Loose Liquidity, High Inflation and the INR Peg
Nepal's annual CPI inflation is 7.8%, credit growth 2.9%, deposit growth 8.6%, and interbank rate 3.2% against a 7.0% policy rate. CRR is 4%, SLR 12%, and excess reserves are rising. Indian inflation is 6.2%, remittances are up 14%, and reserves cover 11 months of imports. The exchange rate is pegged to the Indian rupee. The monetary policy committee debates a 1 percentage point CRR cut versus outright purchase of government securities. A board member argues that cutting CRR will immediately reduce inflation because it lowers lending rates. Traders expect further liquidity but are unsure about imported fuel prices. The committee asks for a diagnosis of the liquidity position, the likely transmission of each option, and the main constraint on policy.
1. Diagnose the liquidity position and the stance of monetary policy using the data given.
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Liquidity is loose, not tight. The interbank rate of 3.2% is far below the 7.0% policy rate, deposit growth of 8.6% exceeds credit growth of 2.9%, and excess reserves are rising. These are classic signs of surplus liquidity: banks have more deposits than they are lending, so short-term rates are pushed down. The real policy rate is also accommodative: 7.0% nominal minus 7.8% inflation is about -0.8%. So the economy has easy liquidity and negative real rates while inflation is high. That combination argues against adding further stimulus. The low credit growth suggests weak credit demand or risk aversion, not a shortage of funds. The policy problem is therefore not liquidity provision but how to avoid fueling inflation and asset-price pressure while supporting productive credit.
2. Compare a 1 percentage point CRR cut with outright purchase of government securities. Which is more appropriate, and why?
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Both inject liquidity, but they differ in precision and reversibility. A CRR cut is broad, permanent until reversed, and directly lowers banks' funding costs; it can expand credit and inflation and is a strong signal of easing. Outright purchase of government securities adds reserves for a chosen tenor and can be calibrated, but it is also an easing tool. Since liquidity is already loose, inflation is 7.8%, and the real policy rate is negative, neither option should be used as stimulus. The board member's claim is wrong: lowering lending rates does not immediately reduce inflation; easier credit can raise demand and inflation. The better response is to hold CRR and use open-market operations to absorb excess liquidity, such as selling securities or using reverse repos, while using targeted refinance or credit guarantees if productive sectors need support. A CRR cut should wait until excess liquidity is absorbed and inflation is clearly easing.
3. What is the main constraint on monetary policy, and how should the peg affect the decision?
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The main constraint is the exchange-rate peg to the Indian rupee. With a peg, Nepal cannot set interest rates far below Indian rates without triggering capital outflows, reserve loss, or pressure on the peg. Indian inflation of 6.2% and imported fuel-price uncertainty also mean that rupee depreciation is not available as a shock absorber. Remittance inflows of 14% are adding liquidity, which partly explains the low interbank rate, but they are not a stable policy instrument. The committee should avoid a sharp CRR cut that widens the rate gap with India and adds to imported inflation. It should coordinate with fiscal policy, manage liquidity through OMO, and use supply-side measures for fuel and food prices. The peg does not eliminate independent policy, but it narrows the room for easing when inflation is already high.