Formulation of Contractionary Monetary Policy Required at the Time When Fiscal Policy Brought into Implementation is Expansionary
1. Unprecedented Level of Budget Deficit
During the three-year period of 2012/13 through 2014/15, there occurred budget surpluses averaging at 1.6 percent of gross domestic product (GDP). As per the revised estimate for 2015/16, there was budget deficit at 2.9 percent of GDP. The budget deficit for 2016/17 is estimated to be substantially high, amounting to Rs. 256.3 billion or 10 percent of projected GDP at Rs. 2574.5 billion which is based on the projections of economic growth at 6.5 percent and inflation at 7.0 percent in 2016/17. However, it would not be advisable to maintain fiscal deficit/GDP ratio higher than 5 percent even for developing countries as the same could promote macroeconomic instability besides increasing the risk of crowding out the private sector investment. Likewise, the gross debt receipt as percent of GDP averaged at 3.4 (foreign 1.1 and domestic 2.3) during the seven-year period of 2009/10 through 2015/16. In 2016/17, the gross debt receipt is projected to surge to Rs. 306.7 billion (foreign Rs. 195.7 billion and domestic Rs. 111.0) which, as percent of projected GDP, will reach 11.9 (foreign 7.6 and domestic 4.3).
In the past, the budget deficit / GDP ratio remained high, especially during the 1980s. The budget deficit / GDP ratio during the 1982/83 – 1991/92 decade averaged at 8.3 percent, with the highest ratio so far being in 1982/83, namely, 9.0 percent. The projected ratio of 10.0 percent for 2016/17 is the highest ratio so far in Nepal. It may be recalled that the current account convertibility in the external sector transactions was adopted in 1992/93. For ensuring viability in the current account convertibility, fiscal discipline became the pre-requisite. Accordingly, budget deficit was managed at affordable level since then. During 2012/13, 2013/14, and 2014/15, there was actually budget surplus which, as percent of GDP, remained at 1.8, 2.1, and 1.0 respectively. So, the economy is facing substantial risk on account of the unprecedented level of budget deficit in 2016/17.
2. Inflation at Double Digit
During the eight-year period (2008/09-2015/16), inflation averaged almost double-digit growth at 9.5 percent whereas economic growth averaged at 3.9 percent. During the last two years (2014/15 and 2015/16), economic growth averaged at 1.6 percent only. This evidences 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 compared to its average projection at 16.3 percent as per the monetary policies for 2013/14, 2014/15, and 2015/16. At the present moment also, inflationary expectation is building up in the economy. If not subsided in time, such expectation could further destabilize the economy. So, the present focus should be on bringing down the inflationary expectation and moving the economy along the normal trajectory.
3. Expansionary Fiscal Policy Requires Contractionary Monetary Policy
At the outset, let us define what is meant by expansionary fiscal policy and contractionary monetary policy. The use of government spending, transfer payments or tax cuts to stimulate a higher level of economic activity is termed as expansionary. Likewise, the use of monetary policy tools to limit the money supply, raise interest rates, and encourage a leveling-off or reduction in economic activity comprises contractionary monetary policy (Goodwin; Neva, and others, Macroeconomics in Context, PHI Learning, 2009)
When the budget is expansionary, the monetary policy should be contractionary. If both the policies are expansionary, stability objectives (both price and exchange rate) will not be achieved. Inflation causes ever-increasing prices, which can negatively impact consumer spending power. A monetary contraction stabilizes prices in the market and the inflation slows. 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 go down with demand.
There is the need for reducing inflationary expectation arising from highly expansionary budget for 2016/17. Besides, 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 for fostering 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 NRB to control inflation within 7.5 percent as projected by the budget for 2016/17. NRB responsibility for price stability is clearly established in the NRB Act which has empowered the NRB to formulate necessary monetary policy and implement or get implemented the policy for ensuring price stability. Along with monetary policy, another associated objective is maintaining exchange rate stability for which the NRB is empowered to formulate necessary exchange rate policy and implement or get implemented the policy for ensuring exchange rate stability. The Act also mentions that the NRB will assist Government in implementing the economic policy of the Government only when such action does not produce any adverse impact on the NRB objectives. So, the need for NRB is complying with the legal mandate. Besides, Government also needs to focus on supply-side policies to improve supply situation and ensure price stability.
– Tula Raj Basyal
Former Executive Director, Nepal Rastra Bank, and Former Senior Economic Advisor, Ministry of Finance, Government of Nepal