Fiscal or monetary policy-led economic recovery?

Amidst worrying signals in the economy, Nepal’s Public Finance Management (PFM) has never been so strongly scrutinised. The magnitude of structural issues in the economy is compelling and the catch is policymakers have to ensure robust economic growth on one hand, without depleting foreign exchange (forex) reserves on the other, a mutually conflicting situation because both are primarily dependent on imports. 

In this context, there were expectations that the recently announced fiscal policy would make strong departures in addressing inherent structural issues in the economy and pave the way for future reforms. However, there is an argument that the policy is inadequate. 

Currently, the central bank — the Nepal Rastra Bank (NRB) — has found moderate success in controlling imports and maintaining adequate forex reserves through a mix of regulatory measures. But many also see that these measures may have instigated a chain of events that have led to an economic slowdown. 

The counter-argument is that the central bank had no other choice. Policy decisions are never easy in an import-based economy with deep-lying structural issues where a large portion of revenue mobilisation is reliant on imports. What is evident is that recent policy-induced corrections have created conditions that mimic an economic shock. 

Credit demand is witnessing a marked decline. Imports have reduced. So has activity in speculative markets. Consumer demand has shrunk and disrupted payment cycles in the value chain. There is reluctance to supply stock in credit terms and small businesses have shut down in substantial numbers. These events have collectively contributed to lowered revenue mobilisation.

The normal course of events would be the announcement of the fiscal policy followed by the monetary policy. In practice, these two policies work in tandem and complement each other. However, amidst a sluggish economy, the debate should have also focused on whether the economic recovery process should be fiscal or monetary policy-led.

The baseline argument at this juncture is whether policymakers should focus on lowering interest rates or introducing some sort of stimulus check to redirect the economy toward a growth trajectory. The traditional approach would be to first focus on lowering credit interest rates and after a point intervene with stimulus packages. The former is already evident — NRB intervened through reduced interest spread rate and tweaks in the methodology to calculate the frequency of bank-specific base rates. 

As a result, interest rates are declining. But there are limits to which interest rates can be reduced as cheaper interest rates in Nepal tend to stimulate import growth. Interest rates are thus expected to remain at slightly elevated levels with the viewpoint to preserve external balances, which reinforces the argument that stimulus packages could prove effective in such a situation.

The crux of this logic lies in the works of some Economists such as Narayan Kocherlakota, who argues that fiscal policy-led tools are more effective during economic shocks due to the inherent need to restore demand in the economy. While interest rate cuts are likely to make credit an attractive proposition, they are also likely to depress the future spending potential of the general public through reduced returns and thus stagnate future demand. A situation like this could be counterproductive.

On the other hand, over-reliance on monetary tools for stimulus purposes could lead to higher inflation levels. This is evident during the aftermath of the ‘COVID-19’ pandemic whereby the regulator injected money into the market in large volumes to prevent a meltdown.

In addition to high inflation levels, increased lending by banks led to the ballooning of the speculative market and windfall gains resulted in high imports amidst heightened disposable income and rebounding demand. Subsequently, this led to a sharp decline in the country's meager stock of foreign exchange reserves.

While we have argued that a rapid economic recovery cannot be obtained through monetary tools alone, the current budget does not wholly address the need to stimulate future demand. The government is clearly acting in haste due to stress on its revenue. For instance, while the additional one percentage point tax on interest income will bolster its revenue, it is only going to further reduce disposable income and consumer demand. This should have ideally been made analogous to progressive income taxation.

The government could be trusted on its ubiquitous promise that fiscal stimulus through timely capital expenditure will be normalised over the whole fiscal year and this will subsequently lubricate the economy through direct and associated job creation. But historical trends show that this promise has been broken far too many times.

Even if it succeeds, Nepal’s capital budget has been too low considering its development appetite. Worse, the capital budget is less by 20.58% for the coming fiscal year compared to the previous year.

While there could be an argument that public spending as a whole is likely to generate employment, the budget is inadequate in the area of targeted income generation schemes. Assuming that the NRs 5.94 billion allocated for the Prime Minister’s employment scheme and the NRs 7 billion allocated to generate employment at the local level is not misused, it may generate some grass root level employment, but not to the extent to make a visible difference. A 17.7% increase in the budget for social security programs may be helpful too but is a compulsion rather than a policy initiative and likely to prove a burden in the longer term.

There is also a need to stimulate credit demand. Governments sometimes tend to address this issue with grants and subsidised loans. Amidst widespread criticism against the diversion of such government programs to unproductive sectors, it is noteworthy this budget has reduced the allocation for interest subsidies by 14.72% while also acknowledging the need to restructure the same. 

However, with banks sitting on excess liquidity amidst low credit demand, the government’s target to raise NRs 240 billion through internal borrowing means banks will now have less incentive to lend to the private sector. With the forecast of lower returns in short-term government securities, banks are increasingly displaying the tendency to lock on to longer-term placements in bonds while rates of returns are still attractive. It does make business sense for banks to invest in risk-free assets in an adverse economic scenario. This has the potential to crowd out the private sector as the government competes to borrow from the limited availability of funds.

In conclusion, while fiscal policy tools seem inevitable for a balanced economic recovery, revenue pressures have clearly diluted government confidence to devise such measures. On the other hand, a correction in the structural setup of the economy is bound to take multiple years of policy design where the recent budget fails at taking stepping departures. 

Against this backdrop, it would not be practical to expect too much from the upcoming monetary policy either as there are limitations to what it can instigate. Measures instilled from monetary tools are often short-term fixes. The real need is for structural reforms reinforced through multiple years of correctly devised policy — and fiscal policy should be at the forefront.