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Nepal Rastra Bank in Fifty Years Part III-Macroeconomy

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Nepal Rastra Bank in Fifty Years Part III-Macroeconomy MONETARY POLICY 277 Part III Macroeconomy MONETARY POLICY 279 Monetary Policy Dr. Yuba Raj Khatiwada Executive Director, Office of the Governor Structure of the Nepalese There was a small change in the Economy and the Role of structure of the economy till 1980s. The Monetary Policy Multipurpose Household Survey of Nepal Rastra Bank (NRB, 1989) showed Evolution of monetary policy of 58 per cent of the household income in Nepal took place at a time when monetary kind, 57 per cent of the rural deepening was very low, when there were consumption on home produced goods only a few financial institutions, and when and services, 84 per cent of the the degree of monetizations was very low. consumption expenditure was on The economy was mostly of subsistence domestic goods and services in 1984/85. nature with agriculture contributing more The monetary deepening was still low with broad than 90 per cent of the economic activities. Till mid money supply/GDP ratio remaining at 28 per cent. 1960s, narrow money to Gross Domestic Product The comparable figures for India and Sri Lanka at (GDP) ratio was 8 per cent only and broad money that time were 43 per cent and 31 per cent to GDP ratio was less than 10 per cent compared respectively. However, the process of monetization with 20 per cent in India and 23 per cent in Sri Lanka. speeded up in the 1980s by virtue of aggressive bank Financialization of assets was very low even till the branch expansion and massive injection of money end of 1960s. Agricultural Credit Survey done in through the fiscal deficit. The outward orientation 1969/70 revealed financial assets of the households of the economy also played a key role in this process. comprising not more than 4 per cent with land Stage of monetization has a significant bearing building and livestock comprising more than 90 per on the conduct of monetary policy. First, income cent of the household assets (NRB, 1972). In 1969/ elasticity of money demand tends to be high in an 70, only 38 per cent of the households were borrower economy which is monetizing; hence, monetary of one kind or the other. Of the borrowers, more targeting without due consideration to this process than 42 per cent borrowed in kind. Of the total can suppress economic activities. Second, the scope borrowing amount, 24 per cent was in kind. Nearly of monetary policy is defined by the stage of 78 per cent of the household expenditure used to monetization and success of the objectives of go on food consumption; another 6 per cent was monetary policy to attain higher output and spent on clothing and footwear; thus leaving only 16 per cent of the expenditure on other consumption. employment, if any, is contingent upon this. Third, The share of institutional credit in total borrowing monetary policy itself has a role to speed up was 18 per cent only of which the share of formal monetization and financialization of savings so that financial institutions was one third (6 per cent). allocative efficiency of limited resources could be 280 NEPAL RASTRA BANK IN FIFTY YEARS maximized through the process of formal financial Evolution of Nepal’s Monetary and Credit intermediation. As the process of monetization Policies speeded up in the 1980s and 1990s along with Nepal Rastra Bank began exercising monetary deepening of the financial system, a wider room for policy since mid 1960 with instruments like credit monetary policy operation could be created by that control regulations, interest rate administration, time. margin rates, refinance rate, and cash reserve ratio. External trade, foreign exchange openness, and In the 1970s, liquidity requirements, credit limits / exchange rate regime also shape the course of ceilings and directed credit programmes were monetary policy. Nepal started looking outwards introduced. Open market operations evolved only in terms of economic relations right since the in the 1990s with policy shift from direct to indirect 1950s, and evolution of external trade and foreign monetary control. Effective exercise of cash reserve exchange regimes began in the 1960s. However, requirement and bank rate as active monetary policy trade-GDP ratio was less than 15 percent till 1970. tools evolved even later—since late 1990s. The basic Both trade and foreign remained controlled till objectives of monetary and credit policies have been early 1990 and exchange rate remained fixed until fostering growth, generating employment, addressing mid 1980s when a more flexible currency basket poverty, containing prices, promoting external trade system of exchange rate determination was and attaining healthy balance of payments of the introduced. But Nepal could never evolve to a country. As so many objectives had been assigned to fully flexible exchange rate regime from fixed monetary and credit policies, it was hard to attain all exchange rate system against Indian rupee. Neither of them, many of them conflicting to each other. there was much room for divergence in Also the distinction between monetary and credit macroeconomic policies the country could adopt policies remained blurred and assessment of the from those of India. Open border, trade impact of monetary policy became difficult. Recent concentration, fixed exchange rate regime, and free shift of the monetary policy objectives from growth and unlimited convertibility of currency still focus to stability has to some extent enhanced its continue to shape the course of Nepal’s credibility. But still the hangover of setting multiplicity macroeconomic policies; and this also limits the of objectives is there in the policy-making institutions. exercise of independent monetary policy even today. Monetary and Credit Policies: a Distinction There have been noteworthy structural shifts in Often monetary and credit policies are interpreted the Nepalese economy—composition of GDP has in the same way. Nepal Rastra Bank has also been changed from more than 90 per cent share of exercising monetary and credit policies through the agriculture in 1960s to less than 40 per cent now, same banner. But monetary and credit policies are trade-GDP ratio has exceeded 40 per cent, foreign not exactly the same. Monetary policy is defined as a exchange regime has been liberalized, and much policy affecting changes in the quantity of money monetary and financial deepening have taken place while credit policy is defined as a policy affecting the with broad money-GDP ratio at more than 56 per cost, availability, and the allocation of credit. Money cent in 2004. But some fundamentals in the exercise differs from credit because (i) money is the liability of monetary policy have not yet changed from the of the banking system whereas credit is an asset, (ii) establishment of NRB in 1956 to date. Nor have money refers to banking system only whereas credit the relationships between macroeconomic variables has a wider coverage; it consists of lending of all the like prices, interest rate and exchange rate diverged banks and non-banking institutions, and (iii) money significantly. So long as Nepal continues to have is the most liquid form of assets whereas credit is current trade, payments, and foreign exchange regime not. But money is created in the process of credit with India, there is not much maneuverability in the creation and therefore they are two facets of the country’s monetary policy as well. Structural changes same coin. in the economy seem to demand shift in The authorities have to make a choice between macroeconomic policies as well; but, as the following monetary and credit policies. One reason why sections will reveal, the room for such policy shift monetary policy is preferred over credit policy as a remains fairly limited. macroeconomic policy variable is the underlying MONETARY POLICY 281 theoretical developments. There is no specific theory of the banking system and hence money supply. of credit demand as the theory of demand for When control of money or credit supply is the need, money. The theory of demand for money regards interest rate structure may be revised upward. If the real income or output, interest rate and inflation as central bank has no direct control over the interest the major factors affecting the demand for money. rate structure of the commercial banks, the same These may be taken also the factors affecting demand can be done indirectly through open market for credit, but with a point of caution. Demand for operations and changes in the bank rate. But control money is for transaction and asset purpose whereas of money supply or credit through interest rate is demand for credit is for investment or consumption possible only if market interest rate is sensitive to purpose. However, as the determinants of demand bank rate and if market borrowing is also sensitive for money seem to closely affect demand for credit to bank lending rates. as well, we may regard business expectation or The situation in Nepal is something different; it desired output growth, interest rate, and inflation rate has past instances of higher credit growth as the factors affecting demand for credit. This in accompanied by high interest rate structure. This has fact works as a monetary reaction function where happened owing to the administered interest rate not only money supply determines inflation, but prices structure for quite a long time coupled with also affect the demand for working capital and thus underdeveloped bond market and substitution of determine the supply of money through the process money to physical assets rather than to bonds taking of credit (and demand deposit) creation. When prices place. The latter is quite common in an inflationary are rising, there is a higher need for working capital; situation when the real value of financial instruments as an entrepreneur has to make a higher payment for depreciates and the value of physical assets raw materials, labour, and machinery.
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