Thursday, April 30, 2009

Cost of finance in Nepal

This is a part of a series of analysis on growth diagnostics of Nepali economy. For discussion of other constraints see these blog posts.

In the growth diagnostics methodology, high cost of finance is divided into two parts: (i) Bad international finance and (ii) Bad local finance (which includes low domestic savings and poor intermediation). Below I discuss all of them.

1.1. Bad international finance

Access to international finance sources seems not to be an important issue for the Nepali economy. It has been consistently drawing out loans and credits from major donor agencies (mainly the IMF and the WB’s IBRD loans and IDA credits) at a comfortable medium and long term interest rate.

The international reserve situation is also comfortable as compared to other LICs. Since 1970, total external debt (% of GNI) consistently increased up until 1993. It then decreased until 1997 and rose again, reaching a peak of 60% in 1999. However, this has declined after that and now it is below 40% of GNI. This level is pretty good as compared to other countries with similar income level. The encouraging news is that it is in a decreasing trend. Moreover, CPIA debt policy rating is 3.5, above the average rating for LIC (ranking goes from 1 low to 6 high).

The central government debt (% of GDP) was alarmingly high before 2002. Though this is still high, it is in a decreasing trend in recent years. The good thing is that external debt is decreasing, government debt is also decreasing, and CPIA rating is well above the average for LIC. These indicators are inconsistent with a hypothesis that bad external finance is a binding constraint on economic growth.

Bad local finance

1.2. Poor intermediation

In the domestic front, it appears that investment is not responsive to interest rate, i.e. investment is roughly insensitive to interest rate.

From 1998 to 2006, interest rate was decreasing but the response on investment was not as expected. As lending rates declined, gross fixed capital formation also declined, indicating the unresponsiveness of investment to changes in interest rates. This indicates that it was not the cost of finance (interest rate) that brought down investment, but rather the low level of expected returns. Even when lending rates were declining, businesses were not willing to take out loans because of appropriability concerns engendered microeconomic risks, particularly high corruption and cumbersome labor and business regulations. Importantly, it was also due to low returns caused by deficient supply of infrastructure. As for investment in the economy, it has been consistently increasing over the past decade.


Getting credit from the banking system is not difficult in Nepal when compared to high growth economies like Maldives and Bhutan. Though getting credit rank has increased by seven positions (i.e. it is becoming harder to get credit) between 2008 and 2009, it is not unique to Nepal’s case. In fact, getting credit became difficult more or less in the same proportion in all the countries in South Asia.

Source: Doing Business Reports

Meanwhile, the increasing inflow of remittances and less investment opportunities in the economy has led to accumulation of excessive liquidity in the banking sector, which has partly inflated the real estate sector recently. Additionally, the previously high Non Performing Loans (NPL) are decreasing these days, thanks to strict measures taken by the central bank and the government. The level of NPL (% of total loans) was 60% in 2002, 30% in 2003, and 15% in 2006. The domestic banking sector is also in a good shape after the government initiated banking reforms five years ago. The two largest national banks with huge NPLs were handed over to private management companies four years ago. Since then they have recovered substantial loan payments from willful defaulters and turned the otherwise negative balance sheets into positive one. The central bank has been proactive in regulating the banking sector. It has even taken over ailing commercial and development banks.

Bad finance due to poor intermediation is not an issue at least in the present context. It, therefore, cannot be a binding constraint on growth.

1.3. Low domestic savings

Looking at savings, though domestic savings is fluctuating and is not that different from the level in 1976, gross savings is increasing since the past decade. As discussed earlier, this is aided by huge inflow of remittances to the tune of over 16% of GDP in 2006 and 18% of GDP in 2007. Moreover, the interest rate on savings deposit is also very low, indicating that banks have comfortable reserves and liquidity. On the lending front, the lending rate has been record low in recent years, indicating the willingness of banks to lend money to the private sector.

These data and analysis are inconsistent with the hypothesis that bad finance caused by low domestic saving is the binding constraint on growth, at least for now.

This shows that high cost of finance (bad international finance and bad local finance) is not the binding constraint on growth. However, this does not mean that it is not an issue of concern in the economy. What it means is that this issue is not as strong and important in terms of kick starting GDP growth rate as is the binding constraint—bad infrastructure.