Amidst a structural liquidity crisis in the banking sector, mounting pressure on foreign exchange reserves, rising trade deficit and inflation, Nepal faces an enormous challenge to maintain harmony between its fiscal and monetary policies. In this challenging situation, an expansionary budget has set the target of an 8 percent economic growth rate and a 7 percent inflation rate for fiscal 2022-23. Following an unnatural fiscal policy, the importance of the monetary policy and the credibility of the central bank should not be compromised. Nepal Rastra Bank presented a flexible policy last year, with various relief packages to mitigate the economic impact of the Covid-19 outbreak. A contractionary monetary policy for fiscal 2022-23 aims to maintain financial stability, external sector stability and price stability.

The banking sector's significant challenges are liquidity and credit risks. An increase in the credit-to-deposit ratio stands at 86.22 percent, lower than Nepal Rastra Bank's prescribed upper threshold of 90 percent. The interbank rate has exceeded its upper limit and increased to 7 percent, indicating ongoing pressure on bank funds as it will be difficult for them to provide loans immediately. The current liquidity crunch is distinct since it results from the inability of banks to meet borrower demand for funds when economic activity increased after the pandemic. The monetary policy for fiscal 2022-23 has projected broad money supply and private sector credit lending to grow by 12 and 12.6 percent respectively. This is the first time in many years that the growth target for increasing credit and the money supply has been kept at such a low level.

The cash reserve ratio, a percentage of cash required to be kept in reserve as against the bank's total deposits, will increase from 3 to 4 percent effective from mid-August this year. While the statutory liquidity ratio, which is the minimum amount of deposits that bank must retain in the form of liquid cash, gold or other securities, will be raised from 10 to 12 percent by mid-January of next year. The central bank aims to limit refinancing facilities to the productive sector such as agriculture, energy, transport and exports. In mid-June 2022, the NEPSE index stood at 1996.3, down from 3025.8 in mid-June 2021. A tightened money supply is likely to impact stock prices negatively. If most of the credit flows to the productive sector, a credit growth rate of 12 to 15 percent is enough to achieve a high economic growth rate. Credit flow compatible with deposit growth should be focused on areas that could directly support economic growth in the coming decade.

External sector stability

The country is in dire need of structural transformation. As the challenge is structural, short-term solutions must be designed through structural reform. In terms of a short-term solution, there is a need to manage credit expansion and sectoral distribution, control high imports and increase remittance inflows through formal channels to ease the pressure on the external sector by achieving a balance of payments savings. Central bank officials have repeatedly conceded that the majority of the credit was used to finance imports, which contributed to a widening balance of payments deficit and a drop in foreign exchange reserves. In the current situation, the monetary policy should guide the private and banking sectors to be more responsible and accountable when utilising credit. The private sector does not enjoy the facility to import with loans as in the past. The private sector should be responsible and play an active role in import substitution (increasing domestic production instead of imports). With favourable government policies, the private and banking sectors must collaborate to increase domestic production.

The Russia-Ukraine war and supply chain bottlenecks stalled the global economy. These exogenous factors have increased the price of energy, food and other necessities while the global economy is still recovering from the Covid-19 pandemic. According to Nepal Rastra Bank's most recent Macroeconomic and Financial Situation Report, consumer price inflation (CPI) reached 8.56 percent in the first 11 months of fiscal 2021-22, as opposed to 4.19 percent in the previous year. India’s CPI stood at 7.01 percent in June 2022. Hence, inflation in Nepal is probably going to increase. Consumption had risen significantly in Nepal, and money poured out to pay for imported goods, reducing foreign currency reserves. The Indian rupee's rapid depreciation against the United States dollar continues to be a significant concern. Since the start of 2022, the Indian rupee has lost more than 6 percent of its value. The Nepali rupee had depreciated against the dollar by 6.64 percent as of mid-July 2022, compared to last year. Since the central bank alone cannot control inflation, contractionary monetary and favourable fiscal policies along with prudent measures should help in taming inflation.

Good governance

The practice of intervening in monetary policy matters by the ruling political parties severely deviates from good governance. Such an approach institutionalises the wrong culture and pushes the economy in the wrong direction. Nepal Rastra Bank should be independent and work within its system to find solutions to monetary policy issues.

The International Monetary Fund (IMF) has urged Nepal to tighten its monetary policy to maintain macroeconomic stability. International financial institutions have expressed concern about Nepal's low level of non-performing assets. Considering that the non-performing assets of banks is an important criterion to assess the financial health of the banking sector, a higher concentration of these assets in the banking industry poses a systemic risk and significantly slows credit expansion. At the end of the current fiscal year, the countercyclical buffer—a macroprudential tool designed to mitigate potential cyclical systemic risks among banks—will be implemented. This policy tool was put on hold last year in an effort to enhance credit flow during the Covid-19 pandemic. Banks will need to raise capital in order to boost lending flow when the countercyclical buffer clause gets reinstated. The Macro Stress Testing Framework is expected to regulate the banking sector more effectively by improving its health and asset quality. Lastly, the central bank should utilise macroprudential instruments to reduce the volatility and vulnerabilities of the financial system and maintain macroeconomic stability.