Assessing The Monetary Policy Calibration

Nepal Rastra Bank (NRB), the central regulatory and monetary authority, has envisioned addressing the challenges of the economy by issuing an accommodative Monetary Policy for Fiscal Year 2024/25. The stance of any Monetary Policy is determined by two key factors: the economic situation of the country and the financial health of banks and financial institutions (BFIs).

“Monetary Policy 2024/25 overlooked the financial health of BFIs through which the policy measures are executed. It failed to strike a delicate balance in addressing the challenges of the economy without adversely impacting financial stability,” said Nara Bahadur Thapa, former Executive Director of Nepal Rastra Bank.

“Derailed from the reforms undertaken in recent years to strengthen financial stability in the country, NRB has set aside its primary role and introduced an expansionary Monetary Policy at a time when solvency issues are a concern for the BFIs,” he added.

The solvency indicators of commercial banks are alarming. The Capital Adequacy Ratio (CAR), which includes two components – common equity tier 1 (CET1) capital, or core capital, and secondary capital – requires a minimum of 11%. NRB has slightly increased CET1 to 9%, incorporating a 0.5% counter-cyclical capital buffer from mid-July 2024. Among these two components of the Capital Adequacy Ratio, CET1 is crucial. Currently, 10 out of 20 banks in operation have solvency concerns.

“CET1 is crucial from a regulatory perspective, and the central bank must enforce prompt corrective action if banks fail to comply with regulatory requirements. This will hinder the banks’ ability to expand their business (credit),” according to Thapa.

Previously, some banks were barred from distributing post-tax profits (dividends) to shareholders despite being profitable. Given the magnitude of their shortfall in regulatory capital, these banks will primarily be barred from paying dividends. Additionally, they will be restricted from loan expansion, which is the major source of earnings for banks.

To avert this adverse situation, Nepal Rastra Bank has allowed banks to issue debentures up to 100% of their core capital to ease capital constraints. Moreover, the Monetary Policy has introduced measures, such as including certain regulatory reserves in Tier 2 capital. However, bankers have expressed concerns that these measures will not sufficiently address the pressure on CET1, making it difficult to achieve the credit expansion target for the private sector.

12.5% credit expansion target for private sector

In light of the flexible policy measures, the Monetary Policy 2024-25 has set a 12.5% credit expansion target for the private sector, compared to a meagre credit growth of around 5.6% in the previous fiscal year 2023/24 and 3% in fiscal year 2022/23. The slowdown in credit expansion adversely affected BFIs’ profitability.

Rameshore Prasad Khanal, former Finance Secretary and a seasoned economist, warned that if NRB does not intervene in time with cautious monitoring of credit expansion, the situation could become extreme. He cited the example of NRB’s flexibility during the Covid 19 pandemic when measures like refinancing schemes, loan rescheduling, and restructuring facilities led to an ‘asset price bubble.’ Khanal emphasised that careful monitoring is crucial to prevent a similar situation where credit flows into unproductive sectors, risking financial sector stability.

During FY 2020/21, BFIs’ credit expansion of around 27% to the private sector spurred a boom in the stock market and real estate. To correct that situation, NRB implemented contractionary Monetary Policies in the following two fiscal years – FY 2021/22 and FY 2022/23. “The slowdown in the economy is mainly due to the hard landing from the soft policy measures taken during the Covid 19 pandemic, exacerbated by import restrictions and a slump in construction activities,” said financial sector analyst Anal Raj Bhattarai. He noted that “NRB, however, has tried to revive construction activities by offering loan rescheduling and other facilities to the construction sector, which has been hindered by delays in settling outstanding dues by the government.”

Chandra Prasad Dhakal, President of the Federation of Nepalese Chambers of Commerce and Industry (FNCCI), expects that the desired credit expansion in the economy will help address the challenges posed by the demand shock. “The target of expanding private sector credit by up to 12.5% is encouraging given the dismal growth in credit expansion during the previous two consecutive fiscal years,” Dhakal remarked. Reportedly, the country’s private sector is optimistic about the various facilities offered to the construction sector, the productive sector and priority sectors, including MSMEs.

Monetary stimulus package for contractors

The Monetary Policy has introduced several measures to support the construction sector including a loan restructuring facility for contractors for the next five months, the avoidance of blacklisting due to bounced cheques, and the relaxation of credit ratings for mobilisation in the construction sector, especially at a time when the government has been unable to settle the outstanding dues of contractors.

Additionally, the policy allows for the renewal of bank guarantees if a contract is not completed within the desired timeframe. Previously, if a bank guarantee – typically a non-fund-based transaction – was not realised by the due date, it would be reclassified as a fund-based transaction, categorised as a forced loan, and subjected to high interest rates. The Monetary Policy now allows these guarantees to be categorised as regular loans, thereby reducing the interest rate burden on contractors.

Moreover, blacklisting has been reformed to only apply to the specific party in a joint venture that is responsible for a bounced cheque, rather than blacklisting the entire joint venture, as was previously the case. “This short-term stimulus is expected to support the rebound of the construction sector. Once this sector bounces back, it will have a multiplier effect on the economy by addressing the ongoing slowdown,” said AD Lama, Senior Vice President of the Federation of Contractors Association of Nepal (FCAN).

Safeguarding MSMEs from volatility of interest rates 

The Monetary Policy has introduced a safeguard mechanism to protect micro, cottage, small and medium enterprises (MSMEs) from interest rate volatility. While fluctuations in the base rate may still occur, MSMEs are shielded by a fixed interest rate with only a two-percentage-point premium above the base rate.

Text: Pushpa Raj Acharya

Recognising MSMEs as the backbone of the economy, NRB has focused on minimising their cost of funds. “MSMEs have been particularly vulnerable following the Covid 19 pandemic, with many forced to close down,” said Umesh Prasad Singh, President of the Federation of Nepali Cottage and Small Industries (FNCSI). “At least, the central bank has provided interest rate protection as a remedy to help revive them.” Singh further emphasised that the country cannot ensure macroeconomic stability without a thriving MSME sector.

Additionally, the Monetary Policy has announced plans to review the ticket size of MSME loans, currently set at Rs 10 million. The central bank has also agreed to revisit the list of eligible industries under this category, potentially including ancillaries of agro-based industries, ICT, tourism and other productive sectors utilising domestic raw materials. Previously, MSMEs with a capital base of Rs 20 million, including those in agriculture and industries relying on domestic raw materials, were eligible under this scheme. Expanding the list of eligible industries and revisiting the ticket size could improve credit flow to the MSME sector.

NRB’s target for MSME credit flow has largely remained unmet. The central bank had initially mandated that 15% of credit be directed to MSMEs by mid-July 2024. However, due to the Covid 19 pandemic and the resulting economic slowdown, which adversely affected BFIs’ credit flow, NRB has extended the deadline to mid-July 2027. By this cutoff date, BFIs are required to allocate 15% of their total outstanding portfolio to MSMEs.

As of mid-July 2024, the average credit flow to MSMEs from the 20 commercial banks in operation hovered around 9.43% of their total portfolio of Rs 4,486.15 billion.

Compromise on prudent regulatory practices

The Monetary Policy 2024/25 has been criticised for compromising prudent regulatory practices. The policy relaxed capital fund and loan loss provisioning requirements. Notably, the loan loss provision for ‘pass’ loans (considered good loans) was reduced from 1.2% to 1.1%, potentially boosting bank profits.

Additionally, the policy lowered risk weights for credit sales and purchases, expanded the Regulatory Retail Portfolio (RPP) limit from Rs 20 million to Rs 25 million, and adjusted Tier 2 capital calculations while maintaining a cap at double the Tier 1 capital amount.

Furthermore, the policy eased credit classification rules. Loans from temporarily closed businesses with consistent debt servicing can now be classified as ‘pass’ loans. Loss loans (bad loans) with regularised debt servicing are reclassified as ‘watch list’ loans for six months before becoming ‘pass’ loans. The watch list category requires only a 5% loan loss provision.

The central bank signalled a review of bank account suspension rules based on bounced cheques and related credit information and blacklisting provisions. Venture capital and private equity funds are now exempt from blacklisting even if their investee companies default, aimed at encouraging investment in these sectors.

Banks and financial institutions have been permitted to include credit and interest recovered until mid-August 2024 in the income statement of the previous fiscal year (ending mid-July 2024).

Reduced loan loss provisioning directly increases bank profits. By hastily lowering provisioning requirements and relaxing credit classification, Nepal Rastra Bank has prioritised short-term gains for banks and borrowers at the potential expense of long-term financial stability. This could lead to a surge in non-performing loans (NPLs). These policy changes mask the true extent of NPLs which are particularly concerning given the International Monetary Fund’s call for audits of Nepal’s top ten commercial banks.

While the central bank has introduced some reforms under the IMF’s Extended Credit Facility, such as working capital guidelines and asset classification measures, it has delayed the implementation of the working capital guideline for a year. Additionally, the Monetary Policy has allowed banks to adjust credit through variance analysis until the end of the fiscal year.

To address the growing NPL issue, the Monetary Policy has proposed establishing an asset management company. However, the policy’s simultaneous removal of margin lending thresholds for institutional investors and introduction of profit-boosting provisions for banks has raised concerns about ‘regulatory capture’ and fuelled stock market gains.

Merger and acquisition among MFIs prioritised

The Monetary Policy has emphasised the consolidation of microfinance institutions (MFIs) through mergers and acquisitions. It has also indicated plans to regulate interest rates and service charges levied by MFIs. Additionally, the policy has introduced loan restructuring facilities with adjusted interest rates for borrowers facing repayment difficulties.

NRB’s target for MSME credit flow has largely remained unmet. The central bank had initially mandated that 15% of credit be directed to MSMEs by mid-July 2024. However, due to the Covid 19 pandemic and the resulting economic slowdown, which adversely affected BFIs’ credit flow, NRB has extended the deadline to mid-July 2027. By this cutoff date, BFIs are required to allocate 15% of their total outstanding portfolio to MSMEs.

NRB revisits stringent criteria for foreign exchange facility

Nepal Rastra Bank has revisited the stringent criteria for providing foreign exchange facilities. NRB, as the custodian of foreign exchange reserves, had taken a stringent measure including cent percent cash margin while opening letter of credit (L/C) for import. Besides, with the support of the government, 10 types of commodities were restricted for import due to the decline in foreign exchange reserves about two-and-a-half years back. NRB has revisited the stringent criteria for providing foreign exchange facilities along with the improvement in foreign exchange reserves due to increased remittance inflow and decline in imports. According to the central bank, the country has gross foreign exchange reserves of $14.72 billion (Rs 1,967.19 billion) by the end of mid-June 2024, which are adequate to cover goods and service imports of 12.6 months.

Against this backdrop, the Monetary Policy has announced to offer foreign exchange facility of up to $50,000 to import goods using draft and telegraphic transfer as a mode of payment from the earlier restriction of $35,000 and up to $100,000 to import under Document Against Payment and Document Against Acceptance compared to the earlier $60,000. Besides, the foreign exchange facility for travellers against the submission of visa and ticket will be revisited along with the amount that can be spent from the convertible currency accounts maintained in Nepali banks. Furthermore, various service imports and transactions related to remittances, travel and trade will be granted sufficient foreign exchange access.

Taming inflation below 5% almost impossible

Nepal Rastra Bank has set a target to tame inflation to below 5%, which is almost impossible to achieve, according to experts. The average inflation rate has been around 7% in the last three decades and taming inflation is not solely in the control of Nepal Rastra Bank as other variables such as supply-side constraints and imported inflation could influence dominantly.

Monetary Policy is cautiously accommodative

Monetary Policy has kept upper and lower ceiling of the interest rate corridor at 6.5% and 3%, respectively. The cash reserve ratio and statutory liquidity ratio remains unchanged. SLR has to be maintained at 12% for Class ‘A’ banks and 10% for Class ‘B’ and ‘C’ financial institutions. The money supply target is 12%, while private sector credit growth is projected to be around 12.5%. With loan rescheduling facility mainly for contractors and borrowers of MFIs as well as soft measures in loan classification and marginal reduction in loan loss provisioning, the Monetary Policy is accommodative as compared to the previous fiscal years.

Nepal Rastra Bank Governor, Maha Prasad Adhikari, has said that some flexibilities have been provided to the borrowers and banks given the available space. “At present, we have a solid foreign exchange reserve and the banking system has ample liquidity,” he said, adding, “Price stability and a drop in inflation have increased the appetite of consumers.”

Analysing the current outlook, the central bank has made a slight downward revision to the bank rate and policy rate and increased the private sector credit growth at 12.5%, or around Rs 650 billion in FY 2024/25, according to Governor Adhikari. “Recognising that Monetary Policy should be supported by macroprudential norms, NRB has cautiously provided some relaxation without compromising on prudential norms. This Monetary Policy is cautiously accommodative, aimed at channelling banking resources to the productive sector, providing support to the construction industry, and easing restrictions on the banking sector to facilitate the anticipated credit growth,” he clarified.

NRB has set a target to tame inflation to below 5%, which is almost impossible to achieve, say experts. The average inflation rate has been around 7% in the last three decades and taming inflation is not solely in the control of NRB.

Private sector hails Monetary Policy 2024/25

The private sector has hailed the Monetary Policy as it has considered most of their demands. “The downward revision of the policy rates was anticipated to support minimising the cost of production and enhance competitiveness. The policy rate must be reflected in the bank rates,” Confederation of Nepalese Industries (CNI) said in its press statement. “As far as the solvency of banks and financial institutions is concerned, the central bank should initiate measures to address the pressure on Tier 1 capital and hold the counter cyclical capital buffer until the situation has eased out,” CNI added.

Besides, CNI has strongly backed the establishment of Asset Management Company stating that it is the need of the hour considering the rise in non-performing loans and non-banking assets. CNI further advised the central bank for a cautious revisit of the provision on bounced cheques and blacklisting including the suspension of bank accounts.

Similarly, the Confederation of Banks and Financial Institutions Nepal (CBFIN) has said that the execution of the Monetary Policy will stimulate economic growth by boosting private sector confidence and maintain financial sector stability. 

CBFIN hailed the Monetary Policy’s announcements, including the review of the capital adequacy framework, reduced provisioning for pass loans, and the inclusion of certain regulatory reserves in Tier 2 capital. “Moreover, the policy rate reduction, increased threshold for regulatory retail portfolio, a special package for the construction sector, removal of the cap on institutional investor margin lending, support for startups and innovative sectors, a one-year deferral for credit adjustment variance analysis in working capital guidelines, and revised MSME loan ticket size thresholds are expected to contribute significantly to economic recovery,” according to CBFIN.

Text: Pushpa Raj Acharya