Predicting economic movements in impoverished economies is a daunting task. It becomes even more challenging when an economy opts to give up independent monetary policy for pegged exchange regime and nearly free capital movement with the economy that commands nearly two-third of the total foreign trade.
As shown by the Mundell–Fleming model, which is often called the ‘Impossible Trinity’, an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. Yes, undoubtedly, I am talking about economic dynamics of Nepal and India. As the leaders continue to breed political mess in name of taking the ongoing peace process to a logical end and bringing a federal democratic constitution, yet another unexpected, though positive, development has surfaced and this time in the county’s balance of payment (BOP).
In 2010 the country suffered the worst BOP deficit in history that, in fact, shook the very foundation of Nepal’s fragile economy. The pace of the BOP deficit was so rapid that many had started questioning country’s ability to finance essential imports for a longtime. When the present governor of the central bank the assumed the post in March 2010, he was exposed to a Herculean challenge of dealing with the whopping BOP deficit, owning mainly to widening mismatch between the inflow and outflow of foreign currency, notably the US dollar. The receipt of dollar declined mainly due to the weakening remittance in the aftermath of global financial crisis and tumbling export sector. In contract, the outflow of dollar surged due to the robust rise in the realty-fuelled aggregate demand, resulting in that hefty rise in imports of gold, vehicles and oil. At one time that is in November 2010, the BOP deficit scaled up to an alarming level of Rs 23 billion.
When new governor unveiled his first monetary policy in July 2010 and declared that he would turn the deficit into surplus within a year, there were very few people, including myself, to take his statement seriously. However, surprisingly he was able to bring a surplus in the BOP, though it is difficult to scan how far his own efforts or the policies adopted by the central bank contributed for such a magnificent turnaround. Anyway, without any hesitation, the present governor Dr. Yubaraj Khatiwada and his leadership to the central bank must be credited with achieving the target of a surplus in the BOP at the end of fiscal year 2010/11.
Fortunately, the decline in imports following the burst of the realty bubbles in 2009 and revival of remittance income due to healthy expansion of the oil-price-based Gulf economies greatly helped to bridge the wide gap in inflow and outflow of dollar, ultimately helping to continue build up the BOP surplus. As the result of whopping rise in the remittance income, which currently stands at 35 percent compared to same period last year, the overall surplus has touched a record Rs 75 billion.
In economics, having good surplus in the BOP is generally regarded as the positive development, for it has little negative impacts on the economy and particularly nominal for those economies that maintains a fixed exchange regime. To put it in a simple way, a surplus in BOP leads to a buildup of country's international reserves, which particularly strengthens external stability of the economy and enhances confidence on the economy.
Such scenario in a market-driven exchange regime will strengthen domestic currency, leading to appreciation of domestic currency vis-à-vis foreign currencies. That is actually what happened to Japanese economy during nineties, which is widely known as lost decade for the Japanese economy. The appreciation of currency brings many ills particularly to the economy that has very limited products to export and weak industrial based to meet domestic demand; thus heavily dependent on imported products.
So in simple term, appreciation of currency makes import cheap and dents competitiveness of exportable products in the international market, leading to widening of trade deficit. However, Nepal no needs to worry about the possible problems since it maintains a fixed exchange regime with the Indian currency.
Another possible consequence of the hefty BOP surplus can be seen in nominal interest rate. The huge inflow of remittance means a robust increment in the Net Foreign Assets (NFA) of the banking system. According to latest data, the NFA has gone up by almost 35 percent by February 2012. However, during the same period Net Domestic Assets (NDA), which together with NFA makes the broad money supply (M2), recorded a negative growth rate when inflation is adjusted. Thus, the nominal broad money supply increased by 11.6 percent along with 7 percent inflation.
This is alarming in the sense that inflation is already hovering around the annual target even at a time when domestic credit from the banking system increased by just 2.2 percent. So, if the economy revives and credit flow to the economy increases, then in no time the inflation will soon shoot up much beyond the annual target.
Similarly, the growing mismatch between the huge accumulation of NFA and yawning demand of fresh credit from the private sector is already putting the banking system in trouble.
The liquidity-obesed banking has already started lowering the deposit interest rate and according to an estimate the average one-year fixed deposit interest rate is already down by 3 percentage point within the period of one year. This can produce two consequences: first; excessive domestic liquidity will induce banks to go for reckless low yielding and speculative loan projects, jeopardizing the long-run financial sector stability in the process.
Second; when the deposit interest rate decline below the inflation rate and starts producing negative interest that will instigate the depositors to the look into other options of high returns, including capital flights, speculative investments and informal lending.
As shown by the Mundell–Fleming model, which is often called the ‘Impossible Trinity’, an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. Yes, undoubtedly, I am talking about economic dynamics of Nepal and India. As the leaders continue to breed political mess in name of taking the ongoing peace process to a logical end and bringing a federal democratic constitution, yet another unexpected, though positive, development has surfaced and this time in the county’s balance of payment (BOP).
In 2010 the country suffered the worst BOP deficit in history that, in fact, shook the very foundation of Nepal’s fragile economy. The pace of the BOP deficit was so rapid that many had started questioning country’s ability to finance essential imports for a longtime. When the present governor of the central bank the assumed the post in March 2010, he was exposed to a Herculean challenge of dealing with the whopping BOP deficit, owning mainly to widening mismatch between the inflow and outflow of foreign currency, notably the US dollar. The receipt of dollar declined mainly due to the weakening remittance in the aftermath of global financial crisis and tumbling export sector. In contract, the outflow of dollar surged due to the robust rise in the realty-fuelled aggregate demand, resulting in that hefty rise in imports of gold, vehicles and oil. At one time that is in November 2010, the BOP deficit scaled up to an alarming level of Rs 23 billion.
When new governor unveiled his first monetary policy in July 2010 and declared that he would turn the deficit into surplus within a year, there were very few people, including myself, to take his statement seriously. However, surprisingly he was able to bring a surplus in the BOP, though it is difficult to scan how far his own efforts or the policies adopted by the central bank contributed for such a magnificent turnaround. Anyway, without any hesitation, the present governor Dr. Yubaraj Khatiwada and his leadership to the central bank must be credited with achieving the target of a surplus in the BOP at the end of fiscal year 2010/11.
Fortunately, the decline in imports following the burst of the realty bubbles in 2009 and revival of remittance income due to healthy expansion of the oil-price-based Gulf economies greatly helped to bridge the wide gap in inflow and outflow of dollar, ultimately helping to continue build up the BOP surplus. As the result of whopping rise in the remittance income, which currently stands at 35 percent compared to same period last year, the overall surplus has touched a record Rs 75 billion.
In economics, having good surplus in the BOP is generally regarded as the positive development, for it has little negative impacts on the economy and particularly nominal for those economies that maintains a fixed exchange regime. To put it in a simple way, a surplus in BOP leads to a buildup of country's international reserves, which particularly strengthens external stability of the economy and enhances confidence on the economy.
Such scenario in a market-driven exchange regime will strengthen domestic currency, leading to appreciation of domestic currency vis-à-vis foreign currencies. That is actually what happened to Japanese economy during nineties, which is widely known as lost decade for the Japanese economy. The appreciation of currency brings many ills particularly to the economy that has very limited products to export and weak industrial based to meet domestic demand; thus heavily dependent on imported products.
So in simple term, appreciation of currency makes import cheap and dents competitiveness of exportable products in the international market, leading to widening of trade deficit. However, Nepal no needs to worry about the possible problems since it maintains a fixed exchange regime with the Indian currency.
Another possible consequence of the hefty BOP surplus can be seen in nominal interest rate. The huge inflow of remittance means a robust increment in the Net Foreign Assets (NFA) of the banking system. According to latest data, the NFA has gone up by almost 35 percent by February 2012. However, during the same period Net Domestic Assets (NDA), which together with NFA makes the broad money supply (M2), recorded a negative growth rate when inflation is adjusted. Thus, the nominal broad money supply increased by 11.6 percent along with 7 percent inflation.
This is alarming in the sense that inflation is already hovering around the annual target even at a time when domestic credit from the banking system increased by just 2.2 percent. So, if the economy revives and credit flow to the economy increases, then in no time the inflation will soon shoot up much beyond the annual target.
Similarly, the growing mismatch between the huge accumulation of NFA and yawning demand of fresh credit from the private sector is already putting the banking system in trouble.
The liquidity-obesed banking has already started lowering the deposit interest rate and according to an estimate the average one-year fixed deposit interest rate is already down by 3 percentage point within the period of one year. This can produce two consequences: first; excessive domestic liquidity will induce banks to go for reckless low yielding and speculative loan projects, jeopardizing the long-run financial sector stability in the process.
Second; when the deposit interest rate decline below the inflation rate and starts producing negative interest that will instigate the depositors to the look into other options of high returns, including capital flights, speculative investments and informal lending.
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