Is a Financial Crisis Looming in Nepal?

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Is a Financial Crisis Looming in Nepal?

A persistently loose or accommodative monetary policy stance for a longer period increases financial fragility and the likelihood of a financial crisis.


The Nepali financial sector is at the crossroads. While the commercial banks are facing an increasing volume of non performing assets (NPA) and on and off liquidity crunch, high interest rates have destabilized economic activities, resulting into a high cost economy. Microfinance and the savings and credit cooperatives seem to have diverted a big chunk of their capital the high margin sectors of real estate and share market.  As a result, a large number of microfinance companies are struggling for their own existence. The case of savings and credit cooperatives are even worse as they are rapidly losing depositors' confidence which has forced most of them to close down their business permanently.

The accommodative stance in monetary policy and the creation of a large, subsidised fund by NRB to ease the severe impact of COVID on industries and businesses, including hotels and other tourism-related activities, led to a surge of commercial banks credit volume. However, there is also a presumption of widespread misuse of these credits.

Theoretically, a persistently loose or accommodative monetary policy stance for a longer period increases financial fragility and the likelihood of a financial crisis. The intermediate channels that lead to this result are mainly credit creation and overheating of asset prices.

The Nepali case seems to be in line with this theoretical relationship. The accommodative monetary policy stance and easy access to subsidised credit have resulted in a significant expansion of credit, with the majority of it being used in real estate with rapidly increasing prices, a bullish share market, and a surge in imports, possibly indicating a large-scale capital flight from the country through over-invoicing.

It is typically observed that the demand for credit increases with the growth of economic activities and GDP level. However, in Nepal, the rapid growth of credit is not contributing to the growth of economic activities, but rather it's being increasingly used in high-margin areas such as the share market, real estate, and imports, possibly for capital flight. The unhealthy use of increased volume of credit signals a prelude to a financial crisis. The looming crisis in the financial sector may explode to a full-scale if not handled properly.

The increasing volume of non-performing assets in the banking system, more than double compared to last year, is not only causing more provisioning in the balance sheets of commercial banks but also pushing the cost of funds higher, resulting in subsequent increases in lending rates. This creates a cost-push interest rate spiral.

The sharp increase in interest rates has seemingly contributed to an increase in the price level, as reflected in the prices of even daily essentials such as cereal grains, vegetables, milk, and milk products. These price increases are not due to an excess in demand, but rather a cost-push effect. If the rise in prices is not checked, it may gradually transmit to other sectors, finally putting pressure on wage increases, creating a classic case of a wage-price spiral.

With the consent of Nepal Rastra Bank, commercial banks increased their lending rates to a hefty 17%, with 11% as the base rate plus a 6% premium. However, neither NRB asked nor the commercial banks justified why the premium is so high. A 2% premium would have been more than sufficient when all the associated costs determining interest are already added to the 11% base rate. The 17% or so lending rates charged by Nepali commercial banks are almost 7% higher than those charged by Indian commercial banks. Such an interest rate differences not only make investment costs higher but also sharply erodes product competitiveness. Hence, it cannot go on at the cost of the economy, and it needs to be narrowed down as soon as possible.

In a fixed exchange rate system with an open border country, a wide difference in the interest rate structure leads to unauthorised capital flight. This is what seems to be happening at present. Whereas the sharp increase in the trade balance with India reflects a possible capital flight through over-invoicing of imports, the appreciation of Nepali rupee in Indian border towns reflects an increasing demand for Nepali rupees to take advantage of the higher interest differential in Nepal.

At a time when the fiscal situation is facing challenges, the problems in the financial sector are likely to create a situation that is not conducive to smooth economic activities and growth. It may take the next two to three years to correct these anomalies before the economy returns to its normal path. The following actions are necessary to ensure the stability of the financial sector and promote healthy economic growth.

1. Strengthen the central bank's supervision and inspection department and carry out periodic inspections of financial institutions. Introduce heavy penalties for any irregularities found.

2. Conduct an in-depth analysis to examine how subsidised credit released during and after the COVID-19 pandemic is being utilised by different sectors. This may reveal the extent of capital flight and its channels, leading to necessary corrective measures.

3. NRB should abandon the base rate system for interest rate determination as it is related to internal management of commercial banks. Instead, a more efficient system should be adopted where the bank rate is used as a tool for determining interest rates. Commercial banks may be allowed to charge a 4% premium on top of bank rate to cover all types of risks and provisions. This will reduce interest rates and make them comparable to Indian commercial bank rates, leading to more efficient monetary policy transmission and transparent interest rate determination.

4.The NPAs of commercial banks are increasing steadily, putting pressure on the lending rates. As the economy is still at its lowest ebb and economic activities are not picking up, creditors are not in a position to repay their loans. Moreover, given the high interest rate, the auctioning of collaterals by banks will hardly find buyers willing to pay a reasonable price. A better option may, therefore, be to create an Asset Restructuring Fund of around Rs 25 billion by NRB, managed by a unit directly under it. The asset restructuring unit will take hold of the expired assets by making payments to the concerned commercial bank. The unit will act as a custodian of these assets and provide 2-3 years for creditors (the owners of the assets) to get them back. The unit will charge a subsidised rate of 5% per annum, inclusive of service charge, on the amount it paid to commercial banks while transferring the asset. Such a mechanism will ease NPA of commercial banks - that may lead to further reduction in the lending rates and also may provide temporary relief to creditors encouraging them to reinvigorate their business.

5. It is to be noted that the interest rates on repo and those in Treasury bills are not in line when compared to bank rates fixed by NRB. Bank rates should generally be higher than Repo rate, and the interest on treasury bills should be lower than that of bank rate and repo. This is not the case at present. commercial banks can easily get benefits of 3% or so by simply taking loans from NRB and buying treasury bills. These anomalies need to be sorted out immediately.

6. Keeping in view of rising interest on treasury bills, a better synchronisation of the timing of treasury bills and auctioning with the credit cycle is very much needed. Besides, a thorough look at the changes in CRR and SLR is recommended for better results.

(Ligal is a former vice chairperson of National Planning Commission)

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