Stabilising prices

  • Monetary tools should be adopted to keep inflation within 7.5 percent as projected in this year's budget
- TULA RAJ BASYAL, Kathmandu

Jul 12, 2016-

The rate of Nepal’s economic growth went down to 2.7 percent in 2014-15 and is estimated to remain below one percent in 2015-16. The current rate of inflation is estimated at 10 percent due to supply-side disturbances. Because of these circumstances, the Nepali economy is suffering from stagflation—stagnant output and high inflation. The situation calls for the adoption and effective implementation of policies aimed at strengthening the supply-side. Equally important is pursuing a monetary policy to ensure price stability and keep the inflation rate 

in check.

High budget deficit

For any country, budget deficit has strong inflationary implications. The budget for 2016-17 has estimated a deficit equal to 10 percent of the projected gross domestic product (GDP)—the highest in the budgetary history of Nepal. Consequently, the gross debt receipt will reach 11.9 percent of GDP (foreign 7.6 and domestic 4.3) in 2016-17. In the past, the ratio of budget deficit remained high during the 1980s, averaging at 8.3 percent during the period from 1982-83 and 1991-92, with the highest ratio (nine percent) recorded in 1982-83. Such a high deficit caused inflation, which averaged at 11.3 percent during the decade. The other consequence of the high budget deficit was the balance of payments (BOP) deficit, which averaged at 1.4 percent of GDP during the consecutive three years of 1982-83, 1983-84, and 1984-85. Economic growth rate only averaged 4.7 percent during this period. Thus, the impact of high budget deficit on internal balance (price situation) and external balance (BOP) was unfavourable, given the diminutive positive outcome in terms of GDP growth. 

Normally, it is not advisable to have the fiscal deficit/GDP ratio higher than five percent, as it could promote macroeconomic instability besides increasing the risk of crowding out private sector investment. Thus, given the current budget deficit ratio, the fiscal policy of the country needs to support the current account convertibility in the external sector transactions, which was adopted in Nepal in 1992-93, when in view of the need for ensuring viability in the current account convertibility, maintaining fiscal discipline by controlling deficit became a pre-requisite. Similarly, the budget deficit was managed at an affordable level since 1992-93 onwards. During 2012-13, 2013-14, and 2014-15, there was actually a budget surplus which, as a percentage of GDP, remained at 1.8, 2.1, and 1.0 percent respectively. Suddenly, the economy is facing substantial risk on account of the unprecedented level of budget deficit and macroeconomic instability in 2016-17.

During the eight-year period (2008-09 to 2015-16), inflation averaged at 9.5 percent, whereas economic growth averaged at 3.9 percent. During the last two years (2014-15 and 2015-16), economic growth has averaged at 1.6 percent only. This demonstrates the situation of stagnant growth and high inflation. As a symptom of high inflation, currency in circulation increased by an average of 17.2 percent during the three years of 2013-14 to 2015-16, higher than the monetary policy projection at 16.3 percent. Inflationary expectation is also building up in the economy at present. If not subsided in time, such expectation could further destabilise the economy. So, the present focus should be on bringing down the inflationary expectation and moving the economy along a normal trajectory.

Contractionary policy

The use of government spending to stimulate a higher level of economic activity is known as an expansionary fiscal policy. Likewise, a contractionary monetary policy—a form of economic policy used to fight inflation, which involves decreasing the money supply in order to increase the cost of borrowing, which in turn decreases GDP and dampens inflation—can be used as a tool to limit the money supply in the economy. When the budget is expansionary, the monetary policy should be contractionary.  When both the policies become expansionary, the objectives of price stability cannot be achieved. The main purpose of a contractionary monetary policy is to slow down the acceleration in inflation. Slowing inflation cools off the markets and brings down overall demand and prices. So, there is a need to reduce inflationary expectation arising from the highly expansionary stance of the budget for 2016-17. 

In view of the past eight years’ near double-digit inflation, consumers and investors have been building inflationary expectation, which needs to be broken and conditions of stability, confidence, and trust restored to promote investment, production, and productivity in the economy. Monetary tools should be adopted to mitigate inflationary effects of the expansionary budget. This is the only measure for the Nepal Rastra Bank (NRB) to keep inflation within 7.5 percent as projected in the budget for 2016-17. The central bank’s responsibility for price stability is clearly established in the NRB Act, which has empowered it to formulate and implement the necessary monetary policy for ensuring price stability. The Act also mentions that the NRB will assist in implementing the government’s economic policy only when such action does not produce an adverse impact on the central bank’s objectives. So the need of the hour is for the NRB to comply with the legal mandate and implement a contractionary monetary policy to ensure price stability.

Basyal is a former executive director of Nepal Rastra Bank and former senior economic advisor to the Ministry of Finance

Consumers and investors 

have been building inflationary expectation, which needs 

to be broken and conditions 

of stability, confidence, 

and trust restored 

Published: 12-07-2016 11:17

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