Money Supply, Instruments & Banking Mechanics

TAKEAWAYS:

• Money supply in Nepal is measured as M0 (narrow money), M1 (M0 + demand deposits), and M2 (M1 + time deposits + savings)—each with distinct liquidity levels.
• Money creation happens when banks lend excess reserves, expanding deposits via the money multiplier (1/required reserve ratio).
• NRB’s tools to control money supply include reserve requirements, repo agreements, and open market operations (buying/selling T-bills).
• Money market instruments (T-bills, commercial paper, repo) are short-term, low-risk tools used by banks, NRB, and even eSewa/Khalti for liquidity management.
• Risk-weighted assets (RWA) determine a bank’s capital adequacy—loans get higher weights (100%) than government securities (0%).
• Liquidity crises (like Sirjana Finance’s 2019 shortfall) are managed via NRB’s emergency lending under repo agreements, which inject cash into the system.

1. Defining Money Supply: M0, M1, M2

Money supply is the total stock of liquid assets in an economy, categorized by how easily they can be converted into cash. Nepal Rastra Bank (NRB) tracks three measures:

Key Definitions:

Why it matters:

• M0 is the base money created by NRB (via printing notes or digital reserves).
• M1 drives daily transactions (e.g., Pathao payments, Daraz orders).
• M2 includes longer-term savings (e.g., retirement funds in Siddhartha Bank).

2. How Banks Create Money: The Money Multiplier

When NRB lowers the reserve requirement (e.g., from 12% to 10%), banks can lend more, expanding deposits beyond initial reserves. This is the money multiplier effect.

flowchart TD
    A["Initial Deposit: Rs 10M in Nabil Bank"] --> B["Bank Holds 10% Reserve: Rs 1M"]
    B --> C["Lends Rs 9M to Kathmandu Shop"]
    C --> D["Shop Spends Rs 9M on Supplier"]
    D --> E["Supplier Deposits Rs 9M in Global IME"]
    E --> F["Global IME Holds 10% Reserve: Rs 900K"]
    F --> G["Lends Rs 8.1M to Another Business"]
    G --> H["Total Deposits: Rs 100M (Multiplier Effect)"]

Step-by-Step Example: Kathmandu Retail Shop’s Loan

Suppose:

• Initial deposit in Nabil Bank: Rs 10 million (from a business loan to a Kathmandu shop).
• Reserve requirement: 10% (set by NRB).
• Bank lends out: Rs 9 million (100% – 10% reserve).

What happens next?

1. The shop spends Rs 9M on inventory (supplier deposits it in Global IME Bank).
2. Global IME keeps 10% (Rs 900K) as reserve and lends Rs 8.1M.
3. This repeats until total deposits = Rs 100 million (initial Rs 10M × 10).

Formula: $$\text{Money Multiplier}=\frac{1}{\text{Reserve Requirement}}=\frac{1}{0.10}=10$$ Total money created = Initial deposit × Multiplier = Rs 10M × 10 = Rs 100M.

3. NRB’s Tools to Control Money Supply

NRB uses three main tools to manage liquidity and inflation:

Worked Example: Repo Agreement Impact Sirjana Finance needed Rs 20M liquidity. NRB lent it via a 7-day repo at 6% interest. Reserve requirement = 10%.

1. Initial reserves before repo: Rs 18M (for Rs 200M deposits).
2. After repo: Sirjana gets Rs 20M cash but must hold Rs 2M as reserve (10% of new deposits).
3. Excess reserves: Rs 18M (old) + Rs 18M (new) = Rs 36M → can lend Rs 360M (36M × 10 multiplier).
4. Total money supply increase: Rs 360M (new deposits created).

4. Money Market Instruments: Short-Term Tools

Banks and NRB use these low-risk, high-liquidity instruments to manage cash flow:

Worked Example: T-Bill Pricing NRB auctions a 90-day T-bill with:

• Face value = Rs 1,000,000
• Yield (bank discount basis) = 8%
• Step 1: Calculate bank discount: $$\text{Discount}=\text{Face Value}\times \text{Yield}\times \frac{\text{Days}}{360}=1,000,000\times 0.08\times \frac{90}{360}=\text{Rs 20,000}$$
• Step 2: Price = Face Value – Discount = Rs 980,000.
• Why? Investors pay Rs 980K now to get Rs 1M in 90 days (8% return).

5. Risk-Weighted Assets (RWA) and Capital Adequacy

Banks must hold capital equal to a % of their RWAs (set by Basel III). Higher risk = higher weight.

Worked Example: Calculating RWA A bank has:

• Loans: Rs 1,100M (100% weight)
• Govt securities: Rs 200M (0% weight)
• Cash in transit: Rs 50M (0% weight) RWA = (1,100 × 1) + (200 × 0) + (50 × 0) = Rs 1,100M.

Capital requirement (Basel III): At least 8% of RWA. → This bank needs Rs 88M capital (1,100M × 0.08).

6. Real-World Applications in Nepal

Case 1: eSewa/Khalti and M1 Money Supply

• Idea Used: Demand deposits (M1).
• How? When you load Rs 5,000 into eSewa, it becomes part of M1 (demand deposits at the bank backing eSewa).
• Impact: If 1 million users load Rs 5K each, M1 increases by Rs 5B overnight.

Case 2: Daraz’s Working Capital via Commercial Paper

• Idea Used: Commercial Paper (short-term borrowing).
• How? Daraz issues Rs 200M CP for 90 days to fund inventory before Diwali sales.
• Why? Cheaper than a bank loan (6% vs. 12% interest).

Case 3: NEPSE and T-Bills

• Idea Used: Open Market Operations (OMO).
• How? When NEPSE stock prices rise too fast (e.g., 2021 bull run), NRB sells T-bills to absorb excess liquidity from banks.
• Result: Banks have less cash to lend → stock prices stabilize.

Case 4: Kathmandu Traffic and Money Multiplier

• Idea Used: Money multiplier in urban economies.
• How? If NRB injects Rs 1B into Kathmandu’s transport sector (e.g., Pathao driver loans), and the reserve ratio is 10%, total deposits could grow to Rs 10B, funding more buses and reducing congestion.

7. Common Pitfalls and Exam Traps

1. Confusing M1 and M2:

   • ❌ M1 includes time deposits. ➡ Wrong! M1 = M0 + demand deposits only.
   • ✅ M2 = M1 + time/savings deposits.

2. Repo vs. Reverse Repo:

   • Repo: NRB lends to banks (injects liquidity).
   • Reverse Repo: Banks lend to NRB (absorbs liquidity).

3. Risk Weights:

   • Government bonds = 0% RWA (not 20% or 50%).
   • Unsecured loans = 100% RWA (unless collateralized).

4. Money Multiplier Assumptions:

   • Banks must lend all excess reserves (no hoarding).
   • No cash leaks (e.g., people keeping money under mattresses).

Exam Tip: How to Score Full Marks

1. Always define terms clearly:

   • "M1 is the sum of M0 (currency + reserves) and demand deposits, representing highly liquid funds used for daily transactions."

2. Use real Nepali examples:

   • "Like NRB’s 2023 repo to Sirjana Finance, which injected Rs 20M and created Rs 200M in new deposits (10% reserve ratio)."

3. Show calculations step-by-step:

   • For T-bills: Face Value → Discount → Price.
   • For money multiplier: Initial Deposit → Reserve → Excess → New Deposits.

4. Compare tools in tables:

   • Reserve requirements vs. repo vs. OMO (as shown above).

5. Link to current events:

   • "NRB’s 2024 decision to cut reserve ratios from 12% to 10% aims to boost SME lending, similar to how eSewa’s expansion required increased M1."

Final Visual Summary:

flowchart TD
    A["NRB Sets Reserve Ratio\n(e.g., 10%)"] --> B["Bank Receives Deposit\n(Rs 10M)"]
    B --> C["Holds 10% Reserve\n(Rs 1M)"]
    C --> D["Lends 90% Excess\n(Rs 9M)"]
    D --> E["Borrower Spends\n→ New Deposit in Another Bank"]
    E --> F["Repeat: New Bank Lends 90%\n→ Rs 8.1M"]
    F --> G["Total Money Created:\nRs 100M (10M × 10)"]
    G --> H["NRB Adjusts Tools\n(Repo/OMO) to Control"]