Here is an article by Prem Khanal published in Republica yesterday. The entire article is copied and pasted below.
Second coming
PREM KHANAL
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.
Comments: The article focuses on the rising spread rate and the various ways in which money is being used (real estate, share market, deposit in Indian BFIs, and pyramid schemes). He bats for introduction of base rate as one of the most viable solutions. But, then it is just a policy tool to stabilize lending and deposit rates within a certain band. It would have been even more revealing if the four main ways in which people are using money and the policy recommendation were linked with the core problems of the banking sector: intense (and unhealthy and non-innovative) competition among too many BFIs and lack of appropriate investment opportunities, which has in turn resulted in bubbles in certain sectors.
In January 2011, I had cautioned about the impending financial disaster and then in January 2012 I argued that the crisis is postponed (possibly) until mid 2013. The core problem is still there and few policy tweaks on the surface would only make a minor scar. Here is a long version of an analysis on the same issue. Also read this one.
