Double-digit danger

In the past few weeks, two important economic policy reviews were made public. The first was the review of current economic situation by Nepal Rastra Bank (NRB), the central monetary authority, for the first five months of the current fiscal year and the second was the mid-term review of the budget. The reviews give a mixed picture of the state of the economy. Going through the reviews, it’s obvious that economic growth was dismal, inflation continued to hit us hard, and the Balance of Payment deficit reached a whopping Rs 20 billion. The only bright aspect of the reviews was that government revenue rose by 37 percent than expected.



The bad news: Nepal suffered from agflation (inflation led by agricultural commodity prices) and stagflation (a condition associated with higher inflation and economic stagnation occurring simultaneously). Despite the long liquidity crunch, the double-digit rate of inflation continued and it is, of course, a dangerous symptom. According to NRB, the year-on-year inflation was 11.3 percent as compared to 14.1 percent in the same period last year. In the review period, the price index of food increased by 17.8 percent. Similarly, the wholesale price inflation increased by 18.9 percent compared to 10.1 percent a year ago. The index of agricultural commodities increased by 38.7 percent compared to 6.1 percent a year ago.



Causes



The first intrinsic cause of stagflation is perennially low real economic growth of the economy. Even this low growth is “cosmetic”, sustained by only remittance inflow and foreign aid/grant and spending by INGOs, which helped maintain gross domestic consumption. The high rate of unemployment and underemployment is one of the key factors behind low growth. However, increases in aggregate demand and national income rose due to remittance inflow. The marginal propensity to consume is nearly 0.90, which means that out of every Rs 100 rupees earned, Rs 90 is spent on consumption. The economy is suffering from supply deficiency—the domestic products could not meet the domestic aggregate demand. More than 80 percent supply depended upon imports. Out of every Rs 100 rupees transaction in international trade, Rs 84 is used for import and only Rs 16 for export. Mild inflation is desirable since it works as tonic in the economy. Despite the fact that inflation hits hard the poor section of the society, mild inflation encourages producers to invest due to lucrative profit margins. However, in the absence of real sector growth and investment incentives, the positive effect of inflation gets totally cancelled out by the supply bottlenecks in the economy.



The second cause is fixed exchange rate arrangement between India and Nepal and corresponding adjustment with US dollar. The trade deficit with India in the last fiscal year was NRs 103 billion. The trade competitiveness of India and Nepal is not the same, however, Nepali currency is continuously overvalued with Indian currency even though the purchasing power of Nepali currency is going down continuously.



Third, remittance inflow is the sole cause of the mushrooming of commercial and development banks and financial institutions despite low domestic growth rate. With the financial sector growth, the private sector credit has also grown dramatically. Recently, an International Monetary Fund (IMF) delegation said that deposits have increased by just 6 percent whereas credit expansion has gone up by a whopping 225 percent. This also led to an inflationary pressure in the economy.




Fourth, money supply is also contributing to price rise. There is now a broad agreement among economists that inflation rate is essentially dependent on the growth rate of money supply in the long run. The factor affecting the money supply in Nepal is not dependent on the real growth in the domestic economy. It is basically dependent on remittance inflow, foreign aid and grant, and INGOs investment on their “development enterprises”. It also helps soar price level.



Fifth, there is no doubt that the provision in this year’s budget for huge personal income tax exemption is also contributing toward rise in price level. The large fiscal deficit is also contributing toward price rises. The development activities are sub-optimal; only 13.68 percent of capital expenditure has been spent in the first half of the fiscal year. This clearly shows employment has not been generated and only recurrent expenditure is being spent, thus contributing to raise inflation.



Remedies



First, the monetary policy is the most important tool for arresting inflation. Increased interest rates will help in lowering inflation. Higher interest rates reduce consumer spending because it increases the cost of borrowing. Higher rates also make it more attractive to save money, thus reducing disposable income.



Second, supply-side policies should aim to increase long-term competitiveness and productivity in the economy. For example, quality privatization and regulation can make economy more productive. The supply-side bottlenecks and economic repression should be removed. Policy-based incentives should be given to attract agriculture and manufacturing sectors. In the long run, supply-side policies can help reduce inflationary pressures.



Third, fiscal policy is another demand-side policy, similar in effect to monetary policy. Fiscal policy involves changing tax and spending levels, in order to influence the level of aggregate demand. To reduce inflationary pressures, the government can increase tax and reduce government spending on unproductive sector. Similarly, fiscal measure in subsidies in agriculture and manufacturing sector can also help to enhance productivity.



Fourth, to control inflation in the long run, Nepali rupees must be depreciated. The present exchange rate has been unaltered since 1992 and that absolutely makes no sense given the relative growth of India and Nepal on the basis of trade competitiveness. NRB must immediately alter the exchange rate to about NRs 2: IRs 1 to adjust the purchasing power of both currencies. In the short-run, it may create inflationary pressure, however, in the long-run, it will help to lower inflation.



Fifth, and most importantly, agflation has been with us for some time. The population growth rate over the past decade exceeded 2.15 percent while the agriculture sector real growth rate has been less than 2.1 percent. This clearly shows the supply-demand imbalance in food stuffs. Given this, the unavoidable conclusion is that food price inflation is not at all the result of inadequate supplies but in substantial measure the result of speculation. What is called for then is not measures that rein in inflation by slowing down growth but direct measures to deal with speculators and to discourage hoarding while augmenting availability through a strengthened public distribution system. This is likely to be more effective and less damaging for the economy. But that does not seem to be the direction the government is taking.



b.p.bhurtel@gmail.com

Related story

Water level of Narayani River crosses danger mark