Silent Features of Monetary Policy 2014-15

Silent Features of Monetary Policy 2014-15

By HomNathGaire

The Monetary Policy announced by Nepal Rastra Bank (NRB) for the fiscal year 2014-15 has introduced some micro level reforms within the banking sector. But it has also introduced some constraining policy measures, which it claims are aimed at controlling inflation. These measures have put the Monetary Policy in slight contrast to the government’s fiscal policy threatening the growth targets set by the government for this fiscal year (FY).

True that the policy unveiled by the central bank, soon after the government announced this FY year’s budget, has tried to use policy instruments to address the banking system’s liquidity surplus problem. Similarly, the policy has focused on strengthening financial discipline in the banking sector so as to maintaining financial stability. It has also paid attention to price and external sector stability. But in doing so, it has also taken some steps that are likely to impede the targeted growth rate fixed by the government through the budget.

To gain these objectives of stability in the financial sector, price level and foreign exchange rate, NRB has introduced various stringent provisions that make it difficult for the banks to expand credit. The only factor that motivated the central bank to tighten the monetary policy is excess liquidity, which has started pulling down short-term interest rates. Currently, the banking system has excess liquidity of around Rs 100 billion which has been pushing the interest rates down. At present the interest rates are already down to almost half what was two years back, both in deposits and loan.

“The fall in interest rates may increase flow of credit towards unproductive sectors like share market and real estate sector, artificially raising asset prices, which may destabilize financial sector,” reads the monetary policy document. Guided by this logic, NRB has already raised the Cash Reserve Ratio (CRR)– the portion of total deposits that Banks and Financial Institutions (BFIs) must park at the central bank at zero interest rate. But paradoxically, this is not expected to have much impact in the liquidity management while it will reduce the profitability of the banks.CRR and SLR for Different Classes of BFIs

Category of BFIs	2014/15		2013/14
	CRR	SLR	CRR	SLR
Commercial Banks	6 %	12%	5 %	12%
Development Banks	5 %	9%	4.5%	9%
Finance Companies	4%	6%	4%	6%

This hike in CRR will absorb more than Rs 10 billion from the banking system. However, it is not expected to have much impact on the credit creation power of the banking system as the Statutory Liquidity Ratio (SLR) fixed by the central bank for BFIs remains unchanged.

Policy Reforms & Liquidity Management

Nepali banking system has been facing the problem of excess liquidity repeatedly in the past; it was more serious for the past one year due to ever increasing remittance and rising government expenditures, especially during the Constituent Assembly (CA) elections lat year. Such repeated occurrence of excess liquidity is the reason that caused the central bank to make its open market operations effective and efficient, so that it can mop up or inject liquidity whenever needed. “In this regard, regular Open Market Operations (OMO), emergency Fine Tuning Operations (FTO) and Structural Operations (SO) will be conducted on regular basis as mentioned in the new OMO bylaw,” reads the policy. Along with this NRB has also opened two new windows to mop up the excess liquidity from the market—purchasing deposits of BFIs through auction and issuing NRB bonds.

OMO’s tools and instruments under new arrangement:

Tools	Instruments
Regular OMO	repo and reverse repo for a period of up to 7 days
Emergency FTO	repo, reverse repo and outright purchase auction for a period of up to 3 months
Structural OMO	repo, reverse repo and outright purchase auction for a period of up to 6 months and NRB bonds

The policy has brought some respite to the private sector. It was as demanded by the private sector that the policy has proposed to amend the existing Act that prohibits Nepalis from investing abroad. In this regard, the NRB has already allowed commercial banks to invest up to 40 per cent of their foreign exchange reserve in foreign money market tools like call deposits, certificate of deposit and other secure instruments for a period of up to two years.

The policy reforms and tools introduced by the central bank to manage liquidity have created space to move ahead in making out ward investment in the globalized context. However, success of this policy will depend on how effective and immediate its implementation will be

Directed Lending

The excess liquidity has now become a problem like 'Double Edged Razor' management. On the one hand, there is a problem of excess liquidity and low interest rate and on the other hand the central bank has been facing problems in directing credit to the so called ‘productive sectors’. In its earlier monitory police, NRB had already asked commercial banks to have at least 20 per cent of their total credit outstanding in the productive sector within mid-July 2015. However, so far the banks have not been able to increase this ratio to even to 12% and they are citing unfavourable investment climate for this shortfall. But, NRB has now directed even the development banks and finance companies to meet a minimum threshold of such lending. Accordingly, they have to extend 15 per cent and 10 per cent respectively of their total loans to productive sector, within mid-July, 2016.

These directives align with the government's focus on developing energy, agriculture and manufacturing sectors for achieving the targeted economic growth, and subsequently graduate to the status of developing country by 2022 AD. Adding to it, NRB has brought down the refinancing rate for loans extended to agriculture, hydroelectricity, livestock, and poultry and fishery businesses to 4 per cent from 5 per cent.

SME Focus

In line with the fiscal policy unveiled by the government, NRB has encouraged BFIs to increase lending to Small and Medium Enterprises (SMEs). In order to promote SMEs, NRB has been planning to introduce more flexible and effective provisions for loan security/insurance by offering more discounts on security fee/premium and loan loss provisioning for such lending.

To boost the real sector of the economy, the monetary policy has also incorporated a provision of collateral free loan for cottage and small industries. Under this provision, SMEs that are already in operation can obtain a collateral -free loan up to Rs one million based on their transactions, while the new ones will be entitled to get credit of up to Rs 0.5 million. "NRB will also introduce provision to extend funds to enterprises that have obtained seed money from start-up funds proposed by the government," reads the policy.

NRB has also assured that it will make necessary provisions to provide agriculture loans at not more than 6 percent interest as announced by the budget.

Price Stability

The Monetary Policy of 2014-15 has set a target of containing inflation at 8 per cent, in line with the fiscal policy projection. But it is almost sure that like in the recent couple of years, this time also NRB will not be able to meet this target. The policy has indirectly conceded to this possibility while stating “keeping inflation under the targeted rate is a challenge due to continuous increment in remittance income, high prices in India, rise in prices of petroleum products and domestic supply side constraints.”

Main objectives (box)

·        Price stability through effective liquidity and demand management

·        Expansion of credit towards productive sector

·        Ensure financial stability

·        Raise access to finance

·        Ensure external stability

Financial Sector Development (FSD)

In order to ensure financial sector stability, NRB has assured that the capital base of BFIs would gradually be strengthened. "BFIs that have failed to meet minimum regulatory capital requirement will be barred from opening new branches, distributing cash dividend along with limiting their lending and deposit mobilization to a certain level," states the policy. The policy has announced to take Prompt Corrective Action (PCA) against BFIs that fail to maintain adequate liquidity. Currently, such an action is taken only if BFIs' fail to maintain required capital adequacy ratio.

Major Provisions for FSD

·        Restriction on opening new BFIs continued

·        To formulate Financial Sector Development Strategy

·        Mandatory credit rating of borrowers prior to extending big-size loans from commercial banks

·        Interest spread a tool to gauge the professionalism of BFIs

·        Incentive to convert financial cooperatives into microfinance institutions

·        Increase in the ceiling of unsecured loans by micro finance institutions

Financial Inclusion

The monetary policy has encouraged micro-finance institutions (MFIs) to ensure increased access to financial services to rural people. "Considering the role played by ‘D’ class financial institutions in financial inclusion and poverty reduction, we will further strengthen the MFIs addressing the problems in the sector," states the policy.

Stock Market (box)

The central bank has tightened flow of credit to the secondary market. Earlier, BFIs were free to make lending against collateral of share certificates on their own risk and analysis of the market. Now, NRB is planning to impose margin ceiling on loan against shares stating that the previous provision was too loose. NRB’s this step would hamper the growth of the country's secondary market, which is heading to break historical high of the market index, Nepse.

Micro Management

Although the monetary policy has tried to be balanced in the macroeconomic fronts, it seems that NRB is interested in some micro issues of BFIs. The policy introduced a provision that bares BFIs from appointing directors and chief executive officers (CEOs) for more than two consecutive terms. Defending this provision, the policy paper argues that corporate governance in BFIs, where chairmen, directors and CEOs served for a longer term, remained weaker and could not protect the interests of the depositors. It has directed BFIs to fall in line with this provision within this fiscal year.

The policy has insisted on separating bankers and businessmen – an issue raised since Dr. Yub Raj Khatiwada was appointed the Governor. It has also restricted BFI directors and CEOs from taking loans from other BFIs for companies in which they own a majority stake.

Meanwhile, the policy has restricted a person having more than a certain percentage of equity in a BFI from holding the position of a CEO in the same BFI. Such provisions in the monetary policy clearly indicate that the central bank is trying to involve in micro management of BFIs rather than focusing on macroeconomic issues.

Contradicts with Fiscal Policy

Generally, monetary policy is adopted in line with the Government’s fiscal policy.  Since the government’s budget is expansionary, as it has considerably hiked the total budget outlay projecting an economic growth rate of six per cent, it was expected that the monetary policy too would be expansionary to support targeted economic growth enabling the private sector to get loans at lower interest rates. However, the monetary policy’s stance of monetary tightening aimed at containing inflation, which currently stands at close to 10 per cent, is clearly in the opposite direction.

NRB is concerned that the persistence of liquidity surplus in the banking system and the excess flow of money into unproductive sectors like share and property markets, is artificially raising asset prices. Though the tougher policy measures are aimed at strengthening productive sector’s growth, the same measures are expected to hinder the banks from lending to productive sector despite availability of liquidity at cheaper rates.

Countries like Nepal, where supply constraints are the major bottlenecks of growth, such demand management policy would further impede the growth process.