Nepal Rastra Bank has issued a notice asking for "opinions and suggestions" on the upcoming monetary policy for the next fiscal year 2022-23. Undoubtedly, these are challenging times for the Nepali economy due to its chronic and deepening vulnerabilities coupled with emerging global economic adversities triggered particularly by the protracted Russia-Ukraine war.

The key economic indicators are already alarming. In the first 10 months of the current fiscal year, consumer price inflation (CPI) has jumped to 8 percent against its 6.5 percent target. The balance of payments shows a deficit of $2.41 billion. The trade deficit in merchandise imports in the last 11 months has increased by 25 percent to Rs1,577.4 billion. The share of exports in total foreign trade remains less than 10 percent. In addition, the deficit in service trade has also crossed Rs90 billion. By the end of this fiscal year (July 15), the total trade deficit, including service imports, is set to touch the $20 billion mark.

Workers’ remittances, still the single largest source of foreign currency inflow to offset the deficit, have also decreased by 1.6 percent to $6.76 billion. Foreign exchange reserves, too, have dwindled to $9.28 billion from $11.75 billion at the beginning of the current fiscal year. These indicators show tremendous pressure on foreign exchange reserves to meet the rapidly burgeoning trade deficit alone.

Expansionary fiscal policy

Despite increasing constraints and risks, the government has presented an unsustainable expansionary budget for the next fiscal year 2022-23, with a growth target of 8 percent. The budget speech instructs the central bank to "formulate a monetary policy to contain the inflation rate within 7 percent to achieve economic growth and maintain macroeconomic stability".

The budget proposes 31 percent deficit financing out of its Rs1,794 billion expenditure. The biggest challenge for the monetary policy is to tame inflation while increasing the money supply to address the government plan of raising Rs256 billion in domestic loans.

Of course, like most central banks in the world, Nepal Rastra Bank also has a dual mandate to facilitate the economic growth target set by the government and control inflation. But when the government brings about an excessively expansionary fiscal policy like the current one, containing inflation by introducing a contractionary monetary policy becomes a compulsion to the monetary authority. Undoubtedly, these two goals, ensuring growth and containing inflation, are mutually contesting objectives. But this is precisely where the central bank’s independence in tandem with functional coordination between the fiscal and monetary authorities counts the most.

External factors

Several ominous external economic factors are bound to cast their long shadow on the following monetary policy. Nepal is at the receiving end of a steep rise in prices of mainly petroleum and food products, looming food insecurity amidst broken supply chains and increased volatility in the international financial markets, and it is already feeling the heat of these developments. For fuel, Nepal is entirely dependent on imports. Almost one-third of Nepal’s total imports comprise agricultural and animal products. The strict pegging of the Nepali rupee to the Indian rupee has generally provided a much-needed cushion for economic stability; but during times of such global economic crises, this arrangement forces us to borrow both inflation and currency depreciation regardless of our economic resilience, if any.

Inflation in the eurozone (the group of 19 countries that use the euro as a common currency) is already the highest ever, at 8.6 percent. In the United States, prices rose to the same level last year, which was the most significant increase since 1981. Consumer price inflation in India was at 7.04 percent in May, mainly due to excise duty cuts on petroleum products. But rapid depreciation of the Indian rupee against the US dollar remains a significant concern. It has lost over 6 percent of its value since the beginning of 2022, including almost 2 percent in June, hovering at INR79 per dollar.

As mentioned above, policy tandem and functional coordination between the fiscal and monetary authorities of the country are inevitable to navigate the economy through such a plethora of challenges. Unfortunately, at present, relations between Nepal Rastra Bank Governor Maha Prasad Adhikari and Finance Minister Janardan Sharma have hit rock bottom ever since Adhikari was suspended by the government at the behest of Sharma but got reinstated by a Supreme Court verdict. Instead of quitting on moral grounds, Minister Sharma now appears to be exerting fresh psychological pressure on Adhikari to issue an equally expansionary monetary policy to enable the mobilisation of financial resources for his populist programmes.

Despite the fiscal policy imperatives, the upcoming monetary policy can barely afford to be as expansionary as expected by the budget in light of emerging unprecedented inflationary risks. As it is, Nepal’s central bank sits on a mountain of accumulated problems that nag the financial system. The protracted crisis of loanable liquidity in the banking system shows no signs of abating. Its effect on the real  sector has been crippling, with investment, productivity and a sharp slide in the capital market due to unaffordable interest rates. It has now minimal room for further reducing the credit-deposit ratio that has already crossed the 90 percent mark.

There are numerous reports of misuse of directed lending schemes aimed at agriculture and small businesses. The cost of fund of the loans targeted at the marginalised and economically underprivileged groups is, ironically, the highest beyond rationale.

Nepal Rastra Bank is still spending a lot of its organisational energy on the traditional role of regulation and supervision. In contrast, major central banks worldwide have already outsourced this responsibility to focus on the core function of system stability and inflation control. It is undoubtedly high time for Nepal’s central bank to calibrate the decade-old monetary policy template and undertake a comprehensive review of the implementation of its policies. But additional external and internal constraints seem to be restraining its move towards that end, even now.