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Kathmandu Tuesday December 25, 2001 Paush 10, 2058.
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Costs and benefits of monetary policy
changes
By Nara Bahadur Thapa
The Nepal Rastra Bank (NRB) has effected
changes in two of its monetary policy instruments with effect from December 20, 2001.
According to the new changes, both refinance rates and the minimum cash requirement/ratio
(CRR) were revised downward. Refinance rates were reduced by 100 basis points to (one
basis point being one hundredth of a percent) 200 basis points. Currently, there are four
refinance facilities with four corresponding refinance rates. These are (i) refinance
against foreign currency export loans, (ii) refinance to financial institutions against
their sick industry loans, (iii) refinance for rural development banks and export loans in
local currency and (iv) refinance against all other loans. The refinance rate against
foreign currency export loans has been reduced by 200 basis points to 2.0 percent from 4.0
percent, refinance rate for sick industry loans by 150 basis points to 3.0 percent from
4.5 percent, refinance rate for Rural Development Banks and export loans in local currency
by 100 basis points to 4.5 percent from 5.5 percent and refinance against all other loans
by 100 basis points to 5.5 percent from 6.5 percent.
Similarly, the CRR has also been cut. The
minimum CRR with respect to domestic current deposits and domestic savings deposits to be
maintained with NRB has been reduced by 100 basis points to 7.0 percent from 8.0 percent.
Likewise, the minimum CRR with respect to domestic fixed deposits to be maintained with
NRB has been trimmed by 150 basis points to 4.5 percent from 6.0 percent. The weighted
minimum CRR to be maintained with NRB has thus been reduced to 6.0 percent from 7.0
percent. However, the minimum CRR of total domestic deposit liabilities to be maintained
in commercial bank vaults has been kept unchanged at 3.0 percent. The average minimum CRR
both with NRB and in commercial bank vaults has been reduced by 100 basis points to 9.0
percent from 10.0 percent.
The accommodative monetary policy stance has
been taken with a view of minimising the current adverse economic situation facing the
country. The current status of economic activities is best approximated by the GDP growth
rate forecast of 2.5 percent for the current fiscal year 2001/02, the lowest since 1987.
The projected economic growth rate of 2.5 percent has decelerated from 4.95 percent in
2000/01 and 6.4 percent in 1999/00. The gloomy projection of GDP has been based on the
unsatisfactory performance of exports, tourism, industries and the agricultural sector.
The available data so far shows that merchandise exports have fallen by 8.3 percent in the
current year as against an increase of 42.3 percent in the corresponding period of the
previous year. The compression in overall exports has been attributed to the continuous
decline in carpet and garments, the top two convertible exchange earners. Pashmina export
has also been witnessing a decline in recent times. The global economic recession and the
internal situation of the country have been the major factors responsible for the decline
of Nepalese exports to overseas markets. The delay and uncertainty in the renewal of the
Nepal–India trade and transit treaty have also adversely affected Nepalese exports to
India. Additionally, factors such as the internal security problem, the September 11
incidents in the USA and the fallout of the Indian plane hijacking that took place two
years before, have all contributed to the decline of the Nepalese tourist sector.
Monetary growth has also decelerated in
recent times. For example, broad money growth, which had increased by 21.8 percent in
1999/00, decelerated to 15.2 percent in 2000/01. The monetary expansion is likely to
decelerate further during the current fiscal year. The bank credit to the private sector
has likewise shown a similar trend of deceleration to 15.8 percent in 2000/01 from 20.8
percent in the preceding year. On top of this, the free reserves of commercial banks have
also gone down in recent months. These indicators suggest that there is a growing need to
augment the liquidity situation in the system. It is with a view to ameliorating the
overall situation that NRB responded with a cut in both the CRR and refinance rates. The
present cut in CRR will release the lendable resources of commercial banks to the tune of
Rs 1.92 billion. The monetary policy changes have also take the global context into
account. The Indian monetary policy regime has been made liberal in recent times. Since
Nepal has an open border with India coupled with unlimited convertibility of NC into IC,
it is not prudent to keep the Nepalese monetary policy regime markedly different from the
Indian policy regime. Additionally, the international monetary policy regime has also been
made easy in recent times. Central bank discount rates and money market interest rates
have come down drastically. Against the background of all these factors, a need was felt
for suitable changes in monetary policy.
There are both costs and benefits associated
with the monetary policy changes. The major concerns of policy changes are the likely
adverse effects on inflation and on the balance of payments situation. Inflation so far
has been tolerable. In 2000/01, the inflation rate measured by changes in the national
urban consumer price index was 2.4 percent. The price situation so far suggests that
prices will not go up more than 5.0 percent in the current fiscal year, which is within
the tolerable limit from developing countries’ perspective. The current monetary
policy changes are not expected to aggravate the price situation further. The improved
price situation in India is also expected to generate a salutary impact on prices in
Nepal. The balance of payments (BOP) is another front where a loose monetary policy stance
is said to create an adverse impact. In this context, it is important to take note that
Nepal had a reasonable level of BOP surplus of Rs 5.2 billion in 2000/01. However, the
current situation in merchandise export and the tourist sector does not portend well for
BOP. Therefore, it is feared that the current easy monetary policy stance will further
aggravate the country’s BOP situation.
But, two factors are to be taken into account
before reaching this conclusion. First, the monetary approach to balance of payments
suggests that domestic credit expansion leads to one to one depletion of the international
reserves of the country. The argument is that the cut in CRR will only lead to a depletion
of international reserves in Nepal. Hence, the CRR cut is not desirable. But we have to
remember the amount of loanable resources of commercial banks that are being released due
to the CRR cut. The amount is Rs 1.9 billion, which is less than 1 percent of domestic
credit of the monetary sector. This suggests that the reserves loss will not be
significant. Besides, the monetary approach to balance of payments is based on an
assumption of full employment of resources, which is not the case in Nepal. This means
that some additional local reserves released from the CRR cut will be absorbed in domestic
production. Second, even if there is an international reserves loss from the CRR cut, it
will not put much pressure viewed from the fact that Nepal has international reserves
sufficient to cover about 11 months’ merchandise imports. After all, there has to be
a productive use of international reserves. Moreover, the cut in refinance rate in general
and the cut in refinance rate for convertible currency export loans for the import of
raw-materials and machinery for export oriented industries in particular are expected to
enhance international reserves.
Capital flight is another concern raised
against the easy monetary policy stance. But the point is that the cut in CRR reduces the
financial cost of commercial banks, thus enabling them to pay relatively higher interest
rates on deposits and charge lower interest rates on loans. It is clear that the cut in
CRR prevents capital flight out of the country and also helps attract foreign capital into
the country. This may be a weak argument but it is true. Another concern is that the
additional reserves that will be released from the CRR cut will enable commercial banks to
hold more government securities at the cost of NRB and thus facilitate the transfer of
profit from NRB to commercial banks. This situation will only arise if commercial banks
invest their additional reserves in government securities instead of increasing lending to
the private sector. Fine, even if this happens. But we must take note of the fact that
reduction of government debt stock is required as per the new NRB Act 2001, which ties the
government debt stock with the previous year’s government revenue. On top of this, if
the policy changes help improve the financial health of commercial banks, it will be good
because effective monetary management depends on the state of financial position of
commercial banks.
The following are the benefits of monetary
policy changes. First, with the reduction in both refinance rates and CRR, the export
sector is likely to benefit. This will help relieve the problems of the export sector to
some extent. Second, sick industries will also benefit as the refinance rate against such
loans has been reduced by 150 basis points. Under this arrangement, production as well as
employment opportunities will increase. Third, the cut in CRR will release Rs 1.92 billion
in loanable funds of commercial banks. If this is channelised into productive investment,
it will lead to an increase in economic activities. Fourth, the cut in CRR will help
commercial banks lower the interest spread, which in turn helps reduce financial
intermediation costs. Fifth, a higher CRR is a tax on financial intermediation. Reduction
in CRR is considered to be one additional step towards the ongoing financial sector
reforms. This will help expand financial intermediation in the country. In the process,
both depositors as well as borrowers are expected to benefit from the monetary policy
changes.
To sum up, both refinance rates and CRR are
indirect monetary policy instruments. Monetary authorities cannot directly force banks and
financial institutions to behave as per these policy changes. The desired impact of these
policy changes depends on the behaviour of banks and financial institutions, on the extent
to which they align their behaviour to the policy changes. It is expected that exporters,
sick industrial units and banks will take advantage of these policy changes. In this will
lie the effectiveness of policy changes in increasing real output and employment
opportunities. This is a good gesture of the monetary authorities taken at a time of
slowdown in economic activities. This gesture taken in a time of need has certainly
heightened the moral authority of NRB, and will enhance the future effective use of moral
suasion as a monetary policy instrument.
(The author is Deputy Director of Nepal
Rastra Bank)
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