Prices and surprises

 Prices and surprises (Kathmandu Post,2011-07-25)

Normally, under tight liquidity conditions and rising interest rate regime, inflation tends to subside as consumers cut back on their spending.  However, in our case, defying normal economic theory, inflation continued to persist in the double digits for much of 2010-11



In line with the target to bring down inflation to 7 percent in the fiscal year 2011-12 as laid down in the recent budget speech made by the finance minister, this year’s monetary policy has also set the same goal. However, given the recent history of high and double-digit inflation in Nepal, coupled with rising inflation in India with whom we share an open border and a pegged exchange rate, it’s doubtful that the target will be met.

Moreover, given Nepal Rastra Bank’s (NRB) recent inability to fight inflation and meet its inflation target (see table for the disparity between projected and actual inflation), the 7 percent target seems to be a fall back figure for NRB and the government of Nepal.

For most of fiscal 2010-11, the Nepali financial system faced an acute liquidity crisis: funds dried up, the cost of funds went up for banks and financial institutions and so did the interest rates in the economy. Normally, under such tight liquidity conditions and rising interest rate environment, inflation tends to subside as consumers cut back on their spending (consumption is an inter-temporal decision where households decide whether to consume now or save and consume tomorrow, and with rising interest rates, savings become more beneficial) and business cuts back on its investments (rising interest rates make projects less feasible). However, in our case, defying normal economic theory, inflation continued to persist in the double digits for much of 2010-11.

Given the above mentioned background, it’s interesting to think about and ask why we continue to face double-digit inflation despite tight liquidity and high interest rates. There are a couple of reasons for this. As a small economy, we have pegged our exchange rate with India to maintain external sector stability. However, such pegging of the exchange rate also has its costs. The Indian economy, due to strong aggregate demand, has been under inflationary pressure for a long time. And those goods with higher prices are being imported here (India is our major trading partner and we have a huge trade deficit of approximately Rs 180 billion with India during first 10 months of fiscal 2010-11).

Normally, under a flexible exchange rate regime, a country with higher inflation (read India) cannot compete with the goods and services of other countries in the international market. As a result, its exports go down, resulting in depreciation of its currency. As exports go down, the value of its currency also goes down against currencies of its major partners. As a result, the price of Indian goods goes down when valued in other currencies. This is how inflation and exchange rates are linked. But in our case, given our fixed exchange rate and import dependence on India, such a linkage falls apart. As a result, we end up importing Indian inflation.

Apart from importing Indian inflation, domestic factors also exacerbate inflationary pressure in Nepal; and sometimes these domestic factors don’t allow us to enjoy lower prices when Indian inflation is low. Supply bottlenecks add to already high imported prices and push up the final price that consumers pay.

Moreover, our own domestic problems have not enabled us to tackle import dependence. If the goods we import cost more in India, Nepali entrepreneurs should have been able to produce and supply those same goods at cheaper prices here and take over the domestic market. But entrepreneurs have shied away from those investments because local factors such as energy crisis, political uncertainty and labour problems, among others, don’t make such investments viable in Nepal, accentuating our import dependence.

(The writer is associated with a private bank. The views

expressed are personal.)