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.

Huge BOP surplus, but no idea how to cheer

Predicting economic movements in impoverished economies is a daunting task. It becomes even more challenging when an economy opts to give up independent monetary policy for pegged exchange regime and nearly free capital movement with the economy that commands nearly two-third of the total foreign trade.

As shown by the Mundell–Fleming model, which is often called the ‘Impossible Trinity’, an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. Yes, undoubtedly, I am talking about economic dynamics of Nepal and India.  As the leaders continue to breed political mess in name of taking the ongoing peace process to a logical end and bringing a federal democratic constitution, yet another unexpected, though positive, development has surfaced and this time in the county’s balance of payment (BOP).

India's aspiration to be a global power

By Prem Khanal
India has recently done much to broaden its global reach to establish itself as an influential global player but, at the same time, done little to strengthen its image among immediate South Asian neighbors.

No doubt, India’s growing clout on the global stage has become distinctly noticeable in recent years with its powerful presence in global forums like G-20 meetings, climate change talks and global trade negotiations. India’s growing ambition to play a larger role in the Asian stage was also reflected in the recent presence of Prime Minister Manmohan Singh at the East Asian Summit along with US and Russia in Hanoi in October. Not only that, the hard effort that Indian has put to come up with a long-term economic and strategic partnership with South Korea and Japan during Singh’s recent visit to the region also reinforce the fact that India is looking beyond the South Asian horizon and wants to stand up shoulder to shoulder along with other Asian powers.

The support that US President Barack Obama announced for a permanent seat for India on a reformed United Nations Security Council during his recent visit has been hailed as a spectacular diplomatic victory for New Delhi. That followed former US President George W Bush´s maiden visit to India in 2005 that produced the civil nuclear deal, which, in fact, was the first bold step taken by the US to recognize India as a growing power.

America’s new strategy of searching new like-minded friends in the rapidly changing global context is understandable. Being the most powerful country in the world, it is obvious for America to take up a strategy of teaming up with other rising powers to contain China, which seemingly is gathering power to repel decades-old American influence in the Asia and Pacific region.

In addition, the poor shape of the American economy and its flagging financial muscle, ever-growing threats of terrorism and reemergence of tensions in its relationship with China have also compelled the US to look for rising muscular partners like India and Vietnam so as to bundle them up with US´s traditional allies like Japan and South Korea. This is being done not only to create a ‘soft alliance´ against China but also to explore emerging economic opportunities there. In addition, the recent assertive diplomacy opted by China has also alarmed its neighbors—most of them are ideologically close to the US, like India, giving enough reasons for the US to reinforce its role as an ultimate guarantor of security and stability in the Asia and the Pacific region.

Among the newly-found friends, it is obvious for the US to find India in its closest orbit, as both the country share many common features such as unshaken commitment to democracy and human rights, independent judiciary and free press. Many Indians still appreciate the great help that the US extended to it during its bloody and humiliating war with China in 1962. Responding quickly to the appeal made by then Prime Minister Jawaharlal Nehru, the US not only supplied arms but President John F Kennedy instructed one of their aircraft carriers to sail to the Bay of Bengal to help the Indian Army, which forced China to announce a ceasefire and lay out a timetable for withdrawal of its forces back to the borders.

Though the recent successes that India has made in establishing itself as an emerging power in global forums is laudable, it is too early for India to rejoice for there is a long way to go before it can widen its global influence. Make no mistake, American backing to India´s attempt for a permanent seat at the UN Security Council is not really an acknowledgement that India has already become a global power but a trust that it would emerge as a sober and responsible power. President Obama rightly pointed out that increased power comes with increased responsibility and that increased responsibility should first reflect in its dealings with its neighboring countries.

True, India has been an uneven supporter of democracy and human rights. It has played a laudable role in promoting democracy in the South Asian region. It stood against Nepal’s repressive regime and helped to restore multiparty democracy in Nepal both in 1990 and 2006, persuaded Bhutan to gradually opt for multiparty democratic system in 2008. However, its entire image as a promoter of democracy in the region fades away when its policy toward Myanmar’s military regime is taken into account.

Once India allowed Burma’s dissident radio station to operate on its soil and honored the recently-freed democratic leader Aung San Suu Kyi with the Nehru Award for International Understanding in 1993. But an amazing U-turn has taken place in India’s foreign policy toward Myanmar’s military regime since then. Not only has its intensity in criticizing the junta remarkably diminished, it showed no hesitation in rolling out the red carpet to Burma’s military leader Than Shwe and used all means to cash business opportunities from the reclusive country. Still, it can restore its badly-tarnished ´Burma Policy´ by putting pressure on the junta regime to respect fundamental values of democracy and human rights if it aspires to emerge as a responsible global power.
India’s economic cooperation with its smaller neighbors such as Nepal, Bhutan and Bangladesh is appreciable. But that generosity is sometimes overshadowed by activities in the border areas, water disputes, trade barriers, and interference in internal matters, among others.

India’s recent success in the economic front is laudable. Studies have reckoned that India that is closely following China’s hefty economic growth track has the potential even to overtake China´s economy in the next decade, thanks mainly to its demographic strength. However, India does not seem open enough to share its economic prosperity among its neighbors and create a conducive environment for them to grow. Not that it has done nothing. India’s economic cooperation with its smaller neighbors such as Nepal, Bhutan and Bangladesh is appreciable. But that generosity is sometimes overshadowed by activities in the border areas, water disputes, trade barriers, and interference in internal matters, among others.

India is still putting a number of non-trade barriers, which is hindering export potential of these countries. Willful obstruction in trade is often used as a tool to secure other economic or non-economic concessions. For example, though Nepal enjoys duty- and quota-free excess to India for its exports, hundreds of commodities are still victims of Indian additional customs duty of 4 percent. Similarly, an Indian allegation that Nepal’s media were making negative publicity against Indian joint ventures operating in Nepal just because they were not given advertisements shows how immature its policy toward small neighbors is. Of course, the smaller neighbors have to take on reciprocal responsibilities and must not allow any activities against India and should be sensitive toward core Indian interests.

India, on the other hand, should extend all possible support for economic prosperity, political stability and promoting democracy in its immediate neighbors like the US did in Europe and Japan after the Second World War. Unstable and fragile neighbors are far dangerous than prosperous and stable ones. As an ancient Roman poet Harace says, your own safety is at stake when your neighbor´s house is ablaze.

Obama in India

WILL Barack Obama, who arrives in India for his first official tour of the country in the next few days, be forced to utter the K-word? America has a tried-and-tested formula when asked if it will get involved in troubled Kashmir: after some 60 years of conflict, unless both Pakistan and India seek outsiders’ assistance, it will not push itself forward. And since India has no intention of doing so, that means America will stay away.

Yet as a presidential candidate Mr Obama promised to seek some sort of diplomatic resolution in Kashmir. He talked of deploying an envoy to encourage peaceful progress there. His envoy to Afghanistan and Pakistan, Richard Holbrooke, has mightily annoyed the Indians in the past by bringing up Kashmir as relevant to the wider region.

All this might have been quietly forgotten in Mr Obama's forthcoming trip, except for thedreadful events of the past five months, in which Indian security forces have killed more than 110 Kashmiri separatist protesters, some of whom had hurled stones at police, and injured many more.

Very interesting article