Dr. Prakash Kumar Shrestha

Nepal has now been reeling from the third wave of COVID-19. Nepal’s economy, which has just been recovering, seems to get badly impacted by the current wave of the pandemic triggered by its new variant of Omicron. With the resurge in infections, the government has already started imposing some restrictions on mobility and carrying economic activities. High infection rate, spreading into communities, has lowered the traffic volume on the street. Passing through the COVID-19 since March 2020, several challenges have emerged in the country’s economy, demanding a serious attention in the days to come.

Growing BOP deficit
The first challenge is to maintain external sector stability because of growing balance of payments (BOP) deficit. As a result of this, foreign exchange reserves have been depleting at a faster rate. Higher import growth and stagnant remittance inflows have created a huge gap in external sector. A BOP deficit of Rs. 195.0 billion was registered as of mid-December of 2021, which is the highest BOP deficit recorded so far.

Because of huge BOP deficit, the volume of foreign currency reserves has declined by 20 per cent from US$ 12.5 billion as of mid-December 2020 to US$ 10 billion as of mid-December 2021. The availability of foreign exchange reserves as of mid-December 2021 remained just sufficient to cover 6.8 months of import of goods and services compared to 13 months a year ago. Such a low level of reserve adequacy has happened after more than a decade. During mid-March 2010 to mid-May 2010, the level of foreign exchange reserves was also sufficient to cover just 6.8 months of imports of goods and services.

Deterioration on BOP deficit is expected to continue in coming few months given the pattern of imports and remittance inflows. However, if the current wave of the pandemic becomes severe and lowers the economic activities, the import growth seems to decline thereby reversing the trend of BOP deficit. Some policy measures recently taken by Nepal Rastra Bank (NRB) and the government to lower the import growth and increase the flow of foreign currency seems to help maintain stability in the external sector.

The second challenge is to maintain enough liquidity in the banking system. This issue is, in fact, related to the first one. The banking system has been witnessing a shortage of liquidity from the second month of the current fiscal year, due mainly to higher growth of credit than deposit. As of mid-December 2021, the year-on-year credit growth remained 31.2 per cent, while deposit growth just registered 15.9 per cent. There is a positive correlation between imports and credit growth. It seems that growing volume of credit has been used to finance the elevated level of imports. Leakage of liquidity as reflected in BOP deficit is a main reason for shortage of liquidity in the banking system. Banks' preference to provide credit to imports, considering it as less risky than to provide credit to other productive sectors, tends to fuel imports. Business community also thinks of selling goods by importing is easy and lucrative businesses to earn profit.

Abundant liquidity owing to the loose monetary policy and higher level of remittance inflows immediately after the first round of the lockdown during the first half of 2020 helped to lower interest rate very low. Base rate of commercial banks declined from 9.45 per cent before COVID- 19 hit the economy to as low as 6.66 per cent in mid-June 2021. Such a low interest rate environment discouraged the deposit and encouraged the credit demand in the economy. Authorities thought that lower interest rate environment would help the economy to recover from the worst impact of the pandemic. However, much of the credit went to finance imports and build up asset prices in the economy. Wealth effect from the rising asset prices like share and land propelled the demand for more imports, particularly luxurious goods.

Higher interest rate of deposits since the beginning of the second quarter of the current fiscal year is expected to help lower the credit demand and increase deposit mobilisations. However, the interest rate growth seems to be not sufficient to make adjustment on credit demand for imports. Earlier haphazard increase in interest rate in October 2021 by wide margin by some banks compelled the NRB to intervene in interest rate determination mechanism to smooth interest rate growth. Such an intervention makes that banks can only increase interest rate by 10 per cent of industry average interest rate of the previous month. In December 2021 and January 2022, banks and financial institutions did not increase interest rates of deposits by forming a cartel in the interest rate determination.

The third challenge is to maintain price stability. The first challenge started to emerge as early as mid-June 2021 and the second challenge popped up in August 2021. With these two issues, the challenge to price stability was surfaced in mid-December 2021, when consumer price-based inflation rose to 7.11 per cent. Such a high inflation has been recorded after fiscal year 2015/16. The last time monthly inflation above 7 per cent was recorded in mid-September 2016 since then inflation started declining.

A number of factors have built up inflationary pressure in the country’s economy posing challenge to maintain the targeted 6.5 per cent inflation in the current fiscal year. Increasing petroleum price in the international market has led to the rise of prices of petrol, diesel and LPG gas in the domestic market several times in recent months. Consequently, transportation price has risen. As in mid-December 2021, transportation price index rose by 16.2 per cent. The price of edible oil has also skyrocketed, registering a growth of 28.5 per cent as in mid-December 2021 over a year ago.

A higher credit growth as explained above has also increased the aggregate demand in the economy, which obviously raises the general price level in the economy. Further, depreciation of Nepali currency against US dollar time and again has also made imports costly most of the time. Before the emergence of COVID-19, the exchange of Nepali currency per US dollar was 113.76 (month end buying rate) which depreciated to as high as 121.09 as of mid-December 2021. Depreciation of the currency and increasing shipping costs have contributed to the rise in the price of imported non-food items. Further, rising interest rate in recent months also helps to push up inflation from cost side.

Inflationary pressure
To conclude, through the COVID-19 pandemic, three serious macroeconomic challenges such as depletion of foreign currency reserves, shortage of liquidity and inflationary pressure have emerged in Nepal’s economy. To manage these challenges, it is necessary to tighten monetary and fiscal policies to lower the aggregate demand in the economy. Rewinding of regulatory relaxation and monetary easing is also required. Such a change in policy direction will obviously hurt the economic recovery process, to some extent. Given the weak source of foreign currency reserves, the developing countries like Nepal have to face the external constraints while expanding internal economic activities and have not many choices but to compromise other objectives to maintain external sector stability.

(Dr. Shrestha is an executive director at Nepal Rastra Bank. (praks.shrestha@gmail.com)