Nepal (mid-year FY2017) and India (FY2016/17): Brief macroeconomic overview

Nepal: Mid-year review of FY2017 budget and monetary policy

The Ministry of Finance released its mid-year review of FY2017 budget. It increased revenue target but lowered expenditure target. There is not much change in expenditure pattern. Actual capital spending was just 11.3% of planned capital spending. However, the government is targeting to bump this to 84% by the end of the fiscal year. Around 49% of total revenue target was achieved by mid-year. 

The NRB also released its mid-year review of FY2017 monetary policy and macroeconomic situation. Inflation averaged 5.8% on the back low fuel and commodity prices, good monsoon-led boost in agricultural output, normalization of supplies and decreasing inflation in India. Current account slipped in the negative territory due to the widening of trade deficit and deceleration of remittance inflows. 

The NRB also tweaked accounting rules on computing CCD ratio. It has allowed BFIs to discount 50% of productive lending (plus lending to deprived sector and lending to agro sector at subsidized interest rate) while computing the CCD ratio. This essentially gives a breathing space to many BFIs that are close to the mandatory threshold of 80. It frees up about NRs130 billion for extra lending (by mid-year BFIs lent about NRs254 billion to productive sector).  

India: Macroeconomic overview (IMF)

• Real growth (at market prices) projected to slow to 6.6% in FY2016/17 and then rebound to 7.2% in FY2017/18
• Normal monsoon rainfall but suppressed private consumption demand (due to demonetization shock)
• Low inflation of around 4.7% (temporary demand disruptions due to demonetization, good agricultural harvest due to good monsoon, collapse of global commodity prices, supply-side measures, tight monetary policy stance) 
• Reduced external vulnerabilities (CA deficit to remain low and international reserves to cover around 8 months of import), and large terms of trade gain (increased by 2.22% in 
• FY2013/14, 2.5% in FY2014/15, and 7% in FY2015/16)
• Focus on fiscal consolidation and quality of public spending (FY2015/16 budget deficit of around 3.9% of GDP; FY2016/17 budget on track to reach 3.5% of GDP target)
• Implementation of key structural reforms including GST (has the potential to raise medium-term growth to above 8%), using Aadhaar identification and bank accounts to make direct benefit transfers, formalization of inflation targeting framework, new Bankruptcy Act

Key challenges: persistently high household inflation expectations, large fiscal deficits, excess capacity in key industrial sectors, strains in financial and corporate balance sheets, the extent of cash shortages, external vulnerabilities (global financial market volatility including from US monetary policy normalization and weaker-than-expected global growth).

Liquidity/credit crunch and mid-year review of monetary policy

In its mid-term review of monetary policy for FY2017 the central bank appears overly accommodative by tweaking accounting rules to compute local currency credit to core capital plus local currency deposit ratio (CCD ratio in popular lingo). It has allowed BFIs to discount 50% of productive lending (plus lending to deprived sector and lending to agro sector at subsidized interest rate) while computing the CCD rato. This essentially gives a breathing space to many BFIs that are close to the mandatory threshold of 80. It frees up about NRs130 billion for extra lending (by mid-year BFIs lent about NRs254 billion to productive sector). At the core of it, the BFIs indirectly got what they wanted— more space to lend irrespective of deposit growth. This is a temporary measure with a sunset clause (ending mid-July 2017). 

But then will this kind of overly accommodative measure by the central bank foster moral hazard (i.e., the BFIs don't have an incentive to guard against reckless lending risk when they know that they will be somehow protected from its consequences = privatize profits, socialize losses)? The BFIs have been indirectly rescued by the central bank again and again. Initially, it was due to the accumulation of high non-performing assets before 2000, then it was due to aggressive lending to real estate, housing and hire purchase around 2012, and now due to reckless lending even when they clearly knew that deposit growth was and is going down. This pattern of making deliberate (or not!) mistake and then the central bank coming to their rescue in one way or the other is amazing!

Here is an article on the current liquidity/credit crunch and its causes. For more background, here is another long article on the causes of severe liquidity crunch around 2011/12. Briefly, the BFIs brought the troubles upon themselves by aggressively lending to few sectors to gain quick returns in such a way that the credit growth far outpaced deposit growth. Keep in mind the following points:

1. Deceleration of remittance inflows was expected from last year because of the slowdown in growth of migrant workers. Remittance inflows are considered a stable source of deposits.  
2. Credit growth expanded more than deposit growth even when BFIs knew the reality (i.e., #1)
3. Ever-greening and at times imprecise classification of risky assets are tricks used by BFIs to navigate through the regulatory loopholes.
4. Asset-liability mismatch is still an issue (think of the problems arising from using short-term deposits to lend to long-term projects)

Lets say the BFIs lend NRs130 billion extra loanable fund they have now because of the tweak in accounting rules till mid-July. Then what? Will they maintain CD ratio below the mandatory threshold with enough space to keep credit flowing even if deposit growth continues to dries down? How can we be assured that they will not continue to engage in reckless lending to meet unsustainably high profit targets? Will these practices lead to building up of non-performing assets? Any tweaking of monetary policy and established rules should be accompanied by clarity/direction on its expected consequences. 

The government might have feared that a sudden credit crunch will squeeze revenue growth from high contributing sectors and will also hurt economic activities. This would mean missing revenue and growth targets for FY2017 (you get a sense of this from the MOF's mid-year review of FY2017 budget). I think the central bank’s decision to tweak the accounting rules indirectly is aimed at addressing this issue rather than cleaning up the mess within the BFIs. Good for short term, but creates uncertainty in the medium term. Interest rates will likely stabilize. .

Lets not forget what the BFIs need to focus on: enhancing their capacity to roll out better operational and management practices. They should scrutinize loan proposals more intensely, invest more in research and personnel training, introduce innovative deposit and credit schemes, diversify their asset portfolio, lower unsustainable profit targets, improve corporate governance and continue consolidation efforts.

Anyway, there are good measures as well: revising down limit on personal overdraft loans to NRs7.5 million from NRs10 million (these are sometimes diverted to stock market, real estate and other speculative investments); limiting interest on call deposit to that of normal savings deposit; allowing issuance of foreign currency-denominated LOC for 90 days (lowers cost of borrowing for traders), limit on lending to personal vehicle purchase based on its value, etc. 

For now, lending rates will stabilize (lets hope deposit rates will rise by some percentage points). The liquidity/credit crunch will normalize as soon as capital spending accelerates (as usual in the last trimester). Addressing the liquidity/credit crunch brought upon themselves by the BFIs is a tricky issue for the central bank. There ain't no easy fix!

Nepal's self-inflicted liquidity/credit crunch

It was published in The Kathmandu Post, 07 February 2017.

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They had it coming

The current liquidity crunch is the result of faulty operation and management of BFIs

The financial sector is in a temporary yet recurring state of disarray right now as a self-inflicted ‘liquidity crunch’ has handicapped most banks and financial institutions (BFIs). While the business community is unnerved by the rapid shrinkage of loanable funds and prospects of an interest rate hike, BFIs are struggling to stay within the mandated credit-to-deposit threshold. 

Nepal Rastra Bank (NRB) has rightly refused to increase the 80 percent threshold as it is one of the widely used tools to ensure the viability of the financial system and security of deposits. The liquidity/credit crunch is the consequence of flawed operation and management practices of BFIs.

BFIs are required to maintain at least 20 percent of their deposits in the form of very liquid assets, which means cash or assets that can be readily turned into cash. The credit to core capital plus deposit ratio should not exceed 80 percent. If they are close to the ceiling and are unable to attract more deposits, they need to hold back on aggressive lending. Any drop in deposits means that BFIs will have to lower credit growth too so that they do not overshoot the threshold.

To better secure deposits, reduce the number of BFIs and improve the financial sector, NRB instructed BFIs to increase their paid-up capital by mid-July 2017 (Rs8 billion for commercial banks). In response, several weak BFIs merged or were acquired by stronger ones. Others floated shares or are in the process of doing so. BFIs also had to increase credit growth to maintain a high profit target. Without many alternatives, they engaged in aggressive, unproductive and irresponsible lending to three particular sectors: real estate, hire purchase and share investment. Demand for loanable funds in these sectors is always high, and with little hassle and transaction cost, BFIs earn disproportionally large profits compared to lending to other sectors such as energy, agriculture, infrastructure and tourism. Underneath this lending practice lies ever-greening and at times imprecise classification of risky assets.

Socialise losses, privatise profits

Real estate prices began heating up after the earthquakes in 2015 following a few years of stability. Most BFIs had some room left for real estate lending, and due to lack of other bankable investment opportunities, they started issuing loans generously. Simultaneously, they increased margin lending, which contributed to a bullish stock market despite no noticeable change in economic fundamentals.

The other profitable market segment that could absorb credit quickly was vehicle purchase whose import demand spiked after a lull triggered by a crippling supplies disruption last year. Lending to these sectors swelled so fast, and without proper scrutiny of sustainability of the balance sheet, that the total credit growth outstripped deposit growth. At the same time, deposit growth slowed because of a deceleration in remittance inflows and the inability of BFIs to offer innovative savings instruments. The situation exacerbated to such a level that BFIs are now imploring the central bank to temporarily increase the credit-to-deposit threshold to 85 percent.

Pleading for an increase in the upper limit is akin to begging for a subsidy so that BFIs can continue enjoying the profits from imprudent and unsustainable lending practices and meet their high profit targets year after year. This is utterly reckless and reeks of an intention to socialise losses but privatise profits. The central bank should remain steadfast in its policy on the credit-to-deposit rate and defend the measures required to ensure a prudent financial system.

We went through this kind of situation in 2011 when there was a slowdown in deposit growth and unhealthy and cutthroat competition to increase lending and the real estate bubble burst disrupting financial flows. It resulted in a severe liquidity crisis and a loss of confidence in the banking system after the then Vibor Bikas Bank knocked the doors of the central bank in June 2011 to either inject money or take over its management. Subsequently, NRB imposed a 25 percent cap on real estate and housing loans and implemented reforms to improve the health of the financial sector.

Incongruous arguments

BFIs still have not learnt from their mistakes. First, the recommendation by BFIs to increase the credit-to-deposit threshold is nonsensical. It will not solve the structural operational and management flaws on which they try to flourish. They point to a liquidity crunch, but react unenthusiastically when the central bank offers temporary liquidity facilities. It looks like BFIs just want to cover up their reckless and imprudent operations. Second, they argue that slow capital expenditure and a slowdown in deposit growth led to the credit crunch. Yes, that is true. But then these two factors (which tend to drive deposit growth) were expected anyway. Given that there has not been any change in the expenditure absorption capacity, low capital spending was entirely predictable when the fiscal budget was introduced. Similarly, overseas migration started declining immediately after the earthquake and remittances started decelerating from May 2016. This was also anticipated well in advance.

BFIs knew that they were close to the threshold as early as the beginning of 2016, but they still engaged in aggressive lending to quick return and unproductive sectors to attain high profit targets. Whining for an increase in the threshold by floating incongruous arguments is irresponsible. They presented the same arguments in 2011 too. BFIs should have been conservative on credit growth (and its quality), which should be consistent with deposit growth to avoid a sustained asset-liability mismatch. The central bank should not increase the threshold now. The situation will likely normalise in the last trimester when most of the capital spending happens.

Unless BFIs change their operational and management model, the same thing is going to happen again. They should scrutinise loan proposals more intensely, invest more in research and personnel training, introduce innovative deposit and credit schemes, diversify their asset portfolio, lower unsustainable profit targets, improve corporate governance and continue consolidation efforts.