monetary authorities is inevitable in navigating the economy through such a plethora of challenges. Unfortunately, at present, relations between Nepal Rastra Bank Governor Maha Prasad Adhikari and Finance Minister Janardan Sharma have hit rock bottom since Adhikari was suspended by the government at Sharma’s request, but has reinstated by a Supreme Court verdict. Instead of resigning on moral grounds, Minister Sharma now appears to be exerting further psychological pressure on Adhikari to implement an equally expansionary monetary policy to enable the mobilization of financial resources for his populist agendas.

Despite fiscal policy imperatives, future monetary policy can barely afford to be as expansionary as budgeted given the emergence of unprecedented inflationary risks. As things stand, Nepal’s central bank sits on a mountain of accumulated problems that plague the financial system. The protracted loanable liquidity crisis in the banking system shows no signs of easing. Its effect on the real estate sector has been crippling, with investment, productivity and a sharp drop in the capital market due to unaffordable interest rates. It now has minimal leeway to further reduce the credit-to-deposit ratio which has already crossed the 90% mark.

There are many reports of the misuse of directed lending programs aimed at agriculture and small businesses. The cost of financing loans to marginalized and economically disadvantaged groups is, ironically, the highest beyond justification.

Nepal Rastra Bank still devotes much of its organizational energy to the traditional regulatory and supervisory role. By contrast, major central banks around the world have already outsourced this responsibility to focus on the core function of system stability and inflation control. It is undoubtedly high time for the Central Bank of Nepal to calibrate the decade-old monetary policy model and undertake a comprehensive review of its policy implementation. But additional external and internal constraints seem to be holding back its progress towards that end, even now.

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