There were three major reasons for the decline in the growth of deposits. First in the international front, the global financial crisis rattled the global economy the same year that squeezed the incomes of Nepali workers in the Gulf States and slowed the breakneck growth rate of remittance. Second in the domestic front, annoyed by the cold response to Voluntary Disclosure of Income Scheme (VDIS), the then Maoists government threatened to investigate bank accounts and sources of income of those not complying with the scheme. Third, the government announced a provision that required a valid source of income while depositing more than one million rupees in the banks.
All those set of actions badly sliced off depositors’ confidence, triggering two immediate impacts. First it slowed growth rate of individual deposits to 9 percent in 2009/10 from 32% recorded a year earlier. Second, it instigated a massive withdrawal of cash from the banks that according to some estimates was over Rs 12 billion. In contract, the outflow of the cash from the banking system in terms of fresh loans continued to grow at as much as twice of the deposit growth rate. As a result, Nepali financial market faced a severe shortage of liquidity. As a result, one-year deposit rate and the inter-banking lending rate, a quick barometer to gauge liquidity in the market, soared to over 12 percent.
Five year down the line, the situation is exactly opposite and the economy is struggling hard to manage excess liquidity. The cause of the problem is very straight. Last year’s exponential growth of over 26 percent in net current transfer, which includes remittance and pension incomes, hugely expanded money supply in the economy. As a result, Nepal witnessed an addition of Rs 233 billion in bank deposits whereas fresh credit expanded only by Rs 178 billion during the same period. As a result, the banking system added fresh liquidity worth Rs 55 billion on the top of around Rs 25 billion worth of liquidity it already had.
Similarly, huge government surplus remained one more reason for the excess liquidity. In the last year, total government income increased by 23 percent whereas total expenditure went up by 16 percent. As the result of government’s inability to expense available recourses on development works, the treasury ran into surplus of around Rs 30 billion. All these surpluses resources created a record liquidity of over Rs 100 billion in the banking system. Though the central bank lately used a new instrument to absorb Rs 20 billion, it is unlikely to make any remarkable impact given the hefty liquidity piled up in the banks.
Now the biggest question is what will be the impact of such a gigantic liquidity on the financial system. Some are already visible. The volume of interbank lending among the commercial banks squeezed to Rs 185 billion last year whereas such figure in the preceding year was Rs 726 billion. As a result, the interbank lending rate – the rate at which banks lend to reach other to manage quick cash imbalances -plunged to a record 0.22 percent whereas it was 2.72 percent in the pervious year. Similarly, weighted average rate on treasury bills plummeted to 0.13 percent. As the consequences, the average deposit rate declined to 4 percent but when official inflation rate, whose credibility is often questioned, was 8 percent last year. The negative interest rate – bank deposit rate minus rate of inflation - was 4 percent last year, which is at least 4 percent per year, is becoming a great disincentive for depositors to put their money in the bank.
This is the point when a time bomb starts ticking and that was how the infamous banking crisis hit Nepal’s financial system in 2009. The chain of reactions was very simple. In order to avoid negative interest rate and secure higher returns, depositors slowly lured towards highly risky speculative investments such as real estate and stock. Banks’ real estate lending and margin lending – lending against share certificate - increased by around 18 folds between 2006 and 2009. When the real estate and stock bubble burst in early 2010, putting at risk Rs 130 billion worth of bank investment, it shuck the very foundation of Nepal’ banking system. The blow to the banking system was severe that some of the banks are still trying hard to recuperate.
Against this backdrop, the continued negative interest rate is clearly an early warning that Nepal’s financial system is warming up for return to the baking crisis of 2010. As the amount of deposits continues to be higher than the lending, banks will continue to add up additional liquidity. In means, coming months will be more challenging in the sense that increased remittance will continue to swell money supply that will further increase rate of inflation and lower deposit rates along with the lending rates. The additional money supply during the Dashin festival might further worsen the situation.
The deadly combination of low deposit and lending rates along with the growing inflation will further provoke people toward risky speculative investments. Despite various restrictions enforced by the central bank to curtail real estate and stock lending, chances are high that both the sectors will see another bubble in coming months, albeit not in a scale seen before the 2010-banking crisis. And, chances are high that the cooperatives, which are in operation without strict regulatory policies and risk assessment mechanism, will be the inflator of the bubble. Despite some reputational issues, the cooperatives in recent times have been able to attract huge amount of deposits by offering deposit rate much higher than what the banks are offering. Though, Nepal badly lacks credible financial statistics on the finances of cooperatives, it is estimated that cooperatives have amassed huge deposits worth Rs 300 billion, one-fourth of deposits held by the banks. As the most of the banks are already close to the limit imposed by central banks on real-estate and stock lending, it is the cooperatives that will most likely emerge as the main real-estate lender after the upcoming festival, a pick season for land transactions. Undoubtedly, Nepal made wonderful efforts to consolidate regulations on the banking system and that produced appreciable results. By contrast, another slowly emerging player of the financial sector – cooperatives - remains in a sorry mess, mainly in terms of exercising financial prudency. No doubt, a major financial disaster is brewing there, but few people seem ready to pay due attention on the impeding risks.
Now the million-dollar question is: How to manage the swelling liquidity by preventing a possible huge flow of deposits from the banking system to cooperatives? One of the options available to deal with the excess liquidity is to lure additional investment to hydropower development by brining more investment friendly policies. It is because hydropower is probably the only sector that can absorb huge amount of liquidity with comparatively less risks, has a good prospect for both internal consumption and export, and has the potential to address the Nepal’s biggest impediment to growth. The recently announced policy to provide a lump-sum grant of Rs 5 million per megawatt is a right step in attracting investments to the hydropower sector.
However, unpredictable fluctuation in lending rates is still a discouraging factor. Many investors still recall the notorious rise in lending rate after the 2010-banking crisis. The rapid up to 5 percentage points rise in lending rate suddenly reversed the financial viability of the hydropower project. Such an unprecedented spike in lending rates badly tarnished investors’ confidence, compelling many to postpone the constructions activities. As one of the policy options to deal with such risks, the government should think of introducing a lending rate band - rate that can fluctuate between the upper and lower limits. The policy will help investors to predict the worst possible cost of lending and adjust returns and investments accordingly. The special refinance facility that the central bank has been administrating can be reformed to make such lending rate band workable.
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