Tuesday, January 22, 2019

Nepal's troubled capital market

It was published in The Kathmandu Post, 21 January 2019, p.8. An earlier blog on the same issue here.

The authorities should have let the stock market self-correct and fall back to its natural state

The recurring financial sector instability recently affected the stock market too. Investors exerted political pressure on the Ministry of Finance and Nepal Rastra Bank to rescue them from the downward spiral of share prices. The government formed a committee to assess the state of the capital market and recommend measures to stabilise it. Some of the proposed solutions will likely push share prices in the bullish zone, but undermine the soundness of the financial system and implicitly foster moral hazard.

The turmoil in the stock market is not because the market perceives declining profitability from trading shares at Nepal Stock Exchange Limited (NEPSE). It is also not driven by quarterly or annual earnings of companies whose shares are traded at the market. The squeeze in liquidity flowing into this market as a result of recurring credit crunch faced by banks and financial institutions (BFIs) and excess issuance of shares given the market size are the main factors behind the current turmoil at NEPSE.

Bullish problem

While chronically low capital spending by the government and tepid growth of remittances have been dragging deposit growth, strong credit demand from almost all sectors and the BFI’s largess in approving loans to sectors that earn quick returns (at times at the cost of quality and overexposure) has led to a situation where credit growth has surpassed deposit growth. Hence, except for the two government-owned banks, all other commercial banks are close to the regulatory credit-to-core capital cum deposit (CCD) ratio threshold. Nepal Bankers’ Association (NBA) lobbied hard to increase the 80 percent CCD threshold, but the central bank refused to do so arguing that it is necessary for the viability of the financial system and security of deposits. The underlying deposit-credit dynamics, asset-liability mismatch and depleting stock of loanable funds have hamstrung the BFIs and lately rattled stock market investors as they are deprived of new funds to maintain bullish trading.

It is not the first time the stock market has crashed after remaining bullish for an extended period. It grew steadily at least since fiscal year 1993/94 before crashing in 2007/08 when the then finance minister hinted of enhanced oversight (after terming trading at NEPSE a ‘gamble’). Concurrently, liquidity also started to dry up owing to deceleration of remittances and the BFIs faced severe stress as real estate and housing prices collapsed. This affected NEPSE index too, as it reached a high of 1084.8 in August 2008 and then crashed to a low of 297.6 by June 2011. A slew of regulatory caps on overexposed sectors, partial bailout by the central bank, and an increase in remittance inflows gradually stabilised liquidity situation. However, increasing margin lending by BFIs and rerouting of approved loans to the stock market in anticipation of quick returns by borrowers started to push NEPSE index in the bullish territory, hitting a record 1815.2 in September 2016. Since the bullish stock market closely followed liquidity situation of BFIs, it took no time for the index to collapse to 1148.8 by December 2018 as liquidity crunch worsened.

The authorities should have let the stock market self-correct and fall back to its natural state, i.e. in line with the broader economic fundamentals. Instead, the central bank loosened rules to push it in the bullish zone. For instance, reducing the risk weight on loan against shares to 100 percent from 150 percent; provision to offer loan up to 65 percent of valuation of shares (up from 50 percent previously) based on the average price in the past 180 days or the prevailing market price, whichever is lower; issuing loan on shares equivalent to at most 40 percent of their core capital (up from 25percent previously); and loosening margin call decisions will increase flow of funds to the stock market. However, these will not correct the underlying flaws in trading and conflict of interest of some investors at NEPSE. Being overly pro-cyclical when prices go up but counter-cyclical when prices come down serves a few at the cost of many. It undermines governance and efficacy of the banking sector, which needs to channel more resources to productive sectors that create jobs and directly addresses binding constraints to shared prosperity.

The central bank also directed the BFIs to lower interest spread rate (the difference between lending and deposit rates) to 4.5 percent by mid-July 2019 by tweaking computation of base rate. Specifically, BFIs will not have to add 0.75 percent return on asset while computing base rate, which includes the cost of fund, cost of cash reserve ratio, cost of statutory liquidity ratio and operating cost. The lower the base rate, the lower should be the lending rate. However, even with this tweak in computing base rate and a directive by NBA to cap deposits rate, there is no sign of lowering of lending rates anytime soon.

Given the operational and managerial inefficiencies, it will be challenging for the BFIs to lower interest spread by the end of this fiscal year. High-interest spread has its root in a number of factors: risky investment, high inflation (although this is not the case now), high operating costs, reliance on interest income for survival amidst cut-throat competition to rope in depositors, diseconomies of scale due to small market size, and poor access to finance. Real sector investors (those that invest in factories and infrastructure to produce or to build something, and at the same time create employment) are worried about the high cost of finance, which will dent whatever prospects there were for achieving the government’s economic growth target of eightpercent for this year.

Recurring problem

BFIs are used to earning high-profit rates by lending to certain sectors, without much self-discipline and due diligence that earn them quick return. Previously, they overexposed themselves to real estate and housing sectors. This resulted in a drastic escalation of land prices and haphazard plotting of arable land. Now, they are overexposing themselves to the vehicle and hire purchase financing, and margin lending.

The credit crunch is a recurring problem in the banking sector and increased volatility of share prices will now be recurring too. The latter is at the mercy of credit flows from the former, which itself depends on the extent to which the government executes its proposed budget and the growth of remittances. Tweaking rules to reinforce the flawed link between them is not a sensible strategy. This may give respite to the government and central bank for some time, but it is a long way from stabilising the financial sector and eventually addressing its structural weaknesses. Currently, the stock market is not resilient and stable enough to mobilise capital for real sector investment, and BFIs are still operating with the same strategy of socialising losses but privatising gains. Nepal needs fewer but stronger BFIs with sound corporate governance. The banking sector has no other option but to consolidate and enhance operational efficiency.

Stabilisation measures should be geared towards correcting immediate flaws by providing temporary relief so that it eventually sets the stage for structural reforms. It should not be designed to foster moral hazard and systemic risks and to provide relief by weakening regulations and soundness of the entire system.