Limitations of Nepalese Monetary Policy

The Central Bank of Nepal is implementing monetary policy since 2002/03 with the objective of maintaining price and external sector stability, increasing financial access and maintaining financial sector stability. The policy has been largely successful in its objectives though there are constraints from supply side and external sector. Due to its fixed exchange rate regime with India, underdevelopment of  financial market, the large size of informal economy and structural constraints, the effectiveness of the policy has somewhat challenged. Such constraints include:

1. Pegged Exchange Rate with India:

In a pegged exchange rate economy, the Central Bank must buy and sell foreign currency in foreign exchange market so as to maintain the pegged rate. In such intervention, if, for example, there is an excess supply of Indian currency in the market, the Central Bank must purchase it so as to prevent an appreciation of Nepalese currency thereby increasing the supply of Nepalese currency in the market. On the other hand, if there is excess demand for Indian currency in the market, the Central Bank must either increase the supply of Indian currency if it is possible or reduce the supply of domestic currency so that people's demand for Indian goods and services falls with a reduction in demand for IC. Whatever the Central Bank does, it's objective is to maintain the peg and the primary objective of price stability may be sacrificed. 

2. Large Informal Sector :

Many studies carried out so far has shown that  40 to 50 percent of the economic activities in the economy are done in an informal way that are out of notice of the government. The informal trade with India is a very good example. In such a market, the demand for and supply of money is hard to be predicted. And it becomes difficult to carry out monetary management in an effective way. 

3. Shadow Banking

In Nepal, besides the banks and financial sector, there are a bunch of other formal and informal institutions that carry our the functions similar to the banks. Some formal institutions include:Employee Provident Fund, Citizenship Investment Trust, Insurance Companies, Cooperatives, etc. The informal ones includes saving groups, dhukuti system, village money lenders, friends and relatives. The financial access survey carried out by UNCDF shows that only 40 percent of Nepalese adults have access to banks and financial institutions, the other 20 percent have access to other formal institutions and the rest are either served by the informal sector or completely out of financial access. This makes both the functions of monetary management and expansion of financial access challenging.

4. Under development of Financial Market

Due to the underdevelopment of money and capital markets, several challenges have been created:

a. There are not enough instruments available in the money market so that the Central Bank  can effectively manage short term liquidity. 

b. The imperfections in the market do not let the interest rate to be settled in realistic range. 

c. Due to underdeveloped capital market, the banking system has to finance the long term capital requirements including hydro-power and other infrastructures. But it's resources are mostly short and medium term, collected through saving and fixed deposit accounts. Such tendency has often created a problem of maturity mismatch in the banking sector. 

5. External Shocks:

Due to the fixed exchange rate regime, there is no mechanism to absorb the shocks that originate in the world market. Thus, the sharp changes in the petroleum prices, shocks in international exchange rates etc are directly transmitted to Nepal. 

6.Supply Side and Structural Constraints:

The supply side constraints like cartelling practices, artificial shortages, lack of information, lack of transport infrastructure, low skilled labor force, lack of agricultural infrastructures have created a challenge to control the inflationary pressures originating from the supply side. In such a case, the demand management policies from the monetary authority have lost their strength in many cases. 

7.Policy Lags 

There are many policy lags in all macroeconomic policies in general including :

a. Recognition Lag : It takes time to recognize the problem. 

b. Decision Lag: It takes time to take a policy decision. 

c.Implementation Lag:  It takes time to implement the policy decision. 

d. Impact lag : It takes some time for the policy decision to show its impact. 

These lags makes it challenging to solve the policy problem immediately. 

Monetary policy is a demand management policy that tries to maintain price and external sector stability in the economy. However, for doing so, it must have sufficient instruments and proper market infrastructures. In Nepal, the pegged exchange rate regime with Indian Currency as well as the structural and supply side constraints have posed some challenges to the effective implementation of monetary policy. Even then, it has been largely successful in achieving its objectives so far.