Monday, April 14, 2014

Taming high inflation in Nepal

[This blog post is adapted from Nepal country chapter of Asian Development Outlook 2014. The FY2014 and FY2015 outlook here.]

Average inflation has surpassed 9% in each of the past 5 years except for FY2012, when it was only slightly less. Inflation at 12.6% in FY2009 was the highest in the past 2 decades, largely driven by 17.4% rise in the price of food, which occupies a 46.8% share of the consumer price index basket. Since then, food inflation has slowed but remains high, averaging 11.7% in the past 4 years. Similarly, inflation for other items and services has surpassed 9% in the past 2 years. Taming high inflation, which erodes consumers’ purchasing power and makes producers less competitive, is one of the country’s major macroeconomic challenges.

Inflation in Nepal tends to move in tandem with inflation in India, which is Nepal’s largest trading partner and with whose currency Nepal has pegged its rupee. According to a study by the International Monetary Fund, inflation in India and international oil price movements account for about one-third of the variability in Nepal’s inflation. Moreover, after FY2007 inflation became more responsive to changes in international oil prices and the nominal effective exchange rate. Food price inflation, which has contributed about three-fourths of all consumer price index inflation in recent years, is more responsive to spillover from oil price movement and India’s food inflation. The impact of international oil price movements seems more pernicious because a rise in petroleum product prices is quickly felt in the price of chemical fertilizers and transportation. Monetary factors affect both food and nonfood inflation, but their effect tends to fade away quickly.

Other factors that have driven inflation in recent years are weak currency, wage pressures, and supply-side constraints. The depreciation of the Nepalese rupee against the currencies of its trade partners has inflated costs not only for final goods but also for imported raw materials and intermediate goods. Furthermore, 161 products, mostly industrial raw materials, are imported from India in exchange for US dollars. Supply-side constraints such as power outages, transportation bottlenecks, and market price distortions imposed by middlemen and syndicates have also played major roles in keeping inflation high. These factors appear to have intensified since FY2007, when inflation in Nepal started to diverge from its usual path in tandem with inflation in India. Syndicates’ arbitrary hikes in transportation costs and the widening gap between farm gate prices and retail prices— estimated to be at least 40% in the case of fresh vegetables— have propped up high inflation.

Though the government has banned syndicates and anticompetitive practices, enforcement remains weak. Effective market supervision and monitoring are needed to rectify market distortions. Another need is to check inflationary expectations by ensuring prudent fiscal and monetary policies. A way to diminish inflationary expectations would be to remove uncertainty over supplies of motor fuel and cooking gas. Appropriate steps to boost agricultural production would also help meet market demand and limit the impact of imported inflation. Taming inflation requires that financial policies and structural bottlenecks alike be effectively addressed.