The Nepal Rastra Bank (NRB) on 21 July introduced the monetary policy for FY2014 largely supporting the budget’s growth and inflation targets of 5.5% and 8%, respectively. Overall, the monetary policy is loose and there is a provision to increase directed lending to deprived and priority sectors (at least 12% of total credit to agriculture and energy sectors).
One of the interesting things about this year’s monetary policy is the unchanged money supply growth target in the face of a decline in cash reserve ratio (CRR) and Standing Liquidity Facility (SLF). The CRR has been reduced by 100 basis points to 5%, 4.5% and 4% for commercial banks, development banks and finance companies, respectively. Similarly, SLF for commercial banks, development banks and finance companies has been reduced to 12%, 9%, and 8%, respectively. In FY2013, SLF for commercial banks, development banks and finance companies was 15%, 12%, and 10%, respectively. The bank rate is unchanged at 8%. Despite these, the central bank has left unchanged money supply growth at 16%.
The reduction in CRR and SLF increases monetary base and then eventually money supply.
- Monetary base = currency in circulation + reserves of banks in central bank
- Money supply = currency in circulation + demand deposits
When you reduce CRR, banks’ reserves in the central bank goes down, allowing them to lend more, which, ceteris paribus, increases the magnitude of money multiplier (the ratio of money supply to monetary base). Even if you keep money multiplier unchanged but increase monetary base, money supply increases. Alternatively, the only way you could have a constant money supply is by reducing money multiplier to such an extent that the total value of money multiplier times the increased monetary base is unchanged from last year, i.e. it would result in constant money supply growth. This seems to be a pretty daunting task for the central bank to hold on to. With the rise in the number of migrants and the incentive to remit more money back home due to the depreciation of Nepali rupee, net foreign asset is set to increase. It means the central bank has to print more Nepali rupees to match the extra incoming dollars. This automatically leads to an increase in money supply. Or am I missing here something?
One argument is that the NRB plans to channel the extra expected increase in lending (due to reduced CRR and SLR) to productive sectors, where the absorption capacity is relatively higher and would exert weak demand-push inflationary pressures. But, irrespective of channeling more credit to productive sectors, the conundrum is: how is the central bank planning an unchanged money supply growth by reducing reserve requirements?