National 6 (Spotlight Weekly)

The Rationale of New Monetary Policy Measures

By Nara Bahadur Thapa

1. Following the announcement of monetary policy for 2004/05 on July 19, 2004, the likely impact of new policy measures on excess liquidity, interest rates, inflation and growth have been well discussed in the press. A number of pertinent issues have also been raised and debated. But the rationale of some new policy measures and the reforms in implementation strategy aimed at improving the transmission mechanism of monetary policy have largely remained unnoticed. Looking at the press reporting of monetary policy it appears that some misconceptions still exist with respect to policy measures and policy goals.

2. Let me first begin with those financial superstructures put in place and associated policy measures, which the media has chosen to ignore. One such measure is the provision of standing liquidity facility (SLF) for the commercial banks. With the growing financial broadening and deepening, a need was felt for a mechanism of safety valve for the smooth functioning of domestic payments system. The new system of SLF ensures commercial banks with eligible collateral an automatic and hassle free access to this facility. It is clearly stated in the monetary policy statement that, for the time being, the global quota of SLF will be based on the quantum of government securities held by the commercial banks. SLF quota for individual bank will be also be fixed on the aforesaid basis. This type of transparent facility did not exist before. This provision is expected to contribute positively to one of the goals of central bank (read Nepal Rastra Bank - NRB) of developing a secure, healthy and efficient domestic payments system.

3. While SLF arrangement is being worked out to take care of likely problem in domestic payments system by way of guaranting commercial banks an automatic access to central bank funds, discretionary liquidity adjustment measures are also being put in place to achieve the monetary policy goals. This time, discretionary market based monetary policy measures are drastically rationalized. In the process, a new system of open market operations (OMOs) has been introduced. Three open market monetary policy instruments namely, sale auction, purchase auction and repo auction have replaced the earlier system of OMOs. Depending upon the nature of liquidity problem, these instruments can be used. An arrangement for sale auction and purchase auction has been made to deal with liquidity of long-term nature. On the other hand, repo auction has been introduced to take care of liquidity problem of short-term nature. As is obvious, the sale auction has been introduced to absorb liquidity from the system. On the other hand, the purchase auction has been introduced to inject liquidity into the system. As these instruments are discretionary in nature, unlike in the past, initiative for their use lies with the central bank.

4. These instruments existed before but not in the form of true monetary policy instruments. Earlier initiative for their use lay with the commercial banks and the NRB acted rather passively. For the secondary market operations, auction system was not used. Market operations were based on the yield curve calculated by the NRB which was often criticized as not being transparent to market participants. Quantities were traded residually.

5. Naturally, market operations through these instruments will not be as frequent as it used to be in the past. Two factors will guide the NRB for the discretionary use of these instruments. First, the quantum and nature of liquidity in the system will determine the choice of these instruments. Second, a perverse and piquant excess liquidity situation may arise making it difficult to drain liquidity owing to the paucity of open market instruments. In this case, the NRB will be guided by the actual conditions of monetary policy objectives. So long as the monetary policy objectives are within the targeted limit, there will be no need to intervene. We never know, especially in the short run, the underlying factors evolving for the marked shift in the money demand functions. For example, a situation of excess liquidity over and above the cash reserve requirements (CRR) may emerge in the system. Yet, there may not be a response from the central bank if the well-defined goals of monetary policy are in right place. Clearly, if the public at large is willing to hold idle cash balances without jeopardizing the goals of monetary policy, it will be meaningless on the part of the central bank to intervene. To determine the excess or deficient quantum of liquidity in the system, a liquidity monitoring and forecasting framework (LMFF) has been put in place. The LMFF will be taken as a guide to market operations.

6. Currently, commercial banks are saddled with reserves in excess of CRR and also well above normal requirement for day-to-day settlement purposes. Against this background, a cut in CRR by one percentage point to 5 percent has attracted much criticism against the 2004/05 monetary policy. A number of issues have been raised. First, it is argued that a cut in CRR is aggravating the excess liquidity in the system. Second, as interest rates, especially deposit rates, are low; they are likely to fall further discouraging domestic savings. Third, a release of an additional liquidity is likely to cause balance of payments (BOP) problem and generate pressure on inflation. The nutshell of all these arguments is that the cut in CRR was not timely. On the face of it, these arguments appear valid. One section of the press even alleged that these measures were meant for appeasing the commercial banks and hence had nothing to do with monetary policy goals.

7. Well, these views and concerns must be respected. Nontheless, there is a case for these policy measures. In this respect, the following points are in order. First, it must be stated that, over the last few years, the cut in CRR has been consistenly and systematically aimed at reducing the cost of funds of commercial banks and thereby helping reduce the financial intermediation cost without adversely affecting monetary policy objectives such as price and BOP. The dominant thinking is that monetary policy in no way should be a factor responsible for a higher financial intermediation cost measured in terms of interest rate spread. For example, a couple of years ago CRR was 12 percent. It is now 5 percent. Consequently, over the last few years, lending rates have come down; and yet both BOP and inflation have remained at a comfortable level. The significant cut in CRR has not affected these two monetary policy objectives. Second, as regards the concern of its impact on deposit rates, it must be stated that interest rates are primarily function of a budget deficit especially the state of government's domestic borrowing requirements. The higher the government domestic borrowing the higher is the domestic interest rates and vice versa. For instance, in 2003/04, the government maintained a negative net domestic borrowing, which brought down the overall interest rate structure. In view of sluggish economic activities, monetary policy response over the last few years has been largely accommodative. Unfortunately, due to non-economic reasons, both the government and the private sector have failed to seize the opportunity of lower interest rate regime. Third, excess liquidity in the system exists due largely to a higher level of reserves with the two large domestic banks, which are under foreign management. These two banks have adopted cautious lending policy and have shifted their emphasis rather on loan recovery, resulting into excess liquidity position with them. Liquidity position with other commercial banks has nearly remained tight. Fourth, the present excess liquidity is a reflection of sluggish domestic absorption especially of the government sector. The same is the case with the private sector. If some big projects were to be undertaken, the present liquidity with the commercial banks will not be sufficient to meet the credit demand. Fifth, if the aim is to force commercial banks to reduce the lending rates, it is right time to cut CRR as both internal and external balances have been maintained at the satisfactory level. Therefore, as discussed in the 2004/05 monetary policy the current malaise is not an outcome of macro economic fundamentals, rather it is a manifestation of unsatisfactory situation at the microeconomic level.

8. In the aftermath of rising global oil prices, pressure is building on price front. The monetary policy framework of pegged exchange rate regime with Indian currency (IC) is currently in place to achieve the goal of maintaining domestic price stability. It is true that small open economies are generally price takers. Nepal is no exception to it. India being a large economy with which Nepal has open border, pegged exchange rate arrangement with IC is a sensible, appropriate and deliberate choice aimed at keeping inflation low. This does not mean that monetary policy has no direct role in keeping inflation low. It does influence the overall price level through the prices of nontradables. Currently, India has higher level of inflation level than that of Nepal. Both supply shock in the form of rise in prices of oil, cement and steel, and increased aggregate demand have put pressure on prices in India. In Nepal, pressure on prices exists from supply side but the sluggish domestic demand and external demand have offset the pressure on prices. This largely explains the price differential between Nepal and India. Lately, some pressure from oil price shock and non-economic factors such as the rebel imposed economic blockade in Kathmandu heightened the anxiety of the people on inflation front. Under these circumstances, as experience suggests, monetary tightening will not be of any help. It will rather increase the corporate sector distress making the matter further worse. Fiscal measures are better suited to deal with this type of situation. Precisely because of this reason, India has decided to combat inflation through the fiscal rather than the monetary route.

9. Despite the micro level economic difficulties, macroeconomic fundamentals are at the sound footing because of growing remittances, which have acted as buffer to the national economy. Growing remittances induced increased international reserves above the adequate level remaining idle is not good for the economy. With a view to enhancing growth through the productive use of international reserves, a number of external sector reform measures have been introduced. The objective of changes in monetary policy measures was also to create monetary conditions supportive to economic growth.

10. In the short run, whenever there exists a mismatch between demand for and supply of liquidity as it happens especially during slack season, short- term interest rates are likely to fall. This does not give a ground for commercial banks to lower deposit rates. If credit off-take is lower, commercial banks should also try to address it through appropriate adjustment in lending rates. As regards the use of monetary policy measures, options are limited. Direct monetary control measures are gradually being phased out. Although CRR has been important policy tool to deal with excess liquidity situation, policy reversal on CRR will not be appropriate at this juncture. Making CRR neutral with respect to domestic currency deposit and foreign currency deposit is one option. The argument is that although people with valid source of earning of foreign exchange should be given the choice of currency in which they want to store their wealth, monetary policy should not be seen as encouraging dollarization. The counter argument, among others, is that as policy of a gradual reduction of CRR, which is being aimed at helping lower the financial intermediation cost, has been initiated, applying CRR on foreign currency deposit will not be a proper option.

11. Mopping up of liquidity through market operations is also limited because of inadequate level of government securities with the NRB. To supplement domestic bills, foreign currency swap arrangement with the commercial banks can be an additional option. This should be a very short-term arrangement not exceeding a month's duration and this cannot be a permanent solution to the problem. Commercial banks should find ways of managing their liquidity. If monetary policy objectives are intact, market forces should be allowed to play their role.

(Thapa is Director at Research Department, Nepal Rastra Bank)