Money, Banking, and Financial Markets: Roles, Functions & Policy

TAKEAWAYS:

• Money’s three core functions (medium of exchange, store of value, unit of account) explain why fiat currency dominates even without gold backing.
• Commercial banks create money through fractional reserve lending, while the central bank (Nepal Rastra Bank) controls the money supply via open market operations, reserve requirements, and repo rates.
• Financial markets (stock exchanges like NEPSE, bond markets) channel savings into investment, but asymmetric information creates risks like adverse selection and moral hazard.
• Monetary policy tools (interest rates, liquidity adjustments) aim to stabilize inflation, unemployment, and economic growth—but lags and unintended effects (e.g., asset bubbles) limit their precision.
• Digital money (eSewa, Khalti) and cryptocurrencies challenge traditional banking by reducing transaction costs but raise concerns over financial inclusion and cybersecurity.
• Nepal’s banking sector faces unique challenges: high non-performing loans (NPLs), dollar scarcity, and the need to balance rural financial inclusion with urban digital innovation.

1. The Nature and Functions of Money

Money is any asset widely accepted as payment for goods, services, or debts. In Nepal, the Nepal Rastra Bank (NRB) issues the Nepalese rupee (NPR), the legal tender. Money performs three critical functions:

Functions of Money

mindmap
  root((Money))
    Function1["Medium of Exchange"]
      - Eliminates barter's "double coincidence of wants"
      - Example: Buying groceries with NPR instead of trading rice for lentils
    Function2["Store of Value"]
      - Preserves purchasing power over time (if inflation is low)
      - Example: Saving NPR under a mattress vs. investing in NEPSE shares
    Function3["Unit of Account"]
      - Standardizes prices and debts
      - Example: A Daraz order priced at NPR 5,000 vs. "1 kg of rice"
    Function4["Deferred Payment Standard"]
      - Enables credit and loans
      - Example: Taking a bank loan to buy a Pathao bike

Types of Money

Money Supply in Nepal

Nepal’s money supply is measured by:

• M0 (Narrow Money): Currency in circulation + bank reserves (held by NRB).
• M1: M0 + demand deposits (e.g., savings accounts).
• M2: M1 + time deposits (e.g., fixed deposits).
• M3: M2 + other liquid assets (e.g., money market funds).

Worked Example: Money Supply Growth in Nepal (2018–2023) Key Observations:

• 2020: NRB injected liquidity (NPR 1.2 trillion) to support businesses during COVID-19.
• 2021: M3 surged due to remittance inflows (NPR 1.2 trillion in 2021) and government spending.
• 2022–2023: Growth stabilized as NRB tightened monetary policy to curb inflation (peaked at 8.9% in 2022).

2. The Banking System: Structure and Functions

Banks act as intermediaries between savers and borrowers, creating money through fractional reserve banking.

Types of Banks in Nepal

How Banks Create Money: Fractional Reserve Banking

When you deposit NPR 10,000 in a commercial bank:

1. The bank keeps 10% (NPR 1,000) as reserves (required by NRB).
2. It lends out NPR 9,000 to a borrower (e.g., for a small business).
3. The borrower spends the loan, and the recipient deposits it in another bank.
4. This process repeats, creating new money up to 10x the initial deposit (money multiplier = 1/required reserve ratio).

Worked Example: Money Creation in Nepal Assume:

• Required reserve ratio (RRR) = 5% (as of 2023).
• You deposit NPR 100,000 in NMB Bank.

Money Creation Process:

Total Money Created = Initial Deposit × (1/RRR) = 100,000 × (1/0.05) = NPR 2,000,000.

Real-World Impact:

• If banks lend aggressively, money supply grows, potentially fueling inflation (as seen in Nepal’s 2021–2022 inflation spike).
• NRB adjusts RRR to control money creation (e.g., raised RRR to 5% in 2022 to curb inflation).

3. The Central Bank: Nepal Rastra Bank (NRB)

NRB is Nepal’s central bank, established in 1956. Its core functions:

Functions of NRB

NRB’s Monetary Policy Tools

NRB uses three main tools to influence the economy:

Worked Example: Impact of Repo Rate Hike on Ncell Loans

• Scenario: NRB raises repo rate from 6% to 7.5%.
• Effect on Banks:
  • Banks’ cost of borrowing from NRB increases → they raise lending rates.
  • Ncell’s loan interest rate for mobile financing schemes rises from 12% to 15%.
• Impact on Borrowers:
  • A customer taking a NPR 50,000 loan for a smartphone now pays NPR 7,500/year in interest (vs. NPR 6,000 before).
• Economic Goal: Higher borrowing costs reduce spending → lower inflation.

4. Financial Markets: Stocks, Bonds, and Foreign Exchange

Financial markets allocate savings to investment and facilitate risk management.

Types of Financial Markets in Nepal

Key Financial Markets in Nepal

Worked Example: NEPSE and Remittance-Driven Investments

• Scenario: A Nepali migrant worker in Qatar sends NPR 500,000 via NMB Bank.
• Investment Options:
  1. Fixed Deposit: Earns 8% interest (NPR 40,000/year).
  2. NEPSE Shares: Buys shares of Ncell (NTC) at NPR 1,200/share (total 417 shares).
     • If Ncell’s share price rises to NPR 1,500 in a year, profit = NPR 120,000 (30% return).
  3. Government Bonds: Buys a 91-day T-bill at 7% yield (NPR 10,500 return).
• Real-World Impact:
  • Remittances (NPR 1.2 trillion in 2021) fuel demand for financial assets, pushing NEPSE to record highs.
  • NRB warns of "stock market bubble" risks if speculative trading rises.

5. Challenges in Nepal’s Banking Sector

Nepal’s banking system faces unique hurdles:

Key Challenges

Case Study: NPL Crisis in Nepal (2020–2023)

• Problem: Banks classified NPR 150 billion in loans as NPLs due to COVID-19 defaults.
• Impact:
  • NMB Bank’s NPL ratio: 3.1% (2023).
  • Government Intervention: Waived loan repayments for 1.5 million borrowers.
• Solution:
  • NRB introduced debt restructuring schemes.
  • Banks sold NPLs to asset management companies (AMCs) at discounts.

6. Digital Money and Fintech in Nepal

Digital payments (eSewa, Khalti) and fintech are transforming Nepal’s financial landscape.

Digital Payment Platforms in Nepal

Worked Example: Khalti’s BNPL Scheme

• How It Works:
  1. You buy a NPR 20,000 smartphone from Daraz using Khalti.
  2. Khalti allows "Buy Now, Pay Later" (interest-free for 30 days).
  3. If you don’t repay in 30 days, Khalti charges 1.5% monthly interest.
• Impact:
  • Merchant Benefit: Higher sales volume.
  • Consumer Risk: Overspending leads to debt traps (seen in 15% of Khalti users).
  • Banking System Risk: If many users default, Khalti’s partner banks (e.g., Global IME) face NPL risks.

7. Monetary Policy and Economic Stability

Monetary policy aims to achieve price stability (low inflation), full employment, and economic growth.

NRB’s Monetary Policy Stance (2020–2023)

Transmission Mechanism of Monetary Policy

flowchart LR
  A["NRB Adjusts Policy Tools"] --> B["Changes in Repo/Reverse Repo Rates"]
  B --> C["Banks Adjust Lending Rates"]
  C --> D["Households/Firms Borrow Less or More"]
  D --> E["Aggregate Demand Changes"]
  E --> F["Inflation/Unemployment Adjusts"]
  F --> G["Economic Growth Stabilizes"]

Worked Example: NRB’s Response to 2022 Inflation

• Problem: Inflation hit 8.9% (highest in a decade) due to:
  • Global oil price shock (NPR 200/liter diesel in 2022).
  • Supply chain disruptions (COVID-19, Ukraine war).
• NRB’s Actions:
  1. Raised repo rate from 5.5% to 7.5%.
  2. Increased RRR from 3% to 5%.
  3. Sold T-bills worth NPR 50 billion to absorb liquidity.
• Outcome:
  • Inflation fell to 6.5% in 2023.
  • But: Bank lending dropped 10%, hurting SMEs.

## In the Real World

1. eSewa and the Money Multiplier

   • When you deposit NPR 10,000 in eSewa, the bank (e.g., Global IME) holds 10% (NPR 1,000) as reserves and lends NPR 9,000 to a small business.
   • The business spends the loan on raw materials from Daraz, whose supplier deposits the money in NMB Bank, creating more loans.
   • Real Impact: eSewa’s growth (NPR 8 trillion transactions in 2023) amplifies the money multiplier effect, boosting Nepal’s M3.

2. Ncell’s Loan Interest and Repo Rates

   • Ncell offers mobile financing schemes (e.g., NPR 50,000 loan at 12% interest).
   • When NRB raises the repo rate to 7.5%, Ncell’s borrowing cost increases → they raise loan rates to 15%.
   • Consumer Impact: A customer paying NPR 6,000/year now pays NPR 7,500, reducing demand for smartphones.

3. NEPSE and Remittance-Driven Investments

   • Migrant workers send NPR 1.2 trillion/year via banks.
   • Many invest in NEPSE shares (e.g., Ncell, NMB) or T-bills.
   • 2021 Boom: NEPSE index rose 30% as remittances surged post-COVID.
   • Risk: Over-investment in stocks led NRB to warn of "speculative bubbles" in 2022.

4. Khalti’s BNPL and Debt Traps

   • Khalti’s "Buy Now, Pay Later" feature lets users buy NPR 20,000 smartphones without immediate payment.
   • Problem: 15% of users default, leading to NPR 5 billion in bad loans for partner banks.
   • Solution: Khalti now checks credit scores before approving BNPL.

5. NRB’s Forex Management and Dollar Scarcity

   • Nepal imports 80% of its oil and machinery, requiring USD.
   • 2022 Crisis: Forex reserves dropped to NPR 1.2 trillion (3 months of imports).
   • NRB’s Actions:
     • Raised import deposit requirements from 10% to 30%.
     • Encouraged remittance inflows via cash incentives (NPR 1,000 bonus per transaction).
   • Outcome: Forex reserves recovered to NPR 1.5 trillion in 2023.

## Exam Tip

1. Money Multiplier Formula: Always derive it from the reserve ratio (e.g., if RRR = 5%, multiplier = 20). Examiners test this in numerical problems.

   • Example Question: "If a bank receives a deposit of NPR 50,000 and the RRR is 10%, how much new money is created?"
   • Answer: New money = 50,000 × (1/0.10) = NPR 500,000.

2. NRB’s Tools vs. Goals: Match policy tools to objectives (e.g., repo rate hike → reduce inflation).

   • Common Mistake: Confusing repo rate (bank-to-NRB borrowing) with lending rate (bank-to-customer).

3. Digital Money vs. Traditional Banking: Compare eSewa/Khalti with commercial banks in terms of reach, costs, and risks.

   • Exam Point: Digital money reduces transaction costs but increases financial exclusion risks.

4. Worked Examples: Always relate theory to Nepal’s context (e.g., NPLs, remittances, NEPSE).

   • Example: "Explain how NRB’s 2022 repo rate hike affected Ncell’s loan interest rates."

5. Diagrams: Draw money creation flowcharts, monetary policy transmission mechanisms, and NEPSE trends in exams. Label clearly!

6. Critical Thinking: Discuss trade-offs (e.g., "How does NRB’s inflation-fighting policy affect rural employment?").