Wednesday, January 19, 2011

Impending Financial Disaster in Nepal

My first piece in 2011 is related to the financial and real estate/housing sectors in Nepal. I believe that these two sectors will be severely affected by decline in housing and real estate prices and loan defaults within a year or two. Comments on this piece have been very .

Nepal has 31 commercial banks, and hundreds of development and finance companies. Without a substantial surge in depositor and borrower bases, the number of banks are mushrooming, particularly due to rise in remittances inflows. They have invested way too much in one sector, created asset and housing bubbles, and are now struggling to recover loans and meet profit targets. It is already late to contain the damage, but it is not too late (hopefully). The central bank has to make difficult decisions soon and it will definitely hurt one or the others sectors.

Impending financial disaster

Nepal has been struggling to maintain macroeconomic balance for a couple of years now. Low growth rate, high unemployment, balance of payments deficit, widening trade deficit, and high and sticky inflation are some of our pressing existing macroeconomic challenges. Now, add to that list an impending financial disaster, engendered largely by the bank and financial institutions (BFIs) themselves and to some extent by Nepal Rastra Bank (NRB), our central bank.

While the latter ignored the unhealthy development in financial sector, let new BFIs prop up without even evaluating if our economy needs so many of them, and took damage control measures of late, the former is in desperation to survive amidst cutthroat competition, which is getting nasty by the day. The BFIs’ inability to effectively cope with the existing pressure on deposit and lending, and to attain unsustainable profit targets might lead to a situation where all profits are private but losses are social, i.e. taxpayers pay the cost of reckless behavior of few sectors in the economy.

Looking at the existing business structure of the real estate and housing sector and the BFIs, it is very likely that their unjustified growth will end soon, raising fear of destabilizing not only the very conduit from where the public is facilitated with credit but also derailing the entire economy. The existing path on which these two sectors are hurtling toward bears the hallmark of the recent housing, financial, and economic crises in the West. It all starts with pumping of too much money in one sector, which after few years of unnatural and unsustainable growth crashes down and puts pressure on the BFIs, leading to defaults, extremely vulnerable financial institutions, and squeezing of credit to all sectors in general.

Before going into detail about symptoms of the impending financial disaster, let me first discuss how the bigwigs of the BFIs are behaving irresponsibly and are trying to scuttle reforms introduced, albeit lately, by the NRB.

Recently, they made a high pitch about the central bank being anti-market when it regulated CEO’s pay; capped lending to the realty and housing sector; and directed the banks to ensure that interest rate difference on various kinds of savings accounts is not more than two percentage points. The negative and nonsense drumbeating by the bigwigs of the banking sector was so incriminating that the central bank governor Dr. Yuba Raj Khatiwada felt compelled to make a statement that he and the NRB are not market unfriendly.

Ironically, the very next day the executives tacitly agreed to cap savings account interests between 4-6 percent. Without shame the Nepal Bankers’ Association (NBA) argued that the banking bigwigs reached “a gentleman’s agreement” to cap interest rates. The same executives who were defending free market colluded to cap interests on savings accounts. This is carteling and an outright hypocrisy. They played the same anti-market game in May 2010 when they colluded to limit interest rate on fixed deposits at 12 percent. The main problem is not financial regulation; it is that we simply have way too many BFIs serving a narrow depositor and borrower base.

Behind the unnecessary activism of the banking sector in pressing their demand, resisting regulation, and trying to circumvent the NRB’s directives lies a bitter truth: some of the BFIs very existence is at stake. They are trying to buy time before the inevitable disaster hits them. This is largely of their own making by imprudently running after short term gains over long term sustainability. The crux of the matter lies at the reckless lending to the urban-centric real estate and housing sector, which is starting to tumble after few years of rapid growth.

First, lending to this sector is unjustified by future growth prospects. This urban-centric sector contributes around 7.8 percent of our GDP and is the highest growing sector in the past six years. Buoyed by easy finance and loans, real estate transactions and housing complexes are rising rapidly. Sometimes artificial demand is created just to jack up prices. This is evident from the fact that our shaky economic fundamentals do not justify multifold increase in land prices in a matter of days. Moreover, liquidity is pumped into this sector without properly assessing risks and the ability of borrowers to repay loans. The BFIs are hardly distinguishing between normal and subprime markets.

This is creating market disequilibrium, i.e. the supply of real estate and housing complexes is outstripping demand, leading to a decline in prices. The media reports indicate that real estate prices have already gone down by 30 percent. Be prepared to brace for even lower prices. As prices dip, borrowers will be unable to honor principal and interest payments on time, forcing the BFIs to restructure loans and variably increase lending rates. Buyers will cancel booking even after paying the minimum required down payment. Soon we will see ‘ghost’ apartments, i.e. empty apartments waiting for customers to either buy or rent them. This will ultimately hit the BFIs.

Second, the uber-generous BFIs are chasing after short term gains without properly assessing borrowers’ ability to repay interest and principal on time. As of November 2010, credit flow of commercial banks to land and buildings sector was Rs 284 billion out of a total of Rs 415 billion, representing about 69 percent of total credit flows with assets guarantee. Since a lot of this credit went to the real estate and housing sector, which is facing a hard time due to declining prices, the vulnerability of BFIs to an ultimate busting of this sector is pretty high.

Now, you might be wondering why the BFIs are lending so much to just one sector. Well, the reason is that the rapid increase in number of BFIs without a proportional increase in depositor base intensified cutthroat competition to attract both depositors and borrowers, and put the BFIs in desperation to meet unsustainable profit targets. Despite knowing the fact that the incredulous profit targets can only be achieved in the short term by putting the foundation of the entire banking sector at risk in the long term, the BFIs played the risky game (by lending too much to one sector) as if everything was normal.

Still, BFIs are offering interest rates above 12 percent in savings account. In June 2010 and July 2004 it was just above 7.7 percent and 5 percent, respectively. Meanwhile, the maximum lending rate has been over 18 percent. In June 2010 and July 2004 it was 14 percent and 11.5 percent, respectively. Due to limited playing field and increasing competition, some of the banks are even offering high interest on a daily basis on demand deposits, which usually does not happen. Since this is unsustainable and is putting the entire financial sector at risk, the central bank capped lending to overly heated sectors and interests differential in deposits. To circumvent this decision the BIFs are capping interests on saving accounts and are variably increasing lending rates without properly informing borrowers. It will increase chances of more defaults.

The development in the housing and real estate sector and the ad hoc decisions of the BFIs do not augur well for the economy. We might end up with empty apartments and ‘ghost’ houses if things continue to go the way they are going right now. Playing with interest rates on loans and savings is just an attempt to buy time before the inevitable disaster hits the BFIs. It is good to acknowledge and rectify mistakes before it is too late.

The tendency to seek short term gains over long term sustainability is a recipe for disaster with severe negative externalities, i.e. it will not only affect the BFIs, but also the public who are not a direct party to the activities of financial sector, and real estate and housing sector. Before these two sectors put the entire economy at risk, strong safeguards should be put in place. It might mean making painful decision of letting some BFIs to either fail (remember Nepal Development Bank?) or forced to merge, and help to rapidly cool down the urban-centric real estate and housing sector.

[Published in Republica, January 15, 2011, p6]