Tuesday, August 20, 2019

Tinkering at the margin

It was published in The Kathmandu Post, 16 August 2019

The governor of Nepal Rastra Bank, Chiranjibi Nepal, recently unveiled the central bank’s monetary policy for 2019-20 fiscal year. Amidst persistently high-interest rates, liquidity crunch, unresolved structural issues including inherent operational and management vulnerabilities, and deterioration of external sector, the governor unveiled an expansionary policy to support the government’s unrealistic 8.5 percent growth target.

Many analysts had expected the central bank to take concrete measures to speed up the restructuring and consolidation of banks and financial institutions (BFIs). They were even planning actions like forced mergers. The idea was that this would result in efficient banking operations with lower management and operational costs, low interest rate volatility, innovation, and healthy competition. Instead, the central bank played it safe and prioritised an expansionary monetary policy. The concern over recurring bouts of a shortage of loanable funds and interest rate volatility remained on the backburner.

The central bank can influence interest rates charged to customers by BFIs and liquidity availability through conventional monetary policy tools that control the supply of money in the economy. For instance, lowering the cash reserve ratio—the minimum share of deposits that BFIs need to hold as reserves either in the form of cash or deposit with the central bank—frees up the funds available to the BFIs to loan out, and hence increases liquidity and lowers interest rates. Similarly, lowering statutory liquidity ratio—the share of deposits that BFIs have to maintain in the form of cash or approved assets and securities—also increases the money supply in the economy. Another measure is to change credit-to-core capital cum deposit (CCD) ratio threshold, which mandates the BFIs to lend a maximum of 80 percent of their deposits. The threshold for these remain unchanged in the monetary policy.

Volatile rates

Intending to lower interest rate volatility and improve monetary policy transmission, the central bank lowered thresholds for its interest rate corridor scheme. This sets a narrow band for the interest rate to fluctuate. The upper limit is lowered from 6.5 percent to 6 percent, repo rate (also called the policy rate) from 5 percent to 4.5 percent, and the lower threshold (term deposit rate) from 3.5 percent to 3 percent. It remains to be seen if this will actually lower retail interest rates because interest rates corridor, implemented since 2016-17, has not been much effective in reining in interest rate volatility.

The central bank has given continuity to directed lending to priority sectors including energy, tourism and agriculture. It has also boosted refinancing schemes, including lowering of interest rates for on-lending to priority sectors, and small and medium enterprises. Furthermore, it has extended the deadline to reduce the spread rate—the difference between deposit and lending rates—to 4.5 percent to mid-July 2020 instead of mid-July 2019. For BFIs that opt for a merger, the deadline is mid-July 2021.

These measures tinker existing regulations and accounting practices and hence address the underlying structural issues at the margin only. Furthermore, they may be insufficient to meet the core monetary policy targets—money supply growth of 18 percent, domestic credit growth of 24 percent and private sector credit growth of 21 percent, all higher than in the previous year. For instance, forcing the banks to maintain higher capital adequacy ratio plus countercyclical buffer (13 percent from 11 percent previously) will potentially lower their lending capacity and hence put upward pressure on interest rates, eventually slowing down credit expansion.

Credit crunch

The central bank has introduced two important measures to increase sources of deposits for BFIs and hence the availability of loanable funds.

First, it now allows BFIs to commercially borrow from not only foreign banks but also hedge and pension funds. Although this technically widens the sources of deposits for BFIs, it is unlikely that they will actively borrow money immediately from external sources due to risks associated with a higher cost of funds and the exchange rates.

Second, the central bank has mandated the BFIs to issue debentures or corporate bonds equivalent to at least 25 percent of paid-up capital. The expectation is that this will encourage BFIs to align their assets with their liabilities (i.e. discourage the tendency to use short term deposits to issue long term loans), and secure reliable sources of loanable funds in case they are close to the CCD threshold. If BFIs fail to meet this mandatory provision within this fiscal year, then they may be compelled to seek a merger. However, in the past, the central bank was too lenient. It repeatedly extended the timeline of what is supposed to be a mandatory provision (for instance, increased paid-up capital threshold, lower spread rate, and adherence to CCD threshold).

Regarding the external sector, the central bank has tightened loans to finance imported goods (especially vehicles) and the foreign exchange facility provided to Nepali citizens who visit abroad. Considering the deterioration of the balance of payments and depletion of foreign exchange reserves, the central bank is targeting to maintain reserves to finance seven months of imports. This is substantially down from barely two years ago, when reserves were large enough to sustain over ten months of imports. External sector stress will compound as exports, remittances and foreign investment growth stagnate or even decrease, but imports accelerate. The pegged exchange rate limits the central bank’s effectiveness to address external sector imbalance. Policy reforms to boost exports and foreign investment are crucial for this.

The success of the monetary policy will be judged in terms of how much interest rate decreases over time, sustainable credit expansion and lowering risks of asset-liability mismatch, further consolidation of BFIs and improved corporate governance, and external sector stability. Tinkering with productive sector lending has been a common feature of monetary policy, and this in itself will not help much to achieve the growth target.