Home » Policies » Monetary & Fiscal Policy Monetary & Fiscal Policy Monetary Policy for FY 2005/06 Brief Review of Economic and Monetary Situation 1. Fiscal Year (FY) 2005/06 is the fourth year of the Tenth Five Year Plan (2002/03 2006/07). The targeted average economic growth rate in the Tenth Plan is between normal 4.3 percent to expected 6.2 percent. Gross Domestic Product (GDP) at producers' price increased on average by 3.1 percent during the first three years of the Tenth Plan. The average GDP growth rate at factor cost remained at 2.7 percent during this period. To achieve the n dnimum targeted economic growth of the Tenth Plan; the GDP at producers price should increase by 6.0 percent on average in the remaining two years. Likewise, to attain the expected target of economic growth in the remaining two years of the Tenth Plan, the GDP should grow by two digits (10.8 percent) on average. 2. The economic growth in FY 2004/05 remained not only below the targeted growth in the Tenth Plan, the growth rate of GDP rather decelerated compared to that of previous years. The decline in agriculture production due mainly to unfavorable weather conditions and significant slowdown in non agriculture production caused such a deceleration in the overall growth rate. For example, the growth rate of non agriculture sector declined from 3.5 percent in FY 2002/03 to 2.9 percent in FY 2003/04 and further down to 1.6 percent in FY 2004/05. 3. Among the various factors, the existing difficult law and order situation has been the principle cause of lower economic growth in the country. The difficult security situation has adversely affected the capital spending of Nepal Government. Consequently, the value added of the construction sub sector, which had increased marginally in the last few years. registered a negative growth of 2.4 percent in FY 2004/05. 4. The exports of goods and services remained unsatisfactory due to internal as well as external factors. Merchandise exports increased marginally in FY 2004/05. The rate of growth of merchandise exports remained lower due to a significant decline in export to the third countries. Among the major goods exported to the third countries, the export of woolen carpet decreased marginally by 0.3 percent in the first eleven months of FY 2004/05 while the export of readymade garments declined substantially. 5. Likewise, the situation of tourism sector has not remained satisfactory either. FY 2004/05 witnessed a significant decline in the net foreign exchange inflows generated by tourism and services sector. Despite the gloomy situation in export of goods and services, remittance inflows have emerged as a backbone of the Nepali economy. In the current difficult situation facing the country, remittance earnings have been playing a pivotal role in maintaining the external and internal stability of the economy. 6. Therefore, it is pertinent to improve the exports of goods and services so as to achieve a sustainable development of external sector. However, the significant decline in merchandise imports in FY 2004/05 particularly the import of raw materials and intermediate goods necessary for exportable goods is also a cause of concern. This does not bode well for the Nepali exports in the near future. 7. Nepal obtained the membership of World Trade Organization (WTO) on April 23, 2004. It was a right step for a small and open economy like Nepal to get itself integrated with the global community through the membership of VVTO. However, the abolition of quota system for garment export since January 1, 2005 under the provision of WTO has adversely affected Nepal's export of readymade garments. In addition, for an open economy like Nepal to be strong, the production and exports of goods and services should be competitive. The sustainable way of making export of goods and services more competitive is undoubtedly to increase their productivity. The crucial element, which help increase productivity of goods and services on a sustainable way are structural reform, legal reform institutional reform, reform in the process of production and distribution, technological advancement and infrastructural development. 8. Monetary policy in itself cannot directly influence export and productivity of goods and services. Nevertheless, the monetary policy can, to some extent, help improve the competitiveness of exports of domestic goods and services in the short run. In the light of this, Nepal Rastra Bank (NRB) through the annual monetary policy statement has been making provision of refinance facility to the exporters both in domestic and foreign currencies and refinancing the sick industries at the concessional interest rate. Likewise, another instrument of making domestic goods and services more competitive through monetary policy is to maintain real effective exchange rate (REER) at an appropriate level, for which it is necessary to maintain the monetary stability. in an attempt to achieve monetary stability, the focus on inflation (commodity pricesf alone may, at times, jeopardize the external and financial lector stability. The countries, which suffered financial crises in 1990s, had maintained price stability. But in those economies, an adequate attention was not paid to misalignments in asset prices. If the prices of assets such as foreign exchange, real estate and shares deviate from their fundamental levels, it may result in both the external and financial sector crises. Therefore, such prices should be also at their realistic levels. Besides, it is important to develop a mechanism directed at influencing these prices through direct and indirect tools of monetary policy tools. 9. In an open economy like Nepal, the effects of external sector are directly transmitted to domestic industries and businesses. The situation of Nepali industries has not been satisfactory due to many reasons including the adverse external sector. The distress of the domestic industrial sector has a direct bearing on banking and financial sector. Undoubtedly, the pursuance of liberal economic policy has resulted in the remarkable development of the financial sector in the last two decades. However, banking sector, a dominant component of the financial sector, has not witnessed a qualitative development to the desired extent. The financial health of some banks and financial institutions has been rather weak and financial discipline has not yet been completel~ restored. The financial intermediation has not been efficient and effective. As a result, the general people have not benefited from the financial sector to the desirable extent. In this context, following the placement of foreign management teams in Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB), the continuous deterioration of financial health of these banks has been reversed. In the process, these two banks have started earning operating profits. However, the situation has not yet returned to the normal hence, satisfactory level. Compliance of international prudential norms, effective regulation and supervision, corporate governance, financial sector legal reforms and financial transparency are taken as pillars of financial stability in the long run. Besides this, the loan recovery of some banks and financial institutions having government's involvement has been difficult and complex. To over come such a problem, an active cooperation and support of all the organs of the state is extremely important. 10. The major indicator of financial sector's efficiency is the level of financial intermediation cost. The difference between deposit rate and lending rate is generally taken as financial intermediation cost. Noneconomic factors have largely contributed to the persistent higher level of interest rate spread in Nepal. It is likely that persistence of higher level of interest spread may weaken the financial intermediation. In the light of this fact, the monetary policy instruments such as gradual phasing out of priority sector credit program, the cut in compulsory reserve ratio (CRR) and the bank rate, provision of concessional refinance facility and conduct of transparent open market operations (OMOs) have been initiated for the last couple of years. A system of allowing banks and financial institutions to determine interest rate freely has been put in place since the last two decades. The system of fixation of interest rate spread has also been already done away with. In this context, the only option available to the NRB in helping narrow down the interest rate spread is through the operation of various monetary policy instruments. The NRB is aware of the need to bring down the interest rate spread to the desired level. In this regard, the Bank will continue to take necessary measures in FY 2005/06. The Bank expects that operations of these measures will relieve the economy from the burden of higher interest rate spread. 11. The rate of inflation was low and stable during the past couple of years. Recently, a pressure on inflation is building up. Significant increase in oil prices in the international market, a rise in price of construction materials until some months ago and an upward revision in the rate of value added tax (VAT) are some of the contributing factors to the upsurge in prices in recent period. In this regard, monetary policy faces a daunting challenge of attaining monetary stability, necessary for achieving macroeconoffiic stability. Monetary Policy Framework for FY 2005/06 Monetary Policy Stance 12. The economic and monetary situation of FY 2004/05, the prevailing situation in financial sector, necessity for a gradual relaxation in external sector and expected performance of domestic and external economies in FY 2005/06 are the bases for the formulation of monetary policy for FY 2005/06. Like in the past, the pegged exchange rate regime of Nepali Rupee vis A vis Indian Rupee is taken as a nominal anchor. 13. Transparency is one of the pillars of effective conduct of monetary policy. As per article 94 of the NRB Act, 2002, the NRB has been making monetary policy public at the beginning of fiscal year. The report includes the evaluation of the implementation of previous year's monetary policy and justification of policy measures for the current fiscal year. This report is the fourth of this kind. The annual monetary policy statements including its semi annual evaluation are published with a view of ensuring the transparent implementation of monetary policy. Both of these reports include implementation situation of monetary policy, measures undertaken with respect to foreign exchange reserve management, reforms in external sector; and the status of the regulation, inspection and supervision of the financial sector. This year's monetary policy stance is thus a reflection of the situation of these sectors and the stated objectives of monetary policy. 14. As the objectives of monetary policy of Nepal are multiple rathethan single, the determination of the stance of monetary polic'. for FY 2005/06 is a daunting task. In the past, there was n~ pressure on the general level of prices and the inflation was ircheck. Hence, the formulation of the monetary policy was rather easy. But the rise in prices in Nepal owing to the global increasc in prices of petroleum products, an increase in the price of g&, after HMG allowed the sale and distribution of liquefied petroleum gas to the private sector and the rise in VAT to 13 percent from 10 percent have all generated a pressure on the general level of prices. This development calls for a tighter monetary policy stance so as to contain inflationary expectations. As the current pressure on general price level is not the result ot pressure from demand side; rather, it is because of the pressure on supply side, a tighter monetary stance may adversely affect the national output. 15. External sector stability is also vulnerable. The export of Nepali goods and services has not been satisfactory due to protracted internal conflict, sluggish improvement in infrastructures and the abolition of quota system of Nepali garments under the provision of WTO. In the context of the likely danger in'the stability of the external sector, monetary policy is required to play a promotional role. Although the import compression has neutralized the negative impact of the slowdown in export on balance of payments (BOP), the declining trend in the import of industrial raw materials as well as capital and intermediate goods does not augur well for export in the near future. However, this problem cannot be overcome through monetary policy alone. To solve this problem, fiscal policy and exchange rate policy are also equally important, Monetary policy can only play a supportive role in reducing the cost of production and simplification of export procedures. 16. GDP at producers' prices is estimated to grow by 2.5 percent in FY 2004/05 compared to 3.4 percent in FY 2003/04. It clearly shows a slackness in economic activities. The economic growth rate in FY 2005/06 is not out of risk due to internal conflict, slowdown in world production, increasing prices of petroleum products, increment in the existing rate of VAT, and increase inthe rate of interest in the international money market. These developments would call for a flexible stance of monetary policy. 17. In this context, for the past couple of years, the NRB had been pursuing an accommodative stance of monetary policy. During this period, policy arrangements were made to help augment the availability of credit in the economy by way of reducing CRR, lowering down of the bank rate and the refinance rates, and reducing the cost of credit through adequate provision of refinance facility for sick industries and exports. The NRB has achieved some success in this regard. In the process, the lending rates of commercial banks have decreased, albeit not sufficient as compared to the past. The credit off take to the private sector has picked up. The excess liquidity with the commercial banks has declined. As a consequence, the profit of the banks has increased. The possible risk to economic growth also requires the continuation of the current soft monetary policy stance. 18. Nepal is experiencing a steadily growing trade concentration with India in the past few years. The share of Nepal's total trade with India increased to 65.0 percent in FY 2004/05 from 54.7 percent in FY 2002/03. In the past, Nepal used to pay for the imports of petroleum product in US dollars. In the last few years, such payments are made through the Indian currency. Likewise, the remittance earnings of overseas Nepali workers were repatriated through Hundi in Indian currency, but it is now taking place in convertible foreign currency due to policy changes and concerted institutional efforts, All these factors have jointly put a pressure on the reserves of Indian currency. In order to manage the reserves of Indian currency and at the same time to enhance the competitiveness of Nepali industries, the number of goods to be imported from India against the payment of US dollars will be increased (Appendix 5). This on the one hand, will ease the pressure on the Indian currency reserve, while, on the other, it will also reduce the import cost of industrial raw materials. 19. Higher level of aggregate demand (AD) emanating from high economic growth in India explains the relatively higher level of the interest rate in India compared to that in Nepal. It is natural that interest rates differ due to the divergent performance of these two economics. However, it would not be desirable to keep high interest differential for a long time for the open economy Ilk, Nepal (although at present there is no high interest rat~ differential between Nepal and India). This situation make, Indian currency reserves management more complicated. Viewec from these contexts, it is difficult to follow a soft interest ratc policy as before. This situation obviously warrants a tighter monetary policy stance. 20. As explained above, there is clearly a trade off between monetar\ policy goals for FY 2005/06. While the present situation o t sluggish economic activities and some problems faced by the financial sector call for a softer monetary policy stance, prevailing situation of the pressure on prices and weak external sector on the other hand, warrant a tighter monetary policN stance. Therefore, in the context of existing paradoxical situation. a cautious monetary policy stance has been followed to strike a balance between the conflicting policy goals. ˆ Top Objectives of Monetary Policy for FY 2005/06 21. The primary objective of monetary policy for FY 2005/06 is to maintain price stability. Notwithstanding the pressure on prices resulting from the increase in oil prices and supply constraint, inflation is implicitly targeted at around five percent. This rate of inflation will not adversely affect the economic decisions and also does not seem to bring any disturbances to the normal functioning of the economy. 22. The second priority of monetary policy for FY 2005/06 Is to maintain a reasonable level of surplus in the BOR The BOP surplus is projected at Rs. 4.5 billion for FY 2005/06. This level of surplus of BOP will help maintain the foreign exchange reserve at the comfortable level. 23. In the context of projected Indian inflation at 5.0 to 5.5 percent, the projected Nepali inflation at five percent will not make the REER of Nepali rupee overvalued. Likewise, in view of the interest rate differential in Nepal and India, which carries the potential to create pressure on Nepal's external sector, the current monetary policy stance is aimed at hardening deposit rates. The objective of this policy is also to help lessen pressure on prices. 24. The slackness in economic activities has continued to persist. Against this backdrop, the objective of monetary and credit policy is also to facilitate the economic activities without exerting any unfavourable impact on primary objective. In the light of this, monetary policy aims to facilitate the economic growth of 4.0 4.5 percent, in FY 2005/06 by channelising most of the incremental credit to the private sector with only a small portion (10.6 percent) to the government. 25. The role of monetary policy supportive to a high and sustainable economic growth is through the promotion of the private sector. The strong and efficient financial sector development is a precondition to the development of private sector. Taking this fact into consideration, the financial sector stability and it's consolidation have remained the objectives of monetary policy over the past few years. Monetary policy for FY 2005/06 is also directed at maintaining the financial sector stability. To achieve this objective, the existing refinance facility and open market operations will be effectively pursued. Intermediate Targets of Monetary Policy/Projection of Monetary Aggregates 26. The pegged exchange rate regime continues to remain as the strategic pillar of monetary policy. With a view to avoid the overvaluation and unnecessary undervaluation of the Nepali rupee in real term, monetary policy for FY 2004/05 has taken price control under its functional domain. Inflation targeting, as an alternative monetary policy strategy, is not a viable and feasible option in the present context of more or less unchanged structure of Nepali economy, existing macro economic policies and fragile financial sector. Therefore, the pegged exchange rate regime has been maintained as a strategy of monetary policy. 27. Implicit targets are set for monetary aggregates in consistence with the framework of current pegged exchange rate regime. Of the monetary aggregates, broad money (M2) is projected to increase by 13.0 percent for FY 2005/06 compared to an increase of 12.0 percent in FY 2004/05 (Appendix 4). Despite higher economic growth rate targeted relative to the previous year level, the growth rate Of M2 is targeted at the rate which is slightly above its previous year growth rate so as to avoid the pressure on price level. In FY 2005/06, the growth of narrow money (MI) is projected at 12.0 percent compared to the 11.2 percent growth in FY 2004/05. 28. Of the above two monetary aggregates, M2 is chosen as an indicator of monetary policy. The M2 is adopted as an indicator of monetary policy because the share of saving deposit in total deposit has remained high, reflecting a change in the deposit structure of commercial banks. 29. While analyzing from the demand side, monetary expansion is expected to be more influenced by money multiplier rather than by the quantum of reserve money (RM) in the current fiscal year. The growth of money multiplier is expected to increase due to the improvement in cash management of commercial banks by way of their lower excess reserves, and expected dynamism in the open market operations. 30. While analyzing from the sources side, monetary sector's net foreign assets (NFA after adjusting foreign exchange valuation) is projected to increase by Rs. 4.5 billion in FY 2005/06 compared to Rs. 6.0 billion in FY 2004/05. Slower export growth, lower level of foreign loan inflows and increase in imports are the bases for the lower level of projection of NFA than that of FY 2004/05. 31. The total domestic credit of monetary sector is projected to increase by 15.4 percent in FY 2005/06 compared to a rise of 14.2 percent in FY 2004/05. Of the total domestic credit, net claims on the government is projected to increase by Rs. 4.8 billion in FY 2005/06 compared to Rs. 3.5 billion in FY 2004/05. Based on the assumption that the capital expenditure of the government will not increase significantly, the monetary sector's claims on government is projected to increase marginally over the previous year. 32. The banks' credit to private sector is projected to rise by 18.0 percent in FY 2005/06 compared to an increase of 17.5 percent in FY 2004/05. Increased import credit as well as credit to private sector for infrastructure and consumption purposes provide the basis for the projected growth of claims on private sector in FY 2005/06. 33. The time deposits of commercial banks are expected to increase by 13.5 percent in FY 2005/06 compared to a growth of 12.5 percent in FY 2004/05. Based on the assumptions of marginal improvement in GDP growth, increased deposit mobilization of other banks and financial institutions, time deposits of commercial banks is projected to increase only marginally in FY 2005/06 compared to that of last year. Operating Target and Operating Procedures of Monetary Policy 34. The choice of operating target is crucial for efficient monetary management. As the pegged exchange rate system has been taken as the nominal anchor of monetary policy in Nepal, interest rate does not stand as a feasible candidate for an operating target of monetary policy. The excess liquidity of commercial banks will continue to remain as operating target of monetary policy for FY 2005/06. As direct effect of the cost of monetary management is reflected on the balance sheet of the NRB, the excess liquidity of commercial banks is chosen as operating target of monetary policy. 35. The management of excess liquidity of commercial banks is considered to be an important operating procedure of monetary policy. First, it helps to achieve the monetary policy objective of maintaining monetary stability through the necessary adjustment in the availability of credit. Second, in turn, the change in credit availability can contribute to achieve the financial sector stability. Hence, the excess liquidity of commercial bank is taken as an operating target of monetary policy. 36. This year too, the liquidity monitoring and forecasting framework (LMFF) will be continued to monitor the excess liquidity of the banking system as an operating target of monetary policy. This framework, which has been.in operation since last year, will be continued in the current year, for it has helped to maintain financial as well as monetary stability through the management of commercial banks' liquidity. Adjustment and Reform in Monetary Policy Instruments 37. For the last few years, no single transaction has taken place at t. bank rate. The interest rates on secondary market operate( including short term repo rates are market based. Therefore, ff year too the bank rate will be continued to convey the ex antestance of monetary policy. Currently, as ' there is pressure (. prices and there is a need for caution in maintaining the external sector stability, the existing bank rate of 5.5 percent is revise, upward to 6.0 percent. With an objective of addressing the inflationary pressure, the bank rate has been marginally increased even in the face of slow down in economic growth. In Nepal, the process of determination of interest rates on deposits and lending has been left to market forces since 1989. Under such a circumstance, with an objective of making a proper co ordination, between market interest rate and the bank rate, the bank rate will be determined at 0.5 percentage points over the repo rate, in case the repo rate gets higher than the bank rate. Pre determined bank rate will be effective in case the repo rate is lower than the bank rate. If liquidity need of any commercial banks cannot be fulfilled through OMOs and standing liquidity facilities (SLF), the last resort liquidity facility will be provided to the commercial banks at the bank rate. 38. As there is an upward revision of the bank rate, refinance rates are also revised accordingly. In this context, refinance rate for export credit (domestic currency) and agricultural credit has been revised from existing 3.0 percent to 3.5 percent. The refinance rate for export credit in foreign currency was revised to 3.25 percent on May 31, 2005. This rate will be continued this year too. However, the refinance rate for sick industries has been kept unchanged at 1.5 percent. When commercial banks and development banks avail this facility, the maximum interest rate charged to borrowers will be retained at the existing rate of 4.5 percent. 39. Over the past few years, the Bank has steadily pursued the policy of gradually reducing the CRR. The objective has been to assist the process of increasing financial intermediation in the economy by way of lowering the cost of commercial banks' funds. But this year, due to the pressures on prices and external sector front, the policy of not reducing the CRR and maintaining at the current level of 5 percent has been continued. The procedure of calculating the CRR has already been revised to help assist the LMFE However, should the situation in price and external sector eases and commercial banks also make efforts to reduce the interest rate spread between lending and deposit rates, CRR could be cut to some extent at the time of mid term review of monetary policy. 40. Industrial and tourism sectors in Nepal are in distress due to uneasy internal security situation and external shocks. The provision of refinancing for sick industries was initiated to help these two sectors since FY 2001/02. In the past four years, such refinance facility amounting to Rs. 2.62 billion has been disbursed step by step to 127 hotels and 37 industries. In view of existing distress in industries and tourism sector, such sick industry refinance facility will be continued in FY 2005/06. For this year, sick industry refinancing facility has been increased to Rs. 2.0 billion. The provision of granting the refinance facility under the conditions determined by Sick Industries Revival Committee will remain unchanged this year. However, concerted efforts will be made to reform the procedure for fuller utilization of such facility. 41. In the monetary policy of FY 2004/05, a change was made in the implementation strategy of OMOs. In this context, a system of OMOs on the basis of auction was initiated by the Bank in pursuance of the objectives of monetary policy and as suggested by LMFF. According to this provision, open market instruments such as outright sale auction, outright purchase auction, repo auction and reverse repo auction are put in operation. Main objectives of outright sale auction and outright purchase auction are to respectively absorb and inject liquidity of secular nature. Repo auction and reverse repo auctions are used to respectively inject and absorb the short term (1 7 days) liquidity. In the context of implementing such open market instruments in FY 2004/05, medium term liquidity amounting to Rs. 10.50 billion was mopped up through sale auction and Rs. 1.31 billion was injected through purchase auction (Tables 7 and 8). Similarly, in FY 2004/05, short term liquidity amounting to Rs. 6.68 billion was injected through repo auction and Rs. 5.27 billion was mopped up through reverse repo auction (Tables 9 and 10). In the light of their successful implementation last year, these open market instruments will be implemented in FY 2005/06 as well with a view to achieve monetary policy objectives. As in last year, the LMFF will continue to guide these operations. 42. Under OMOs, repo auction is used to inject short term liquidity to the commercial banks and reverse repo auction used to withdraw short term liquidity from the commercial banks. To ensure timely payment and also maintaining financial discipline as per the international practice fully secured HMG's treasury bills is taken as collateral for the repo and reverse repo transactions. Currently, there is a provision of injecting and mopping liquidity to and from the commercial banks through repo and reverse repo respectively on the basis of price auction. Through repo and reverse repo transactions, only collateralized loans are provided and taken respectively by the NRB to and from the commercial banks. Actual'purchase and sale of these securities do not take place. Therefore, for ensuring interest rate determination on the basis of liquidity, a system of repo and reverse repo auction will be initiated on the basis of yield (interest rate). For both transactions, the provision of taking HMG's treasury bills as full collateral will remain intact. 43. The system of OMOs has been changed with the intention of achieving the monetary policy objectives on the basis of LMFF. According to new provision, primary issue of HMG's securities will be undertaken every Monday and secondary market operation will generally be performed every Wednesday. 44. Currently, a paper certificate of certain standard is being issued at the time of issuance of treasury bills. Selling through auction of 28 day, 91 day, 182 day and 364 day treasury bills involves high paper and administrative work and cost. Most of the central banks have started to issue scripless securities based on book entry. Transaction through this process reduces costs and lowers the risk of loss and damage of certificate and also low administrative hassles. Necessary infrastructure will be developed to facilitate treasury bills transactions through such book entry system in FY 2005/06. 45. Currently, to achieve the objectives of monetary policy, secondary market operations of treasury bills such as sale auction, purchase auction, repo and reverse repo auctions are undertaken at the initiative of the NRB. To develop secondary market of treasury bills even outside the NRB, a system of buying and selling of these bills based on endorsement has been started since October 1, 2004. In case of primary issuance of scripless treasury bills, secondary market operation will be done on the basis of book entry ledger maintained at the NRB. 46. With an objective of making internal liquidity injection/ absorption more effective in the process of implementing monetary policy, OMOs in domestic bills will be coordinated with foreign exchange intervention of the Bank. Such OMO will be intensified to modulate the effects of intervention on money supply. 47. Currently, treasury bills, development bonds, and national saving certificates (NSCs) and citizen saving certificates (CSCs) of the government are being issued targeting commercial banks, banks and financial institutions and general public (household) respectively as the intended clientele. Further, in the context of collecting tax, special bonds are being issued to reconcile the liabilities of HMG with the private sector. With a view to streamline the number of securities issued in mobilizing public debt, a system of issuing only treasury bills, development bonds and CSCs will be introduced. Moreover, the CSCs will be made eligible as collateral in obtaining loans from banks and financial institutions. HMG will be requested to issue temporary special bonds instead of currently being issued special bonds and to make prompt payment by shortening administrative processes. In case, the prompt payment becomes difficult, the temporary special bonds should be liquidated by issuing treasury bills, development bonds or national saving certificates. 48. According to the provision made in the monetary policy of FY 2004/05, the development bonds amounting to Rs. 3.0 billion was issued through auction. Such development bonds with 5.5 percent coupon rates and having a maturity period of five years were over subscribed and sold at premium in all auctions. Such bonds have already been listed in Nepal Stock Exchange (NEPSE) Limited for secondary market transactions. Taking the situation of money and capital market into account, in the current fiscal year too, as in the last year, some portion of dome, borrowing proposed in the budget will be issued through auction of development bonds. 49. In Nepal, a system of issuing long term debt instruments agencies other than HMG has not yet evolved as a means mobilizing capital to expand investment in the economy. On other hand, investment opportunities for the general public with small savings are confined to the deposits in the commercial banks and financial institutions. There is a need for attracting financial institutions specialized in undertaking debt related mutual fund transactions. This is needed to ensure an alternative instrument for investment for small savers and also to develop system of mobilizing resources through the issuance of long term debt instruments. 50. The NRB undertakes OMOs to achieve monetary policy objectives at its own initiative. With an objective of ensuring a smooth functioning of internal payment and settlement system in the face of liquidity crunch among commercial banks, the NRB ha introduced SLF since the last fiscal year. This was a full , collateralized and automatic provision to provide liquidity for ' period of 5 days. At first, liquidity facility of up to 90 percent o' the face value of government treasury bills and development bonds taken as collateral was made available to the commercial banks. With an objective of eliminating adverse effects or OMOs and inter bank transactions and controlling the misutilization of SLF, the interest rate on such facility is determined by OMO committee adding certain percentage points on the latest auction average discount rate of 91 day treasury bills. This is the short term liquidity facility provided to commercial banks. However, commercial banks having frequent liquidity problem seemed to use this facility excessively instead of exploring the alternative measures of resource mobilization. With a view to discourage the excessive reliance of commercial banks on SLF, the limit of such facility has been revised downward to 50 percent from existing 90 percent since December 22, 2004. During FY 2004/05, commercial banks utilized the SLF amounting to Rs. 49.3 billion. To avoid the misutilization of this facility, the time limit has been reduced to 3 days from 5 days, keeping the existing interest rate determination procedure and the limit of the facility (50 percent) unchanged. Though international tradition is to determine the limit of such facility on the basis of total capital fund, clearing balances, and deposits of commercial banks; due to the negative capital fund, unavailability of reliable data of clearing balances and deposits of some commercial banks, the basis (HMG's treasury bills, development bonds) of determining the limit of such automatic credit has been kept unchanged. 51. Necessary process will be initiated to start online system among the Public Debt Management Department, Banking Office of the NRB and its district level offices to make public debt and open market transactions prompt, simple and accessible. 52. So far, all the repayment of principal of HMG bonds is being carried out solely by the NRB. From this fiscal year on, market makers and commercial banks will also be making principal repayment of HMG's domestic debt instruments. Until the reimbursement of such amount from the government, the amount of repayment will be counted as CRR. An arrangement will be made for appropriate commission to commercial banks for making payment of interest on HMG bonds and pension to retired government employees. Rural Credit 53. With an objective of increasing the availability of credit to the priority sectors as specified by HMG, this bank in the past had implemented the directed credit programs through the commercial banks. The directed credit programmes are not consistent with the financial sector liberalization policy. As directed credit programmes constrain the portfolio choice of commercial banks, hence their profitability, this bank has taken a policy of gradually phasing out and ultimately giving complete freedom to the commercial banks in regard to the composition and structure of their loan portfolio. However, the deprived sector lending programme will continue to remain for some more years to come. The micro finance organizations operating in the country include five Rural Development Banks (RDBs) which came into existence under the initiation of the NR13 and HMG: Rural Self Reliance Fund (RSRF) and Rural Micro Finance Development Centre (RMDC) both of which provide wholesale credit to microfinance institutions; and other miicrofinance organizations operating in the private sector. As the modus operandi, scale of operation and the types of problems faced by the microfinance institutions are quite distinct from other financial institutions, it is strongly felt that the former need different kind of treatment. This calls for a separate, independent and comprehensive policy set. This exercise will be undertaken in the current fiscal year. 54. Rural sector is suffering from a huge magnitude of excess demand for credit. The services being provided by the existing institutions are inadequate and un uniform. As mentioned in he Income and Expenditure Statement of HMG for FY 2005/06, in order to increase the access of institutional credit to the deprived group, the National Microfinance Policy (NMFP) 2005 will be formulated and implemented from the beginning of the current fiscal year. The policy will be implemented on a temporal basis of short term, medium term and long term action plan. 55. With an objective of homogenizing the range and scope of services of various community based organizations (CBOs) operating in the sphere of micro saving and credit programmes and to bring all microfinance institutions and CBOs under a single legal framework, a Microfinance Act will be formulated and implemented by amalgamating all the scattered acts into a single one. In this regard, HMG has already expressed commitment to this in the recently published income and expenditure statement for FY 2005/06. 56. The experience gained so far suggest that there is no alternative to rural and micro-financing in intensifying and dispersing economic activities which is considered to be the most essential factor to boost up the economy and alleviate widespread poverty by means of generating income as well as the employment opportunities. In this regard, HMG has already announced to immediately come out with a "NMFP 2005", which will be followed by the enactment of a separate 'Microfinance Act' HMG's income and expenditure statement, 2005/06 also commits to set up a Second tier Institution (STI) which will be responsible to issue and enforce prudential regulation, inspection and supervision for all the micro-financing institutions. 57. As mentioned in the budget speech for FY 2005/06, RSRF currently operating under the NRB management will be converted into an independent and autonomous "National Microfinance Fund (NNIF)". After maturing of various micro-financing projects currently being handled by the NRB, all of the assets and liabilities of each matured individual projects will automatically be handed over to the RSRF. 58. The outreach of micro-financing, a powerful and effective too] for poverty reduction, will be extended to the door steps of the marginal and ultra poor with a view to enhance employment opportunities for the poor. For sustainable development and effective coordination of diverse range of microcredit sector, HMG has already stated to constitute a "High Level National Microcredit Development Council". The NRB will make necessary efforts to set up the Council's secretariat at the Bank itself. 59. As mentioned in the FY 2005/06 budget speech, this Bank shall ,continue to restructure the RDBs. As a result of the past restructuring efforts, Eastern Rural Development Bank (ERDB) is under the process of its second phase of privatization, while others will be privatized after restoring them in profit. Similarly, after the implementation of second phase of privatization of Western Rural Development Bank (WRDB), the NRB has brought down its equity participation from 61 percent down to 10 percent. In the process of the NRB handing over its shares to group members and other microfinance institutions, the offer got over subscribed and sold at attractive premium. As per the 2005/06 budget speech, the government has announced to off load its share from WRDB. 60. A three member taskforce formed by High Level Coordination and Direction Committee will submit a report on reforming and suggesting alternative approaches for the management of a financially weak Far Western Rural Development Bank (FWRDB). 61. With an objective of encouraging the investment in microfinance development banks, the provision will be made to increase current ceiling on buying of shares from the existing 15 per, of paid up capital per person/organization to 25 percent. public statement of income and expenditure for FY 2005/06. made the provision to exempt the income tax on the interest income earned from the deposits amount of upto ten thousand rupees held in the rural microfinance institutions. As this step HMG will be very helpful for the small depositors microfinance institutions, the NRB has taken this endeavors very positively. ˆ Top Financial Sector Reform Programmes 62. The main objectives of the financial sector reforms are to create a competitive banking and financial environment, developing a dynamic and a robust financial sector and ensure a secure and risk free internal payments system. Moreover, developing financial sector to facilitate private sector led high growth trajectory by way of meeting the ever growing credit needs of various socio economic sectors also constitutes as an important policy goal of this Bank. 63. Nepal is gradually turning into a liberal and market friend economy. In the context of obtaining the membership of t~ WTO, Nepal has committed to allow the operation of branches k foreign banks from 2010. In this context, so as to make the existing institutions capable of absorbing the external shocks, the Bank wants to strengthen the capacity of banks and financial institutions. To achieve these objectives, the NRB in FY 2005/( is undertaking various financial sector reforms progranimes. 64. The primary responsibility of this Bank is to maintain financial sector stability. Monetary Policy instruments and monetary easing alone do not guarantee financial sector stability. Therefore this Bank will strive to improve the licensing policy of financial institutions, inspection and supervision based on basic prudential Bank for International Settlement (BIS) principles, compliance corporate good governance, legal reforms in the financial sector liberalization and structural reforms to the international standards. The Bank considers that these components are the basic pillars of financial sector stability. In this context, steps will be initiated to draft the Banking Fraud Control Act (BFCA) so as to pre empt possible frauds that could infect the financial sector. 65. With a view to develop the NRB into a modern central bank, capable in maintaining financial sector stability, the second phase of financial sector reform will focus on updating the information technology, supervisory capability and human resource management. Moreover, the accounting system of the NRB will be updated to comply with the requirements of international accounting standard and Nepal accounting standard. 66. The Bank will formulate and bring into implementation from this fiscal year a medium term strategic planning 2005/06 2009/10). This planning will include the road map in attaining the objectives of the Bank as laid down by the NRB Act 2002; and the mission and vision as determined by the Bank. The proposed strategies, activities and its work plan will also deal with the human and other resources that will be required to achieve the vision and mission statements. 67. There is no argument that the development of industrial and trade sector is a necessary condition for the overall economic development of the country. The development of industries and commerce requires increased production and productivity by means of investment friendly environment. At the same time, increased industrial and commercial productivity pre supposes the existence of a healthy, capable and active role of banks and financial institutions. In this context, Nepali banks are experiencing growing complexities in credit recovery and payments settlement for the last few years. If non performing loan (NPL) problem is not timely solved, there will be no prospect for getting expected results from the financial sector reform programme. There is also a danger of this HMG programme, which incurs a very huge cost, of not being beneficial to the extent of expectation. In this background, the Committee, constituted by the cabinet and, chaired by the vice chairperson of the National Planning Commission (NPC) has suggested to group all the defaulters into willful defaulters and nonwillful (circumstantial) defaulters and ascertain the conditions and reasons behind not repaying the loan. The Committee has also suggested short term and long term measures. In this regard, appropriate directive relating to credit information and blacklist has already been issued and being implemented. The Income and Expenditure Statement for FY 2005/06 has expressed the commitment to implement the recommendations of the Committee. 68. Following the policy of financial sector liberalization in the past two decades or so, a large number of financial institutions have come into operation. Qualitative development of banking and financial services require appropriate management of their numerical growth. Merging of a bank and non bank financial institution (NBFI) with another one, or a bank and NBFI acquiring others into itself, is a natural and an inevitable consequence of a soundly functioning financial system. The Bank and Financial Institutions Ordinance (BFIO) and the Company Act contain the provision of merger and acquisition. Based on these, a finance company got successfully merged with a commercial bank recently. A few number of similar institutions are in the process of acquiring and merging within the provision of existing legal framework. The NRB strongly feels the need to streamline and simplify the existing process of merger and acquisition such that Nepal's banks and NBFIs get transformed into vibrant and resilient intermediaries by means of mergers and acquisition. In this direction, this bank will initiate the review1of existing legal framework. 69. .Similarly, to lower down the magnitude of non performing assets (NPA), and to effect necessary reform in the debt recovery front, the bank will initiate steps on establishing Assets Management Corporation (AMC) and on strengthening the capacity of Debt Recovery Tribunal (DRT). 70. To redress and settle the grievances that result from the misunderstandings between banks, financial institutions and customers, a grievance hearing cell (GHC) has already been constituted in the central office of this Bank under the chair of the Deputy Governor. 71. Notwithstanding less than satisfactory performance in recovering the non performing loans, after the management contract of NBL and RBB, which capture a dominant part in the overall banking sector, the restructuring process of these banks has been improving. This process will be continued in the current fiscal year. In this context of providing such continuity, the participation of the bank employees and domestic experts will be expanded and measures will be adopted for minimizing the expenditures of management team. 72. In the context of promulgation of the BFIO 2005, the existing regulations and directions, which were separately issued for banks and financial institutions, have already been revised and integrated into a single directive. This has already come into implementation from the day one of FY 2005/06. 73. To minimize the risk involved in financial sector, risk management culture will be developed in the licensed institutions. Efforts to create a healthy, secure and capable financial system through corporate good governance will keep apace. To monitor such system by this Bank, the policy of implementing risk based supervision will be pursued. To develop risk management system, private sector will be encouraged to establish credit rating agency. Budget Speech 2005/06 has assured the creation of legal infrastructure for this. 74. To enhance the reliability and credibility of various negotiable instruments such as cheque, draft, bill etc., Negotiable Instrument Act (NIA) needs to be refined and amended. In this context, this Bank will draft such amendment and submit to the HMG. 75. There is a need for promulgating a separate law with regard to anti money laundering to control illegal transactions that may take place through the banking system. In the absence of such a law, the above mentioned objective can be achieved to some extent by banks and financial institutions following the practice of KYC (know your customer). For this reason, the bank will draft, finalize and issue KYC policy for the implementation of all the stakeholders within FY 2005/06. 76. A study will be conducted about the likely effects of the implementation of Basel 11 accord from 2007 on the commercial banks' capital structure. Based on the findings of this study, necessary adjustments will be made in their capital structure. 77. In the context of implementing International Convergence of Capital Measurement and Capital Standard (Basel 11) ratified by Basel Committee on Banking Supervision (BCBS) in Nepal, an Accord Implementation Group (AIG) with the participation of commercial banks' representatives has already been formed. This group will prepare the draft on the modalities of the implementation of the accord in Nepal. This group is expected to submit the final draft of such regulation by the end of FY 2005/06. In this context, the proposed study will focus on the effects of implementation of Basel 11 Accord on the capital structure of Nepali commercial banks. Commercial banks' capital structure will be gradually made healthy and efficient on the basis of findings of the proposed study. All the financial institutions will be made aware of the context of implementing New Capital Accord Basel 11. They will also be asked to initiate necessary homeworks. 78. The capital adequacy ratio (CAR) to be maintained by bank and financial institutions (BFIs) was set at 12 percent of their total risk weighted assets from FY 2003/04. But, taking into consideration the difficult situation of the country, such rate had been fixed at I I percent for both FY 2003/04 and FY 2004/05. Now, taking into account the present capital fund position of BFIs, such ratio has been raised to 12 percent, with core capital requirement set at a minimum of 6 percent for FY 2005/06. From this provision, capital structure of banks and financial institutions is expected to be sound and robust. Accordingly, for FY 2005/06, the CAR to be maintained by the financial institutions belonging to D' category has been fixed at eight percent of risk weighted assets (RWA), of which core capital should comprise a minimum of 4 percent. 79. With an objective of strengthening the supervisory capacity of NRB, the Inspection and Supervision By Law, and On site Inspection Manual both of which are in implementation since FY 2004/05, will be reviewed and updated. Moreover, off site supervision manual will be drafted, finalized and brought into implementation. This is expected to enhance the efficiency of off site supervisory role. In this context, as per the provision set out in the financial sector reform programme, the Bank has already initiated the process of hiring international supervision consultants. 80. In the context of large borrowers undertaking credit transactions with more than one BFIs (multiple banking), a detailed study will be undertaken which will assess the impacts of such credit concentration on the total loan outstanding of such BFIs. Existing prudential regulations issued by this Bank will be amended appropriately based on the findings of the proposed study. Foreign Exchange Sector Reform Programme 81. Nepal has adopted a policy of gradually opening up its external sector. Though there is capital account convertibility for nonresident investors as per the provisions contained in Industrial Policy 1992, and Foreign Investment and One Window Policy 1992, it still remains closed for the residents. In the context of less than expected pace of development of the private sector and not a happy state of financial sector stability, and also taking into consideration the possibility of economic crisis originating from the external shocks on the weak Nepali economy, the policy of opening capital account gradually has been adopted in a cautious manner. The proposed foreign exchange sector reforms for FY 2005/06 are a reflection of such situation. 82. Currently, there is a provision of providing forex facility of up to US$ 1,000 to individual and institutions by commercial banks for settling petty international transactions for various purposes. In the context of small payment system being simplified and general public rejoicing its benefits, such limit has been revised upward to US$ 1,500 from the existing US$ 1,000. This measure is expected to further simplify this provision and impart convenience to the needy. 83. Currently, there is a provision of providing foreign exchange facility of up to US$ 5,000 once per family as settlement expenditure while migrating to developed countries like USA, Canada, Australia, New Zealand and UK. Users of such facility have been complaining on the inadequacy of this amount. For this reason, from FY 2005/06, a provision of providing USS 5,000 for an individual and US$ 10,000 for a family has been made for Nepali citizen permanently migrating to these destinations. 84. The firms/institutions/companies having the source of foreign exchange earnings have been refrained from the requirements of taking permission from the NRB while making payments for the purpose of stall booking charge, registration fee, service charge in foreign currency while taking part in exhibition in the countries other than India to promote their business. They can use their foreign currency account held with commercial banks in Nepal. This measure is expected to promote tourism and export. 85. In the context of liberal policy framework, not to allow foreign currency account holders to grant permission to her/his family member to operate the account seems stringent. Therefore, effective from FY 2005/06, a provision has been made whereby the spouse and the parents of foreign exchange account holders will be allowed to operate his/her forex deposit account held with banks in Nepal after obtaining the prior permission from such account holders. 86. The provision of exporting goods and services based on bank guarantee under the Cash Against Document (CAD) mechanism is being simplified and relaxed over time. Currently, under this provision, the NRB can grant permission for exporting goods amounting to US dollar 100,000 at a time with a bank guarantee of 5 percent of this amount. In the context of growing popularity of this provision among exporters, effective from 2005/06, the limit of US dollar 100,000 has been revised upward to US dollar 200,000. In addition, based on the collateral acceptable to the commercial banks, the banks can themselves make payment. However, in case of exporting the goods through bank guarantee, the existing provision of requiring the NRB's permission will remain in force. 87. If the third country exporter to Nepal fails to make the shipment of goods and wants to refund the advance payments made for import under Draft/TT facility, a provision has been made whereby the commercial banks can themselves cancel the cheque that they had issued in favour of the customs office. This provision is expected to relieve the business community from the burden of making unnecessary visits to the NR13 for the very simple reason of canceling the cheques. 88. In a situation of receiving the document in excess of the amount than stated in import L/C denominated in convertible currency, a provision is made under which commercial banks can accept a document up to 2 percent of the L/C amount or US dollar 1,000 whichever is lower. 89. In case of failure to make use of cheque issued in favour of concerned customs office while releasing the document or sending advance payment under draft/T.T. or import L/C denominated in convertible currency, a provision has been made for extending the validity of such cheques by concerned commercial banks themselves under the condition that the concerned party apply to the bank within 90 days of the issuing of the cheque with sufficient supporting evidences. 90. Commercial banks are now free to swap the interest rate while hedging the interest rate of the loan borrowed by any party in foreign currency, for which the NR13 will not bear any obligation, what so ever. 91. Under the existing provision, private importers of chemical fertilizer are required to deposit 10 percent of import value in commercial banks or they have to produce bank guarantee while releasing the document to import chemical fertilizer in Nepal. In order to provide additional incentive to private sector to import chemical fertilizer, and lower the cost to farmers, this margin is reduced from 10 percent to two percent. 92. International agencies located in Nepal that hold foreign currency deposit account with the Nepali commercial banks, if required to make payment in convertible currency in India, can make such payments by debiting their forex deposit accounts held at the Nepali commercial banks. 93. The existing provision allows the individuals to exchange foreign currency under passport facility only once in a fiscal year. The provision of restricting this facility to not more than once in a year in any circumstances (for medical treatment of his/her and family members) has created difficulty to the needy people. As this provision is contradictory to the present V framework, only once in a fiscal year restriction on forex facility for passports has been terminated. As per the existing provision, e endorsement has to be made in the passport after providing the foreign exchange. This provision has been terminated effective from the current fiscal year. Recently passport is issued in Nepal for a validity of ten years period, there will not be enough space left in the passport. Furthermore, it may also make passport through and untidy. Considering all these factors, and maintaining all other provisions in this regard intact, the forex facility endorsement in the passport gets terminated from today. 94. Currently, private sector industries, companies, and firm operating in Nepal are required to get approval from the NRB borrow from abroad. In the present context, such provision on one hand is creating encumbrance to the entrepreneurs while the other, it signals a wrong message to the outside world Nepal's foreign exchange policy. Therefore, under the revise provision anybody who intends to borrow from abroad, for period of one year and above, without pledging any domestic asset as collateral, instead of taking prior permission they will be required to just notify the NRB. 95. In order to make the Nepali entrepreneurship competitive in the international market, it is imperative that Nepali entrepreneurs I allowed to invest in foreign countries. This would, on the or? hand, help attract foreign direct investment (FDI), and on the other, this would also bring modern technological know how an managerial skills inside the country. In this direction, the NR will request HMG either to repeal or amend the existing Foreign Investment Prohibition Act (FIPA), 1964. 96. Presently, the NRB is providing silver bullion to exporters of jewellery and utensils made from silver, by importing fro overseas. Between 1987 to 2003, the NRB made available a total of 58.42 metric tons of silver valued at US dollar 9.7 million t the Nepali exporters of silver ornaments and utensils. This ban' is holding 140 metric tonnes of silver in its stock, which does n yield any return. Looking at the trend of annual consumption silver for the last 17 years at about 3.4 metric tonnes a year, silver stock with the Bank can accommodate the domestic demand for a period of next 40 years; whereas, the Bank has been annually importing silver against the payments of precious foreign exchange, which generates return. Domestic sale of silver at international market price will reduce the cost and hassles to the local jewellers. This will enhance the export competitiveness of Nepali ornaments and utensils made from silver. This will also relieve the NRB from the burden of holding dead asset like silver, while at the same time it will conserve foreign exchange which has a higher opportunity cost. Similarly, the bank also stands to gain from the unnecessary burden of inventory management and prospect of loss during its physical transfers within the vault. Furthermore, the investment of foreign exchange thus saved adds to the bank's profitability. Therefore, beginning from FY 2005/06, the Bank will sell silver to local exporters of ornaments and utensils from its own stock at the prevailing international market prices. 97. With a view to make Nepal's exports further competitive, there will be further addition in the number of industrial raw materials and intermediate as well as capital goods that will be eligible for imports from India against the payments of US dollars. Finally, 98. Overall economic and monetary developments of FY 2004/05, review of FY 2004/05 monetary policy, annual progress matrix of the policy parameters of monetary policy as outlined in FY 2004/05 monetary policy statement, and the statistical tables used in the preparation of this report are all attached in the annex of this report for public knowledge. 99. The analysis of the available economic information/data shows that although macroeconomic indictors are in right shape and size, they are not out of risk. Despite slower growth in AD, the economy experienced inflationary pressures due primarily to upward revision in the administered prices of petroleum products, and in the rate of VAT. The level of overall imports has gone down. As a manifestation of adverse non economic factors, industries and enterprises are faring poorly. Thus, on the one hand, economic stability is facing vulnerability, while on the other, growth performance is at risk. This year's monetary policy is formulated to strike a balance between these contradictory and conflicting policy goals. We expect that implementation of this monetary policy will help to attain monetary stability which is essential in generating a favourable macroeconomic balance which, in turn, is very essential for sustainable econ, development. We in the Bank hope that financial sector reform programme will ensure financial stability through increasing competitiveness in the country's financial system. Similarly reforms and simplification of procedures in the external set are expected to enhance country's international trade and attract foreign investment. I would like to extend my sincere thank to HMG, donor agencies, banking and financial community, L society and media for their support in the conduct of monetary policy in the past. I expect to receive similar support from al you in the implementation of monetary policy in the day to come. ˆ Top