Monetary Policy and Nepal Rastra Bank
Structure of Nepalese Economy and Monetary Policy
Evolution of monetary policy of Nepal took place at a time when monetary deepening was very low, when there were only a few financial institutions, and when the degree of monetization was very low.
The economy was mostly of subsistence nature with agriculture contributing more than 90 per cent of the economic activities.
Till mid 1960s, narrow money to Gross Domestic Product (GDP) ratio was 8 per cent only and broad money to GDP ratio was less than 10 per cent compared with 20 per cent in India and 23 per cent in Sri Lanka. There was a small change in the structure of the economy till 1980s. The process of monetization speeded up in the 1980s by virtue of aggressive bank branch expansion and massive injection of money through the fiscal deficit. The outward orientation of the economy also played a key role in this process.
Stage of monetization has a significant bearing on the conduct of monetary policy. First, income elasticity of money demand tends to be high in an economy which is monetizing; hence, monetary targeting without due consideration to this process can suppress economic activities. Second, the scope of monetary policy is defined by the stage of monetization and success of the objectives of monetary policy to attain higher output and employment, if any, is contingent upon this. Third, monetary policy itself has a role to speed up monetization and financialization of savings so that allocative efficiency of limited resources could be maximized through the process of formal financial intermediation. As the process of monetization speeded up in the 1980s and 1990s along with deepening of the financial system, a wider room for monetary policy operation could be created by that time.
External trade, foreign exchange openness, and exchange rate regime also shape the course of monetary policy. Nepal started looking outwards in terms of economic relations right since the 1950s, and evolution of external trade and foreign exchange regimes began in the 1960s. However, trade-GDP ratio was less than 15 percent till 1970. Both trade and foreign remained controlled till early 1990 and exchange rate remained fixed until mid 1980s when a more flexible currency basket system of exchange rate determination was introduced. But Nepal could never evolve to a fully flexible exchange rate regime from fixed exchange rate system against Indian rupee. Neither there was much room for divergence in macroeconomic policies the country could adopt from those of India. Open border, trade concentration, fixed exchange rate regime, and free and unlimited convertibility of currency still continue to shape the course of Nepal’s macroeconomic policies; and this also limits the exercise of independent monetary policy even today.
There have been noteworthy structural shifts in the Nepalese economy—composition of GDP has changed from more than 90 per cent share of agriculture in 1960s to less than 40 per cent now, trade-GDP ratio has exceeded 40 per cent, foreign exchange regime has been liberalized, and much monetary and financial deepening have taken place with broad money-GDP ratio at more than 56 percent in 2004. But some fundamentals in the exercise of monetary policy have not yet changed from the establishment of NRB in 1956 to date. Nor have the relationships between macroeconomic variables like prices, interest rate and exchange rate diverged significantly. So long as Nepal continues to have current trade, payments, and foreign exchange regime with India, there is not much maneuverability in the country’s monetary policy as well. Structural changes in the economy seem to demand shift in macroeconomic policies as well; but, as the following sections will reveal, the room for such policy shift remains fairly limited.
Evolutionof Nepal’s Monetary and Credit Policies
Nepal Rastra Bank began exercising monetary policy since mid 1960 with instruments like credit control regulations, interest rate administration, margin rates, refinance rate, and cash reserve ratio. In the 1970s, liquidity requirements, credit limits / ceilings and directed credit programmes were introduced. Open market operations evolved only in the 1990s with policy shift from direct to indirect monetary control. Effective exercise of cash reserve requirement and bank rate as active monetary policy tools evolved even later—since late 1990s. The basic objectives of monetary and credit policies have been fostering growth, generating employment, addressing poverty, containing prices, promoting external trade and attaining healthy balance of payments of the country. As so many objectives had been assigned to monetary and credit policies, it was hard to attain all of them, many of them conflicting to each other. Also the distinction between monetary and credit policies remained blurred and assessment of the impact of monetary policy became difficult. Recent shift of the monetary policy objectives from growth focus to stability has to some extent enhanced its credibility. But still the hangover of setting multiplicity of objectives is there in the policy-making institutions.
Monetary and Credit Policies: a Distinction
Often monetary and credit policies are interpreted in the same way. Nepal Rastra Bank has also been exercising monetary and credit policies through the same banner. But monetary and credit policies are not exactly the same. Monetary policy is defined as a policy affecting changes in the quantity of money while credit policy is defined as a policy affecting the cost, availability, and the allocation of credit. Money differs from credit because (i) money is the liability of the banking system whereas credit is an asset, (ii) money refers to banking system only whereas credit has a wider coverage; it consists of lending of all the banks and non-banking institutions, and (iii) money is the most liquid form of assets whereas credit is not. But money is created in the process of credit creation and therefore they are two facets of the same coin.
There is no specific theory of credit demand as the theory of demand for money. The theory of demand for money regards real income or output, interest rate and inflation as the major factors affecting the demand for money. These may be taken also the factors affecting demand for credit, but with a point of caution. Demand for money is for transaction and asset purpose whereas demand for credit is for investment or consumption purpose.
As an instrument of monetary policy, interest rate can be used for encouraging or discouraging credit flows of the banking system and hence money supply. When control of money or credit supply is the need, interest rate structure may be revised upward. If the central bank has no direct control over the interest rate structure of the commercial banks, the same can be done indirectly through open market operations and changes in the bank rate. But control of money supply or credit through interest rate is possible only if market interest rate is sensitive to bank rate and if market borrowing is also sensitive to bank lending rates.
Interest Rate as a Monetary Policy Variable
In the Nepalese context, money supply is supposed to be the superior policy variable than interest rate on several counts. First, various empirical studies have shown that money supply is closely related with policy goals like money income, prices, and balance of payments than interest rate is. Second, though money supply is an endogenous variable, affected by policy autonomous factors also, the effects of policy induced factors on it are more dominating and thus more prone to manipulation than interest rate. In the recent years, interest rates are liberalized and the Nepal Rastra Bank has no direct control over them. And, indirect policy tools such as bank rate or discount rate or refinance rate cannot effectively work as a tool for attaining the desired level of market interest rate. This is because financial market is still narrow, shallow and fragmented; and inter-financial institutional flow of fund is very limited. The existing number of commercial banks and the level of competitiveness in the financial market have not allowed interest rate structure to evolve through a perfect market mechanism. Further, there is a great deal of difference in the level of interest rates on loans between the formal and informal markets. Informal market rates for borrowing are much higher than the formal market rates which signal that availability rather than cost of credit is the major determinant of credit supply in the economy.
But in a situation when banks are themselves over liquid and do not resort to central bank borrowing for financing their lending activities, revision of bank rate by the Nepal Rastra Bank makes no difference and commercial bank lending rates do not necessarily change. This is the reason why bank rate has not yet evolved as a potent tool of credit control or monetary management in Nepal.
Interest rate spreads indicate the level of financial intermediation cost. The higher the interest rate spread, the higher is the financial intermediation cost. Persistent higher intermediation cost causes financial disintermediation. The liberalisation of the whole interest rate structure was directed at fostering competition among the financial institutions. Consequently, it was thought that competition would bring down the interest rate spread. However, as there was no such achievement ,a number of factors still hold the spread at a higher level. They include (i) segmentation of financial markets, (ii) high non-performing loans and lenders’ temptation for high risk premium (iii) inefficiency of the large commercial banks and development banks under state equity capital. There is not much scope for exercising interest rate as an independent monetary policy tool at this stage of the financial reform.
Role of Autonomy in the Conduct of Monetary Policy
Central bank is the apex financial institution assigned the task of designing and operating monetary policy, regulating / supervising the financial system, and ensuring a healthy growth of the payments system in the country. The successful operation and conduct of monetary policy by the central bank in terms of achievements of its policy objective is, however, closely associated with the degree of independence the central bank obtains from the government
When NRB came into existence in 1956, the preamble of NRB Act, 1955 stated the objectives of its establishment as (i) to insure proper management for the issue and circulation of Nepalese currency throughout the kingdom, (ii) to stabilize the exchange rates of Nepalese currency in order to ensure convenience and economic interests of the general public, (iii) to mobilize capital for development and encourage trade and industry in the kingdom and (iv) to develop the banking system in Nepal. There was no limit of government borrowing and exchange rate was also directed by the government.
The new Nepal Rastra Bank Act, 2002 has been instrumental to ensure autonomy and correct the anomalies inherent in the NRB Act. The major objectives of monetary policy have been maintaining price stability(inflation control), external sector stability(foreign exchange stability and BOP), financial sector stability, and thereby facilitating a high and sustainable economic growth. There are now statutory limits to central bank borrowing, freedom for the fixation and management of exchange rate and managing the financial system.
But one single statutory objective for monetary policy could not be fixed in the legislation for obvious reasons. Nepal is a small open economy with open border with India. Empirical studies have shown that Indian prices have greater influences on Nepalese prices. This implies that the central bank could not be assigned domestic price stability as the sole objective. Monetary policy has a lesser role in controlling inflation when its sources are oil price rise and increasing food prices rather than the expansion in aggregate demand. In the short-term horizon, monetary policy alone cannot control inflation. Theoretically, monetary policy can be used to bring price stability only in the medium to long-term horizon. An exchange rate regime of the present type in a capital controlled regime did not fully support exchange rate targeting. And, achieving a higher economic growth rate could not also be the objective of monetary policy because of weak relationship of monetary variables with real GDP. Since the last few years, strengthening of the financial sector stability has been one of the important objectives of this bank. To achieve this objective, various financial sector reform programs have been implemented. But the result is not satisfactory. The financial sector of Nepal, however, is not yet free of risk. The NPL of commercial banks as mentioned above still stands at 18 percent. In terms of absolute amount, the amount of nonperforming loan stood at Rs.29.0 billion as of mid- April 2006. Thus, maintaining financial sector stability is still a daunting task for Nepal. The mounting level of NPL of problem banks, RBB at 50.9 percent and NBL at 43.4 percent, has resulted in a higher aggregate NPL level in Nepal's banking system. There is also serious note of the high growth of NPL in some private sector commercial banks (NB Bank, United Development Bank etc).
Transmission Mechanism of Monetary Policy
Monetary policy objectives have traditionally included promoting growth, achieving full employment, smoothing the business cycle, preventing financial crises, and stabilizing long-term interest rates and the real exchange rate. Although some objectives are consistent with each other, others are not; for example, the objective of price stability often conflicts with the objectives of interest rate stability and high short-run employment. Many countries have place greater emphasis on the objective of low inflation. This recent shift has been triggered by strong empirical evidence that high inflation (and its associated high variability) distorts the decision-making of private agents with regards to investment, savings, and production, and ultimately leads to slower economic growth. The liberalization of exchange rate regime, capital account liberalization, and growing trade openness have made many countries to shift monetary policy objectives from domestic to external sector stability while some others have opted for inflation targeting as a single most objective.
Price and external sector stability (exchange rate/ balance of payments) are probably the most important goals of monetary policy in Nepal. Excess money supply causes an upward pressure in the level of prices by increasing aggregate demand in the economy in the wake of inelastic supply of output. So monetary policy purports to contain prices by not allowing money to increase in excess of the desired demand for it. However, the control of money over inflation would be contingent upon the share of non-tradable goods and services in the consumer basket and the degree of demand side pressure on prices. As about one-third of the items under consumers’ price index in Nepal are non tradable, and as excess demand is often a cause for price rise, targeting inflation as monetary policy objective is not irrelevant. Regarding balance of payments stabilization, it is observed that in an open economy, excessive monetary liquidity leads to higher aggregate demand and if the demand cannot be met by domestic supply of goods and services, imports from abroad would increase. This would cause deterioration in the balance of payments of the country. Proper monetary planning prevents the economy from such a situation. Price stability can also be instrumental for a healthy balance of payments because stable prices not only help maintaining export competitiveness of the country but also encourage foreign capital inflow in the country, both of which contribute to healthy balance of payments position. With the liberalization of the external sector and introduction of a more flexible exchange rate system, the objective of monetary policy is also to ensure a stable exchange rate of the domestic currency.
Monetary Policy Variable(s) and Instruments
The main monetary policy variables at the disposal of the monetary authority for achieving ultimate targets are the quantity of money, bank credit, and interest rates. Broadly, two schools of thought prevail on the choice of appropriate policy variable. Keynesian economists prefer interest rate as the proper monetary policy variable whereas quantity theorists opt for money as the appropriate policy variable. Many others from neo Keynesians and Radcliff economists to open economy monetarists advocate for credit as the proper policy variable; although the definition of credit and the objective assigned to this variable are different. In the Nepalese context, money supply is supposed to be the superior policy variable than interest rate on several counts.
In the Nepalese context, money supply is supposed to be the superior policy variable than interest rate on several counts. First, various empirical studies have shown that money supply is closely related with policy goals like money income, prices, and balance of payments than interest rate is. Second, though money supply is an endogenous variable, affected by policy autonomous factors also, the effects of policy induced factors on it are more dominating and thus more prone to manipulation than interest rate. In the recent years, interest rates are liberalized and the NRB has no direct control over them; and, indirect policy tools such as bank rate or discount rate cannot work as the signal for a desired level of market interest rate in the wake of underdeveloped financial markets, particularly when financial layering ratio is very low or nonexistent.
An alternative to quantity of money as a policy variable is bank credit. It is argued that in an open economy with a fixed exchange rate regime, balance of payments becomes an additional source of money supply. Under such situation, the monetary authority can control only the domestic component of the money stock (net domestic credit). Given this, money supply cannot be characterized as an independent policy variable and domestic credit, which is independent of policy goals, should be regarded as the policy variable. However, as discussed earlier, there is no well-developed theory of the supply of credit effect on economic activities, particularly on income and price, as the theory of the effect of money supply is. Thus money is to be preferred over credit as the policy variable.
Monetary policy instruments in general can be listed as bank rate (BR), open market operation (OMO), cash reserve requirement (CRR), statutory liquidity requirement (SLR), administered interest rate, credit ceiling, margin rate, and moral suasions. In a liberal financial system, only the indirect means of monetary control like OMO, CRR and BR are exercised. That is what Nepal has been doing for the last one decade and a half.
The “Impossible Trinity” and Dilemma of Nepal’s Monetary Policy
The impossible trinity is achieving three things at the same time: exchange rate stability, free flow of international capital and an autonomous monetary policy (which means the ability to target inflation and/ or interest rates). It is not possible for straightforward reasons: if capital is free to move in and out, and the exchange rate is fixed, then money can swing in and out in huge quantities and play havoc with domestic inflation and interest rates — which then rules out an autonomous monetary policy. Similarly if interest rate is targeted, monetary aggregates might move beyond desired level (depending upon interest elasticity of money or credit demand) having its implication for external sector balances. In a perfectly open economy case, excess or deficient money supply would then change the course of capital flows, ultimately thwarting the target of interest rate level.
There is a view that real interest rate has to be positive in order to encourage financial savings mobilization. So there is a temptation to control interest rate along with targeting monetary aggregates.
Targeting an inflation of less than 5 per cent and attempting to maintain interest rate at a level close to that in India means that both interest rates and money supply have to be at the disposal of the authorities. In a market related monetary and financial structure, this cannot be attained through direct interventions.
Take the exchange rate case next. The central bank has traditionally tried to defend the peg with Indian currency. That policy still holds, which means that the central bank wants one of the legs of the trinity: stable exchange rates. At a time of high capital flows, more frequent interventions have to be made to defend the current peg. Non-sterilized interventions in the foreign exchange market then have serious implications for monetary aggregates which impinge upon prices and balance of payments.
Talking about the third aspect of the impossible trinity that is free flow of capital, Nepal has so far loosely maintained capital control. But institutional capital flows mainly through the banking system and from the private sector individuals towards India remains unregulated. Thus, if the domestic rupee is ruling stronger than what the central bank would like, and if there is cross border difference in interest rates even in fixed exchange rate regime, there is a possibility of strong capital flows from/to the country which would affect directly the exchange rate or would indirectly affect the same through the balance of payments.
In an economy with shallow domestic financial system and high potential for capital flows, monetary targeting for inflation control and exchange rate targeting to defend the peg would be a difficult task for the central bank. In the similar vain, defending a peg would imply a loss of autonomy in monetary operation. This means that NRB has perhaps some times in future to make a hard choice between breaking the peg and loosing monetary autonomy.
The basic objective of monetary policy is economic stability – both internal and external. Economic stability implies containing inflation, stabilizing the interest rate and the exchange rate which would promote investment for economic growth. The relationship between money supply and inflation is weak in Nepal. This reveals that money supply has very limited role in determining inflation in Nepal. There are other domestic and external variables like domestic supply side costs, imported prices and exchange rate which influence the inflation rate.
There have been noteworthy structural shifts in the Nepalese economy in the recent decades. The composition of GDP has changed with services sector emerging as nearly the largest sector, trade-
GDP ratio has increased, foreign exchange regime has been liberalized, and much monetary and financial deepening has taken place. But some fundamentals for the exercise of monetary policy have not yet changed. Nor the relationships between macroeconomic variables of Nepal and India like prices, interest rate and exchange rate have diverged significantly. So long as Nepal continues to have current trade, payments, and foreign exchange regime with India, there is not much maneuverability in the country’s monetary policy as well. Structural changes in the economy seem to demand shift in macroeconomic policies as well; but the room for such a policy shift in the near future remains fairly limited. Special characteristics of the Nepalese economy imply that monetary policy continues to have more than one objective to meet. They are attaining price and external sector stability. These objectives are so far mutually consistent, exchange rate changes affecting more inflation than trade and money supply growth affecting balance of payments more than inflation, a typical case of an open and small economy. However, as economic sophistication deepens further with opening of the economy and financial deepening, macroeconomic relationships are bound to shift. A structural shift in the economy would allow the central bank to move from multiple objectives of monetary policy to a single one. But whether it will be inflation or exchange rate depends on the nature of the shift it might take. A move away from monetary aggregates to new instruments of monetary policy will also depend on the changes of basic macroeconomic relationships.