Observation on Nepali Monetary Policy for 2007/08

By Shirish Ranjit

Acting governor Mr. Krishna Bahadur Manandhur gave a written monetary policy for Fiscal Year 2007/08 on July 23, 2007. Following are few notables from the policy document.

• Central bank is reducing the involvement in private banking management and holdings. Monetary Policy makers and private bank management (including holding shares and board of directors)

• Central bank is targeting Inflation.

• Central bank is ‘Refinancing to sick industries.’ (de facto Central Bank is bailing out the “Sick Industries.”)

• No mention of the investment made on the Dollar Reserve.

• Some key figures in the report: GDP Growth of average of 3%, Core inflation 5%, Consumer inflation 6.5%, Balance of Payment Surplus Rs 6.87 Billion.

• No mention monetary policy of availability of credit, and capital mobility and investment.

• Exchange Rate Pegged with Indian Currency

   

• Due to the pegging NRs appreciated by 14.3% against USD. The report states that the currency appreciation against dollar in fact reduced inflation.

In the next series, we will discuss on Central bank’s involvement in private banking and ‘Refinancing of Sick Industries.’

Part II

Nepal Central Bank published Monetary Policy statements on the private banking and refinancing 'sick industries.'

It is the notable policy of the Central Bank to let private banks to operate independently without hindrance from the Central Bank or the government. Points 21 and 22 in the policy statements state that the Central Bank is withdrawing their involvement in the private banking sector. The Central bank is withdrawing board members and also equity holding from private banks. This is a positive policy toward free private enterprise without any interference from government agencies.

As we move toward private banks free from tight government control, we also have to develop a system that keeps consumer's faith in the banking system (not in a particular bank). So, the question is how can we develop a policy that develops faith in the banking system so that people are not inclined to stuff money under their mattress? One such policy may be to insure bank deposits to certain amount. For example, in USA, the Federal Government insures bank deposit up to 100,000.00 dollars. The policy must mandate that banks must insure deposits through the government. This insurance provides assurance from private banks failures. Such policy will provide confidence in public and provide incentive to people to save money in local banks in the country rather than putting in the foreign banks.

The point 15 states that sick industries get refinancing rate of 2% while other get 5.5%. While the industries refinancing rate went up to 6.25%, the rate for the sick industries refinancing dropped to 1.5%.

The policy statements does not define 'sick industries.' Are these industries unable to repay their debt or are these industries unprofitable; and hence cannot keep their output level? Is refinancing sick industries in effect an industry bailout? Does this refinancing policy provide incentive to healthy industries to be sick so that they have a much lower financing rate than the healthy industries?

The policy of providing refinancing to sick industries is not the capitalist paradigm. If an industry is 'sick' cannot fix it, then the management should not be in the business of running the industry. Only way we can build a healthy economy is to let the healthy industries to prosper and sick industries to fail. Not only the economy will do better but also capital investment become more productive gaining better return to the investors. In the meantime, the labor force will adjust to the change in labor demand as per the need for labor in the healthy industry sector rather than keeping the productive labor in the sick industries.

The point 7 states about restructuring government own banks, NBL and RBB with the foreign consultants and the point 8 states about recovered Non Performing Loan; and those banks being in profit after foreign consultants took over the management. These are good developments for NBL and RBB banks. However, a question is what is the criteria for hiring Foreign Consultants? Are there not enough educated Nepalese living and working aboard that are capable of doing such work? When hiring a consultants or outsourcing, cultural difference can provide a reason for failure. In this case, the outcome is positive. However, it is still better to invite Nepalese with qualification and experience for such work to bring experience and expertise to the country. At the same time, it is our pride to train, educate, and keep expertise in the country. Besides expertise and experience being in the country, the large sum of money that is paid out to foreigners is effectively does not get infused into Nepalese economy. But if the money is paid out to Nepali experts, then that money will most likely be infused into the Nepali economy.

In the next installment of the article, we will focus on 'Current economic and financial situation.'

Part III

This article is the third installment in our series. In this article, we analyze the 'Current Economic and Financial Situation.' Following are few key observations from the monetary policy document.

The GDP growth of Nepal is estimated to be 5 percent. The improvement in political situation and internal conflict creates a favorable environment for economic growth. In addition, wet mansoon season also provided a favorable environment for economic growth in the farm sector.

The inflation was 8 percent for the year 2005/06. The inflation is estimated to be 6.4 percent for the year 2006/07. The energy cost has put inflationary pressure on the economy. The core year on year inflation remained at 5 percent; and the headline inflation remained at 4.5 percent.

The government revenue grew by 20.6 percent in the year 2006/07 compared to the growth of 3.1 percent in the year 2005/06. The revenue growth is due to the increase in the rate of custom duty and the expansion of excise duty. Due to the higher revenue and multi-national grants, the government fiscal deficit was smaller compared to previous years. The government borrowing remained at 1.2 percent of GDP.

The balance of payment (BOP) is the lowest for the last 10 months of 2006/07 compared to previous years. The total export increased by only 0.8 percent, compare with the 2.9 percent increase the previous year. The export to India grew by 2.1 percent while the export to other countries declined. Similarly, the imports also declined compare to the previous year.

Due to the payment for petroleum products in IC and declining export to India, the IC reserve depleted at the faster rate. As central bank had more Dollar reserve compare to IC, the central bank made provisions to pay in Dollars for imports that previously paid in IC.

On the currency market, the Nepalese Rupees appreciated by 14.3 percent against US Dollars. This is the side effect of currency being pegged to the Indian Rupee. The effect of currency appreciation is that the export to countries other than India, which amount to 31.2 percent, is affected but the extent of damage to the export was not clear in the policy paper. Also, it is not clear what was the extent of effect on the remittance due to currency appreciation. One upside of currency appreciation is that the inflation was contained and also all the imports in Dollar became relatively cheaper. As per the central bank, the low economic growth, the currency appreciation coupled with the high energy price has created a period of economic instability.

The major source of foreign currency earning was from the private sector remittance. Though the remittance is the major source of earning and is sizable, the growth of remittance for first 11 months of 2006/07 is significantly lower compare to the previous year. Though the remittance grew at much a lower rate, the foreign reserves stayed healthy. It was not clear from the policy paper, if this is the effect due to appreciation of Nepalese Rupee against Dollar.

On the financial market, the Nepalese index has increased to 76.8 percent. According to the central bank, this is a bubble in the market as the share prices are not quite supported by fundamentals of the industry that they represent.

Though we have a political instability in the country that does not create an environment for sound economic activity, the Nepalese economy seem to be doing better than the political situation. The economy has upheld

The question is that does it still make economic sense to peg Nepalese Rupee with Indian Currency? As India's economy grows and strengthens its fundamentals, the Indian Currency will appreciate against major currencies. As India does not control the currency exchange rates; and does not have enough foreign currency reserves to keep the currency exchange rate artificially low against major currencies as China can offer to do. Thus, Indian currency will appreciate in near future. This will lead to Nepalese Rupee to appreciate against major currencies if the central bank does not devalue against the IC. At this juncture, it does not make sense to keep a fixed exchange rate with IC.

Our major trading partner is India with 63.1 percent of trading volume. However, it is not clear if the policy paper has taken into account of remittance in the trade number. This indicates that our trading currency is IC and our income currency is Dollar. The current foreign exchange regime support the trading with India by keeping the exchange rate between Nepalese Rupee and IC fixed. However, this policy hurt those who are earning in Dollar and sending those money home.

We need to have a policy that can keep the income currency and trading currency exchange rates in balance instead of just supporting the trading currency. The current fixed exchange rate regime certainly favor traders and businesses that does business with India alone. The current exchange rate regime does not support the labors that receive income in US Dollars and send those money home to their families.

Therefore, a trade weighted exchange rate regime where Nepalese currency exchange is fixed based on a value of basket of the currencies, shall provide a better way of managing foreign exchange rates. The currencies in the basket shall include the major 5 to 10 trading partners including the income currencies. When we peg Nepalese Rupees with this weighted basket of currencies, we will have a sustainable foreign currency reserves and trading. This type of regime will put less pressure on Nepalese Rupee dues to a single currency appreciation.

Part IV

This article is the fourth installment in our series. In this article, we analyze the 'Monetary Policy Framework for 2007/08.'

Due to the election for in November the Government of Nepal is not expected to make significant capital investment. Also due to the political turmoil, there is no conducive environment for private sector capital investment. Frequent strikes have caused disruption in outputs; hence, impacting the productivity and cost of production in Nepal. Due to the low productivity and the high cost of production, Nepalese goods and services are less competitive in the international markets. Besides costs, the quality of goods and service also caused reduced demand in international markets.

The Central Bank is aware of inflation due to higher energy prices. It also fears that the government spending may put pressure on the price level. The Central Bank is worried about the foreign currency reserves. As we have discussed in the previous series on the foreign exchange regime, the Central Bank has correctly identified problems arising from current foreign currency regime. In the policy paper, in the number 59, it states that the remittance has decelerated. However, the paper has not made any connection between Dollar exchange rate and the remittance inflow. As Nepalese currency gets stronger against Dollar due to the fixed exchange rate against Indian Currency, the workers abroad have less incentive to send money home in the form of dollar than in the form of gold.

The policy paper, in the number 59, also states that the Central Bank did sell 920 million US Dollar to purchase Indian Currency. This intervention in the foreign exchange market is to support the exchange between Indian Currency and the Nepalese Rupee. It is almost a BILLON US Dollar that the Central Bank spent in supporting the Nepalese to Indian currencies exchange rate. How can the Central Bank justify this action and therefore the policy of fixed exchange rate regime against Indian Currency. Nepal does not have the trade surplus and also the remittance for US Dollar reserver to support such a policy. We have ample example of currency crises in East Asian countries where they tried the same policy to keep the exchange rate fixed. The question is, does the Central Bank have a plan to take action if there is foreign exchange crisis? Why does the Central Bank believe that it can support the current level of fixed exchange rate against Indian Currency?

On the financial institution section, the policy paper stated that the Central Bank not only bailed out Nepal Bangladesh Bank Limited (NBBL) but also took over management for a brief period. The paper does not provide explanation of why the Central Bank became a savior of the NBBL. This action of the central bank sends a single to the management that they do not have to perform. If they fail they will be bailed out by the Central Bank as in the case of the NBBL.

To avoid wide spread loss of saving of local people, the Nepal Government along with the Central Bank shall provide saving insurance as oppose to bailing out the failed banks. In the USA, the Federal Government proves insurance up to 100,000.00 USD for savings if a bank fail. This type of policy protects people rather than the management who runs the bank. We do need to let bad management fail rather than reward them.

In the next installment, we will discuss on the Central Bank's Economic, Monetary, and Operating Targets.

Part V

This article is the fifth installment in our series. In this article, we analyze the Central Bank's Economic, Monetary, and Operating Targets.

The Central Back (in line number 65) assume that energy price stays constant in making the policy statement for target inflation of 5.5 percent. Also, the Central Bank states that it projected growth and inflation number based on the same assumption. Is the Central Bank really believes that the energy price will stay constant through the year 2007/08? Can the Central Bank's really create price stability policy without taking the changes in energy prices into account? As we know, energy goes in everything in our daily life. So changes in energy price will cause changes in price level in almost every sector of the economy.

In the number 67, the policy paper stated about the lower interest and capital flow. When interest rates are low, that leads to capital investments that may not be as productive as the alternative investments. The central bank had identified the low interest rate problem of investment in low return sectors. However, the central bank stated that stock market as unproductive sector for investment. The question to the Central Bank's monetarist is that how can a capital investment through Stock Market be unproductive?

A Stock Market allows people to invest in ventures that they cannot do by themselves; at the mean time allows companies to raise capital by selling its equity. A company being a profit maximizing entity (in capital market term), the capital that it has raised through the Stock Market, shall invest in the areas where it can have the maximum profit. Therefore, maximum return to their shareholders. So, in this capital market system, how can a Stock Market be an unproductive sector for capital investment?

Monetarists view interest rates as a major tool to control inflation and economic growth. In the USA, the Federal Reserve Bank (Fed) uses interest to boost and cool the economic growth. The Fed uses interest rates such as Federal Funds Rate for affecting the economic activities. By lowering the interest rate, we are encouraging investments. A side effect of the lower interest is that it can spur a housing market bubble as in USA. The policy design of lower interest rate is to spur investment and therefore economic growth. When there is cheap capital, there is going to be investment in the area where it was not invested before – so called unproductive sector.

The Central Bank has lowered interest rate for those companies which are exporting goods (stated in line number 74). The paper does not clarify what problems are faced by exporters. Also, it is good to encourage export based company, but the paper does not state why it is subsidizing the cost of borrowing capitals to companies that exports. Also, it does not state any provisions to police that those capital are invested in export oriented companies only. This is a big loop hole in the monetary policy in which the Central Bank has effectively lowered the interest rate to all the corporations as most of the companies in Nepal qualify as exporters.

The policy has provisions for sick and underclass investors. The question to the Central Bank is that is this an effective use of capital? In the capitalism, only those that can maximize profit can survive. We are not saying we shall not help those are in need; however, in the world of capital investment, we shall take the policy of survival of the fittest. On the other hand, the government must keep the market competitive such that there is no monopoly or oligopoly in the market. The government shall enforce competitive rules and regulations. However, there is a doubt in enforcing those rules in the country like Nepal. Therefore, may be financing 'Sick' and under privileged class investors, is a way to increase competition. But this policy still has more problems than having monopolies as these sick investors may be manipulated by those very successful ones.

In the next installment, we will discuss on the Central Bank's Micro-Finance Program.