Monetary policy curbs credit expansion to control inflation

Covid-19 had compelled the Nepal Rastra Bank to pursue a liberal monetary policy over the past two fiscal years with a view to extending credit to revive the pandemic-hit economy.

With the situation now having changed with excessive credit expansion causing a surge in imports resulting in the depletion of foreign currency reserves in addition to contributing to rising inflation, the central bank has devised a plan to reduce the expansion of credit and money supply in the market. .

Measures were also announced to help banks and financial institutions maintain more liquidity, as excessive lending in the early months of last fiscal led to a shortage of loanable funds to finance the productive sector in recent months.

Unveiling the monetary policy, central bank governor Maha Prasad Adhikari announced that credit expansion to the private sector would be limited to 12.6%, a sharp reduction from the 19% targeted last fiscal year.

Similarly, the new monetary policy aims to limit the growth of the money supply (cash, sight deposits, highly liquid non-monetary assets easily convertible into cash) to 12% compared to the 18% objective for the last financial year.

This is the first time that the growth target for credit expansion and money supply has been kept at such a low level for many years.

The greater the money supply and the expansion of credit, the greater the possibility of an increase in inflation due to the demand they create in the market. In the first 11 months of the last fiscal year, credit expansion to the private sector stood at 16%, as banks and financial institutions stopped lending more in the second half of the last fiscal year.

In the first few months, credit growth to the private sector had exceeded 30%.

Central bank officials have repeatedly admitted that most of the credit issued was for financing imports, contributing to a bloated balance of payments deficit and dwindling foreign exchange reserves.

Merchandise imports climbed 27.5% to 1,763 billion rupees, compared to 186 billion rupees of exports during the period. As a result, gross foreign exchange reserves fell 19.6% to $9.45 billion in mid-June 2022 from $11.75 billion in mid-July 2021.

Massive imports coinciding with a surge in global inflation caused by rising petroleum product prices contributed to high inflation of 8.56% over 70 months and the depletion of foreign exchange reserves.

Although monetary policy aims to keep inflation under control at 7%, as announced in the budget statement for the current fiscal year, the central bank estimates that it will be very difficult to keep inflation within this limit.

“The impact of rising fuel prices and supply constraints on prices will continue to linger for some time,” the monetary policy says. “While domestic demand (for goods and services) will increase due to the upcoming general elections, increased salaries (for government staff) through the budget and the expansion of the social safety net, there will be difficult to keep inflation within the limit.”

Experts say monetary policy has recognized that rising inflation and massive imports have become major concerns for the country’s economic health. “The question is whether the policy adopted will be adequate to control inflation and imports,” said Chiranjeevi Nepal, a former central bank governor.

Nepal said the central bank should have terminated some of the credit schemes, including refinancing, which contributed to an increase in imports and caused inflation from abroad with imported goods. Under this program, companies affected by Covid-19 would receive refinancing at the rate of 3 or 5%.

In the first 11 months of the last financial year 2021-22 ended July 16, a total of 24,305 borrowers received Rs 115.70 billion. In the previous financial year 2020-2021, a total of 48,890 borrowers received Rs 148.75 billion.

Governor Adhikari said the central government will review the refinancing policy, limiting this program to the productive sector, including agriculture, exports and sectors that have not yet recovered from the Covid-19 pandemic.

“Questions have been raised whether the refinancing package has been received by companies that urgently needed such a measure,” said Narayan Poudel, a former executive director of the central bank.

“Such refinancing should only be provided as emergency aid. If the central bank offers this option continuously, it will lead to credit expansion and affect economic stability.

Considering the impact of Covid-19, Nepal Rastra Bank had allowed banks and financial institutions to restructure and reschedule loans. He said he would reconsider this provision. The central bank has also proposed some measures to improve the liquidity situation of banks and financial institutions.

After Covid-19 hit the country, the central bank had adopted a policy allowing banks and financial institutions to keep the level of liquidity as low as possible so that they could increase credit to help the economy recover. .

Hence, the Cash Reserve Ratio (CRR), a certain percentage of a bank’s total deposits which it needs to keep its liquidity in Nepal Rastra Bank, and the Statutory Liquidity Ratio (SLR), which is the minimum percentage of deposits that a commercial bank needs to maintain in the form of cash, gold or other securities, have been reduced.

As the new monetary policy seeks to reduce credit expansion, it announced that the CRR and SLR would also be raised.

The CRR will increase from 3% to 4% from August 17, while the SLR will increase from 10% to 12% for commercial banks by mid-January next year. In the case of development banks and finance companies, it will be increased to 10% against respectively 8 and 7% currently.

The former governor of Nepal said that the CRR and SLR should have been increased more given the current situation of shortage of liquidity in the banking system and expansion of credit.

Poudel said the new monetary policy was mainly aimed at solving the problem of external sector risks such as widening balance of payments deficit, depletion of foreign exchange reserves and rising imports.

“To this end, he sought to control credit expansion and the money supply,” he said. “These are also necessary measures in the current context, but it may not help to achieve the projected economic growth of 8%.”

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