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Kathmandu,Wednesday March 22, 2000 Chaitra 09, 2056.
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Monetary policy : Is there a choice ?
By Dr Raghab D Pant
Following the election of new leader of NC parliamentary party on Saturday, I
found a number of bankers and the professional economists extremely curious to correctly
identify the person who will lead the Ministry of Finance in the next government. Their
argument was that the choice of the next Finance Minister will also affect (i) the future
leadership of the Nepal Rastra Bank and (ii) the ways monetary policy in the country are
formulated and implemented. I refused to comment on the first, as it was more a personal
and moral issue, but with respect to the second, I did not agree with them because the
next Minister of Finance, in my view, will have little independence in formulating
monetary policy. The decision has already been made, and, in the short run, it is
irreversible.
Current situation: These are the current fiscal and monetary situations of
the country:
1. The financial position of His Majesty’s Government is not in a good
shape. The growth in revenue has not been able to keep pace with the growth in
expenditure, due largely to rising regular expenditure. As a result, the budget deficit in
the first six months of the current fiscal year increased by 81 percent to Rs 3.60 billion
compared to corresponding period of the last fiscal year. The government has taken some
measures but the prospect is not very encouraging.
The activities of the Maoists initiated from the district of Rolpa and Rukum
from February 13, 1996 have now spread to over fifty-five districts. It has been viewed by
many simply as a problem in internal security. Its implications on budget deficit have
seldom been raised or discussed, though it might turn out to be a serious problem in the
not too distant future. The government, according to press reports, has recently provided
Rs 1 billion plus to the police, in addition to those allocated in the budget for the
current fiscal year. In addition, a high level committee is examining the need to create
an "armed police" which will have its own financial implications. The Maoist
activities, now, cannot be ignored from the problems of financial management.
2. The banks and even the financial institutions, on the other hand, have
excess of resources at their disposal and it is estimated to increase further in the
coming months due partly to the expected rise in the budget deficit. This has not led the
commercial banks, notorious for their incompetitive behaviour, to reduce the loan or the
spread between deposit and loan rate. Instead, some of the commercial banks are using
their resources for investment abroad. The total foreign exchange holding of the
commercial banks in January, 2000 totalled Rs 25 billion. This has led many to charge,
perhaps correctly, that a few of the commercial banks have emerged as effective
institutions for the outflow of domestic capital. This is an agenda for future research
but such disturbing phenomenon has been noticed even by the international organizations.
In February 18, 2000, the Executive Board of the International Monetary Fund concluded
that "a fairly loose monetary policy led to excess liquidity in commercial banks,
much of which has been placed in foreign currency assets."
Structural factors: The Minister of Finance will have to work within the
following structural environment:
1. Nepal is committed to maintain free convertibility of Nepalese currency
into Indian currency and vice versa. Neither are there quantitative restrictions on the
movement of goods and services between the two countries. Nepal also maintains fixed
exchange rate with India at NRs 160= IRs 100; the exchange rate with other currencies is
fixed taking into account the exchange rate of that currency with Indian currency. We are
following what the economists call "Indian Currency Standard", almost similar to
the system of Gold Standard followed by the European countries in the nineteenth century.
2. These arrangements will have their own economic implications. In
particular, given fixed exchange rate and free convertibility of currencies, inflation and
interest rate in Nepal is closely linked with corresponding rates in India. If Nepal has
to maintain an interest and inflation rate different from India it has to lift its
discretionary control on exchange rate system to let the market determine the exchange
rate of Nepalese currency vis-a-vis Indian currency.
3. The interest rate between India and Nepal cannot be different if the
movement of capital between the two countries is sensitive to interest rate differentials.
For example, if the interest rate in Nepal is higher than in India, the capital from India
might flow to Nepal. This will bring Nepalese interest rate close to Indian interest rate.
Similarly, if the interest rate in India is higher than Nepal, the capital might flow from
Nepal to India.
4. Nepal, in fact, has been lucky until now in that it has not noticed
massive capital flight due to interest rate differentials between India and Nepal. But it
cannot be expected as a regular feature, specially by the Nepalese authorities. The Indian
banks, until now, were popular for their bureaucratic hassles. But the Indian Finance
Ministry has recently proposed several measures which will further liberalize the
financial system of India. This will also make the Indian banks and even the stock market
more attractive to the foreigners, including Nepalese.
Monetary policy: The arguments made by the bankers and the
professional economists cited above give us the impression that they are not aware of what
is popularly known as ‘impossible trinity’. We cannot have all, namely, free
capital movement just like between India and Nepal, a fixed exchange rate and an effective
monetary policy. A country must pick up two out of three. Nepal has three options:
(a) It can fix exchange rate and maintain freedom to formulate monetary
policy only if it imposes restrictions on the movement of capital between Nepal and India.
(It cannot be done according to our agreement with India dated June 10, 1990)
(b) It can maintain present system and retain autonomy to formulate monetary
policy only by following flexible exchange rate system.
(c) It can fix exchange rate but then abandon the use of monetary policy to
change inflation, interest rate and even to help the implementation of poverty alleviation
programme.
We are now following option (c). This means inflation and interest rate in
Nepal is closely linked with the corresponding rate in India. Economic Overview, a
newsletter by Institute for Development Studies, says: "Nepal cannot fix its exchange
rate without giving up all control over its monetary policy". The staff of the
International Monetary Fund that visited Nepal recently was more straight in its report
submitted to the Executive Board. It said "The fixed exchange rate requires that
domestic monetary conditions be consistent with the peg and monetary policy be broadly
harmonized with that of India." Nepal has no choice.
We therefore need a finance minister who will understand this issue.
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