Poor Bloke’s understanding of Money and Nepal Rastra Bank

The Taxanomy of Money: From Barter to Cryptocurrency

What is money?

While we are at it, why not start here. What is money?
Money is any item or verifiable record that is generally accepted as payment for goods and services. This is an all-encompassing definition. For our purpose, let’s just understand money as the bank note or coins printed by the central banks of countries or a verifiable record of it (e.g. bank deposits, debts etc). 

History of Money

Barter Money
The history of money probably started with barter system. Barter system is simply exchanging the good/services with another person in need. When barter did not occur basically the money market was limited to gift economy or labor debt. 
Commodity Money
The barter system basically evolved into commodity money where more tradeable goods like grains/pellets/fuel/garments were used as a medium of exchange for necessary goods/services. 
Precious Metal Money
Precious metals like gold, silver, bronze etc. found more tradeable sense due to their limited supply. They were more tradeable as metals are malleable and could be produced into units of various values without significant degradation in their quality. 
Representative Money
Representative money were issued in the form of promissory note by the holder of the precious metal money. Eventually, these receipts became generally accepted as a means of payment and later under the same concept the gold standard money concept was introduced. 
Gold Standard Money
The governments around the world came to a realization that the representative money which where generally accepted in the form of general tender i.e. merchants promissory note could bring serious impact on the economy due to the fact that it was susceptible to authenticity of the issuer. The gold standard system was introduced around the world by governments through central banks, a monetary system where the medium of exchange are paper notes that are convertible into pre-set, fixed quantities of gold, replaced the use of gold coins and merchant’s representative money as currency, starting from 17th–19th centuries in Europe. 
Instead of directly being backed by gold, the money could also be backed by the reserve of foreign currencies i.e. dollar which was readily convertible into gold. After World War II and the Bretton Woods Conference, most countries adopted fiat currencies that were fixed to the U.S. dollar. The U.S. dollar was in turn fixed to gold.
Fiat Money
In 1971 the U.S. government suspended the convertibility of the U.S. dollar to gold. After this many countries de-pegged their currencies from the U.S. dollar, and most of the world’s currencies became unbacked by anything except the governments’ fiat of legal tender and the ability to convert the money into goods via payment. Fiat currency are simply backed only by a formal authorization or proposition of the government. 

How is the asset backing the money in circulation in Nepal composed of?

In Nepal, Nepal Rastra Bank issues notes and the liability of such issued notes shall be equal to the value of property kept as security. Such property is composed of: 
At least 50% of the property (or 40%, if the permission of the GON) to be kept as security shall be one or more of:
Gold, Silver, Foreign currency, Foreign securities,  Foreign bills of exchange
The remaining percentage shall be one or more of:
Coins (Mohar Double or coins of higher denomination),  Debt Bond issued by GON, Promissory note or bills of exchange payable in Nepal within a maximum of 18 months from the date of repayment by bank.

So is Nepal’s currency a Gold Standard Money or a Fiat Currency?
Like many countries around the world, Nepal also issues currency some % of gold backing and major component relates to Foreign Currency and Foreign Securities. So, since the gold backing is very small component of the asset backing of the Nepalese Currency, Nepal’s currency is also a Fiat Currency. 

The Balance Sheet of NRB

Basic things @ first

Central Bank is an institution owned by the Government of the Country. Central bank prints the money based on its monetary policy. Here it might be useful to highlight what are the major objective of central bank of Nepal: 
a. To formulate necessary monetary and foreign exchange policies in order to maintain the stability of price (मूल्य स्थिरता) and balance of payment (शोधनान्तर स्थिरता) for economic stability and sustainable development of economy, and manage it;
b. To increase the access of the financial service and increase the public confidence towards the banking and financial system by maintaining stability of the banking and financial sectors,
c. To develop a secure, healthy and efficient system of payment;
d. To extend co-operation in the implementation of the economic policies of GON.

How were money issued before the central bank or government intervention?

Let’s forget about NRB issuing the currency. Let’s say its you who want to issue currency. 

  1. Why would you want to issue currency?: To facilitate the trade. To ease the unit of account and to stop worrying about generating the perfect goods/service to barter against the goods/service that you want to receive. 
  2. How would you print the currency?: You would do it by issuing a promissory note stating that you would pay the bearer of the promissory note what is due against the goods/service that you received. But would people believe you for this instrument? Is your promise enough to make the bearer of the promissory note confident that he will receive what’s due against the said transfer of goods/service? What is lacking?
  3. What is lacking?: The thing that is lacking is unit of account and security for the your promise. Your promise is to pay the bearer what’s due for the goods/service you received. It is lacking two things:
    Firstly, it doesn’t have unit of account. This makes your promissory note untradeable/ non-transferable to other person by the first bearer. 
    Secondly, the instrument doesn’t have the asset backing. What is to guarantee that at the time of presentation of the instrument to you for payment, you will not default but honor the payment?

Early notes issued in China were issued by merchants and the risk of the note not being honored at the presentation for payment were high. This could bring disruption in the trade and cause unforeseeable losses to the business. There were two alternatives to solving this problem: 
1. Either handover the entire practice of issuing the notes to the central bank or government who is trusted by all the public and issuing guaranteed notes that would be honored for the underlying backing assets (like gold, investments etc.) upon presentation. 
2. Either build a trust system so that everybody’s promise to honor the payment could be accounted and trusted. This is giving rise to the modern method of blockchain mechanism that led to the issue of cryptocurrency. We will talk about block chain and cryptocurrencies in another blog. 

How is money accounted in NRB's books?

Balance SheetSo we have now understood that no matter how the money is printed or how much by the central bank, it doesn’t matter until it reaches the hands of the consumers. And they reach in our hand in the form of interest in deposits made in financial market or loans obtained from financial market. Central banks around the world create currency literally out of thin air. Quoting BundesBank, central bank of Germany, “Central bank create money just by making an accounting entry. Excess reserve is not a necessary precondition for a central bank to issue currency.”

  1. NRB was established with capital contribution of GoN. The capital contribution was made in the form of foreign reserves, gold and silvers that existed with the GoN treasury held as security against the currency issued before the establishment of NRB. 
    Dr. Foreign Currency / Gold
    Dr. Cash Equivalents 
    Cr. Banknotes
    Cr. Equity
  2. NRB is engaged in various income generating activities like: income from its investment in foreign currency, foreign securities, gold deposits that earn foreign currency income. Similarly it is also engaged in investing in government securities, loans and refinance activities that earn local currency income. 
    Dr. Foreign Currency / Gold
    Dr. Cash Equivalents
    Cr. Equity
  3. NRB issues new currency into circulation. Central bank creates money against monetary liability after ensuring the security backing as prescribed by NRB Act 2058. A necessary precondition is that the money that is being issued should be to the extent of security backing as prescribed by NRB Act. 
    • Firstly, ensuring the security backing for currency to be issued though necessary purchases: 
    Dr. Foreign Currency / Gold
    Cr. Cash Equivalents
    • Then, printing the currency to be issued
    Dr. Cash Equivalents 
    Cr. Banknotes
  4. NRB also retains a cash reserve from financial institutions as a part of Fractional Reserve Lending mechanism. 
    Dr. Cash Equivalents
    Cr. Deposits from Banks
  5. NRB is also engaged in creation of monetary policy assets and monetary policy liabilities as a part of
    Open Market Operation: Purchase or sell the debenture issued on behalf of the GON or the debenture issued or fixed by NRB. Manage short-term liquidity by forging repurchase agreement or reverse repurchase agreement upon the security of the GoN debentures or the letter of credit issued by NRB itself. 
    Discount Operation: Discounting the negotiable instruments submitted by the financial institutions who maintain their accounts with NRB into cash. 
    Loan and Refinance: Make loan and refinance available to financial institutions against international negotiable instruments, GoN debt bonds, deposits of gold and precious metals or other instruments.  

Is public debt visible in balance sheet of NRB?

No, public debt is the debt raised by GoN. It doesn’t appear in the books of NRB. It might appear in the books of NRB in form of asset when NRB invests in debt issued by GoN. The GoN may, subject to the prevailing laws, raise public debt by issuing any one type of or more types of bonds at the same time or at several times in such a quantity as it may consider necessary for the proper mobilization of government finance. Public debt is typically raised to finance the deficit budget of the government and fulfilling the political promises kept by the government.

It is necessary to discuss about public debt because such debt raised by the GoN, when held by NRB, actually qualifies for being an asset backing the currency to be printed by NRB, like discussed above. So this is an important thing to factor in while considering the money in circulation. 

How does NRB print money?

Against security backing

Not all the financial statement of central banks around world are in net surplus of general reserve. NRB financial statement however, stands in net surplus that is around 20% of the total assets. 
But does Nepal print currency out of thin air? No, Nepal has been maintaining 100% security against the monetary liabilities (i.e. currency issued) against the backing of Foreign Currency and Securities only. Not gold, not silver not the government securities but solely against Foreign Currency and Securities, since 2013. This is very prudent and conservative practice of NRB as countries around the world print money against the asset treasury bonds issued by their own governments. This foreign currency and securities includes mainly 
• Foreign currencies held in hand / vault
• Investments in treasury bond issued by GoI
• Investments in treasury bond issued by USA
• Time Deposits (a deposit in a bank account that cannot be withdrawn before a set date)
• IMR related Special Drawing Rights
• FIXBIS Investments (Fixed Rate Investments)

So, one could say that Nepal’s currency is pretty well backed. Or is it? Since the currency in circulation in Nepal are backed by foreign currency, it is closely interlinked with how those foreign currencies are backed. Since, major foreign currency comprise INR and USD, one could say its as stable as INR and USD are. 

Out of thin air

Central banks around the world create currency literally out of thin air. Quoting BundesBank, central bank of Germany, “Central bank create money just by making an accounting entry. Excess reserve is not a necessary precondition for a central bank to issue currency.” Is it really possible and how so?
How does central bank print money out of thin air? 

This all has to do with who you vote for in the general election. The political promises are mostly unachievable and are costly. The government will head into budget deficit.
NRB has to print currency to sustain such deficit. 
Dr. Cash and Cash Equivalents
Cr. Banknotes in Circulation
The government will issue a promissory note (GoN Treasury Bills) to NRB. NRB will invest in these treasuries. 
Dr. Investment in GoN Treasury
Cr. Cash and Cash Equivalents

How simpler could this be? It how money gets printed at the times of budget deficit. 

How does the currency printed by NRB reach your hand?

No matter how the money is printed or how much, it doesn’t matter until it reaches the hands of the actual spenders in the market. That’s the consumers of the market and includes common folk like you and me. The consumers of the market will receive money in the form of 
• interest in deposits made in financial market or 
• loans obtained from the financial market 
• deficit spending made by the GoN