Excess liquidity: Pros and cons

he current excess liquidity in the banking system is more or less the replay of the story that hogged news headlines in 2009, but with different actors and the situation. In that sense, Nepal’s bumpy financial system has come to a full circle in the last five years, and moved to one extreme point from another. A quick flashback: In early 2009 Nepal’s financial system experienced an unprecedented shortage of liquidity. All that started with the hastily appeared huge mismatch between inflow of cash into the banking system in terms of deposits and loan repayments, and the outflow in terms of fresh credits.

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.

Second coming: Impending banking crisis

It was published in Republica on August 19, 2012, p.6.

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Second coming

Nepal’s financial system seems to have come full circle as it is headed towards the same bumpy path that ended with a banking crisis in 2010. A flashback: Between fiscal 2004/05 and 2008/09, Nepali economy witnessed a breakneck monetary expansion and the total money supply, during the period, increased by 17 percent on average, owing to hefty growth in remittance. As a result, bank deposits doubled to Rs 422 billion in four years and liquidity soared due to low credit demand, despite record low lending rates. The one-year deposit rate remained at 4 percent for almost five years whereas inflation was 7 percent on average.

The negative interest rate that shrunk depositors’ savings by at least 3 percent each year for five years became a great disincentive to park saving at banks. This along with low lending rate diverted depositors toward highly risky speculative investments. Four distinctly visible scenarios emerged during the period. First, those with moderate deposits, say more than Rs 1 million, managed additional financing from banks and invested in real-estate, mainly on land. The sudden rise in the demand of land increased its price and provided handsome returns for both individuals and lending banks. That not only prompted initial investors to invest even more by taking additional loans but also lured others looking for alternative investment avenues to avoid negative interest rate and secure high returns.

Banks were happy as they were easily securing monthly installments and confidence of real estate traders was at a high as they enjoyed hefty returns. Real-estate lending soared to Rs 25 billion in 2009 from Rs 1.4 billion in July 2006. However, the realty business started losing steam in the beginning of 2009 and real-estate bubble burst in early 2010, putting at risk Rs 100 billion worth of bank investments. Two years down the line, the banks are trying hard to recuperate.

Second, those without enough savings to invest in real-estate were initially lured by the share market, which witnessed a whopping expansion, as market capitalization as percent of GDP jumped to 52 percent in 2008/09 from 11 percent in 2004/05 and the number of listed shares increased by three-fold. The share market soon started showing irrational behaviors. Even the shares of the companies that had declared their inability to generate profit for at least five years saw their shares oversubscribed manifold. Similarly share prices of some new finance companies increased by up to four-fold, even before they had released their first audited financial reports. That phenomenal growth in turn made banks invest heavily in margin lending—lending against share certificates—which rose to almost Rs 9 billion in July 2009 from nowhere.

The manipulation in the share market spurred mainly by weak regulations was so alarming that the share prices of regional financial institutions, with capital of Rs 100 million, were for years being traded at much higher prices than that of national banks, whose capital were Rs 2,000 million. But share market soon started losing its shine following the slump in realty business, as ballooning realty sector was the main propeller of the stock market. The contraction of the share market was so rapid that market capitalization was squeezed to Rs 377 billion within a year from its peak of Rs 513 billion in July 2009.

Third, those residing in border areas of the southern planes where there was neither realty boom nor shining stock market for speculative investments, shifted deposits, worth billions of rupees, to Indian banks offering as high as 12 percent interest in one-year deposits. The bordering Nepali markets were so lucrative for the Indian financial institutions that they used to put advertisements on Nepali side, promising quarterly interest payments at doorsteps. The fact that Nepali banks operating in bordering cities witnessed an unexpected increment in collection of Indian currency after Nepali banks increased deposit interest rates in 2010 was a strong evidence that low interest rate was one of the major reasons for the huge capital flight to India during the period. In addition, low interest rate also created conducive environment for various networking and insurance schemes to penetrate into the bordering Nepali markets.

Fourth, those in the emerging towns making small savings either from the money they were receiving from family members abroad or from local business, but had no access to share market, were attracted by illegal pyramid-styled networking business that promised unnatural returns. The infamous Unity Life scandal in which innocent people from rural and emerging cities lost Rs 3 billion was a brilliant example of the level of risk savers are ready to take even for moderate returns.

Against these facts, the recent rapid decline in deposit interest rate that was as high as five percentage points is a clear early warning that Nepal’s financial system is warming up for return to the vicious circle that shook the very foundation of the banking system in 2010. As remittance income continues to rise against the background of slow credit demand, and with liquidity in banks building up to around Rs 40 billion, it leaves banks no alternative to lower deposit rates. They are sure to further bring down the lending rate that so far has declined by three percentage point on average. The deadly combination of low deposit and low lending rates once again can goad people towards risky speculative investments. Though chances of reemergence of a real-estate bubble in near future is slim given various restrictions enforced by the central bank, particularly on land, the economy will surely see bubbles on other sectors if the current vicious circle of low-deposit-lending is not broken.
But how? Global experience shows that implementation of a functional base rate or benchmark rate for lending is an effective tool to deal with the abovementioned problems, though it is also not without shortcomings. The practice of adopting base or reference rate has become a popular tool to reduce lending risks, particularly after the global financial crisis and many regional central banks like Reserve Bank of India, have successfully implemented the policy to avoid lending risks. Indian experience show that the base rate policy has been effective in controlling lowering of lending rate to some borrowers that come with right political or commercial connections but lack adequate financial backings and real entrepreneurship skills.

To its credit, Nepal Rastra Bank in its monetary policy for current fiscal year as vowed to introduce a base rate, a monetary mechanism that will fix the minimum lending rate below which banks will be not allowed to lend. Since banks themselves have to fix the lending base rate on the basis of major cost elements like cost of deposits, cost of maintaining the SLR and CRR, cost of operations, and profit margin on each quarter, it will improve transparency in the banking sector’s interest rate mechanism.

The introduction of base rate will not only open a new avenue for floating interest rate to borrowers, who currently have no option than to accept fixed rate, but also help the central bank to maintain a solid base to determine spread rate. Moreover, it will help peg the deposit rate at a certain level above the inflation rate so as to ensure minimum reward for depositors.