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Twin policy problems
After a decade of political crisis, we could be heading towards an economic collapse. Our industrial sector is already in a moribund state. Agriculture is stagnant. And only few sectors— communication, transportation, airlines and the financial sector—flourished during the political turmoil of recent years. Among these, the financial sector has seen vigorous growth.
However, the Nepali financial sector is seemingly heading toward serious distress. Indicators points to a looming crisis in the near future. One after another, financial institutions have floundered. It appears that it is a matter of time before the next financial institution gets into trouble. A downward spiral is now apparent. If the financial institutions crumble in this way, the nascent deposit insurance scheme will not able to do anything for financial stability.
Paradoxically, when the economy was mired in the never-ending political drama, the financial sector expanded rapidly. A higher prospect of return lured people to invest in this sector, but the scope of other sectors gradually disappeared with a growing political instability and uncertainty.
While the financial institutions were competing for profit, the NRB came up with the conventional policies to fight increasing inflation and the balance of payments (BOP) deficit by tightening the monetary policy. The operations rested on Friedman’s quantity theory of money to quell inflation, which may be inapplicable in case of financial liberalisation with open borders. Inflation and BOP may no longer be a monetary phenomenon. Nevertheless, monetary tightness proved to be the seed of downfall in the financial sector.
In addition, while the financial sector has been expanding, the central bank itself has contracted its scope with the implementation of financial sector reform. This was done in the name of consolidation. But, despite shrinking manpower, the need of the hour is for the central bank to focus on regulation and supervisions. At the same time, the NRB has ignored the analytical capability of its employees. As a result, with the implementation of a set of measures such as new capital adequacy ratio, early warning system, prompt corrective action and risk based supervisions, financial institutions began to fail.
Another policy mistake was hiking the interest rate, but maintaining the exchange rate regime intact for a long time. Since 1993, the pegged exchange rate with the Indian currency has not been changed, causing the real exchange rate to overvalue. This has further hampered the industrial sector, flooding in the cheap imports from neighboring countries. Although other factors also play a role, an overvalued exchange rate may be suicidal for economic growth.
Given the economic structure, Nepal may not able to withstand the flexible exchange rate. Maintaining a currency pegged for so long time means inviting an economic disaster sooner or later. It has been 18 years that the exchange rate pegged with Indian currency has remained unchanged. As a result, there has been intense pressure on the demand for Indian currency with a higher trade deficit, and the management of this demand has become a tough task for the NRB.
Instead changing the exchange rate, even marginally, to correct the BOP deficits, the NRB hiked the interest rate in the last two years. This has constrained the financial sector. A simultaneous rise in interest rate and tightening credits to real sector has had repercussions in the financial sector. As a result of higher interest rates, the liquidity shortage has become worse. There is usually a tradeoff between liquidity and profitability. A shortage of both leads to financial fragility.
The NRB lost its share investment in Nepal Development Bank and it is rumored that it has a big amount of deposits in other troubled financial institutions. Then, a question arises for general public, which is safe—the financial cooperatives or the NRB licensed financial institutions? It may be an important reason why self-regulated cooperatives have mushroomed even in the urban areas.
Financial institutions also bear some of the blame. Nominal industrialists and businessmen, after failing in their respective areas, are venturing in the financial sector, with the inherent motive of embezzling public deposits. Coupled with increased risk taking, this has added to financial fragility. The practices of having exotic and fancy buildings, unnecessary colourful advertisements, unrealistic high interests on deposits, and the elevated pay for executives in our financial sector are nothing but ploys to deceive innocent depositors. Not only individual customers, but institutional depositors with the greed of a higher return have followed suit. In a time of distress, these institutional depositors are the main agents that destabilise the financial system.
In conclusion, to quote Joseph Stiglitz, “the financial institutions didn’t understand the risks that they confronted and their deceptive accounting practices, designed to mislead regulators, investors, and the tax collector alike, also deceived themselves.” The NRB’s tight monetary policy amidst lax supervision is equally responsible for planting the seeds of financial fragility.
Shrestha is a PhD Student at The New School for Social Research, New York
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