Financing conundrum: Capital, lending and merger in Nepal

An explanatory analysis, by Rupak D Sharma, about the issues surrounding the regulatory requirement to increase capital, financing (earning) requirement to increase lending, and at the same time ensuring higher cash dividends for shareholders. The message is that, as of now, consolidation of BFIs is the most viable path for a competitive and healthy banking sector. 

Excerpts from the article:

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[…]sudden hikes in interbank rates – which clearly indicate credit tightness in the banking sector -- could precipitate a decline in private sector investment, make the banking and financial sector unstable, and eventually affect the real economy.

[…]commercial banks need to maintain a capital buffer -- known capital adequacy ratio -- of 10 percent. These ratios -- which are measures of the amount of capital held by banks and financial institutions in relation to risk-weighted credit exposures -- stand at 11 percent for development banks and finance companies.

[…]these buffers ultimately protect the interest of depositors, who park hard-earned money in banking institutions, and prevent financial risks from building up in the country’s banking system.

[…]however, the level of these buffers at banks and financial institutions has been gradually declining. The average capital adequacy ratio of commercial banks stood at 11.30 percent as of mid-April, according to Nepal Rastra Bank’s latest report. Although the figure shows holding of an extra 1.30 percentage points of capital fund by commercial banks, the discomforting part is the regulator’s instruction to maintain a capital buffer of at least 11 percent to be able to distribute cash dividend to shareholders.

[…]banks are currently operating with very little extra capital, which is constricting their ability to lend.

[…]Although one may argue there is not much credit demand these days due to the not-so-encouraging investment climate, banking institutions will gradually need to stimulate lending to meet the country’s target of attaining a seven percent growth rate till 2022 to graduate from the category of least developed country to developing country. And data shows there is ample room for credit expansion, as lending of banks and financial institutions as a percentage of GDP currently stands at only 59.2 percent.

[…]if the regulator asks banks to raise paid-up capital to, say, Rs 5 billion within the next three years, and to Rs 10 billion within next seven years, then this technique might not work for all, as many may not be able to earn such huge profits in such a short period of time.

[…]other options for raising capital, such as, asking promoters to inject cash, mergers, or leveraging -- that is issuing corporate bonds.

[…]Currently, many promoters are not as enthusiastic about putting money from their own pockets as return on equity is gradually declining. At the end of the third quarter of the current fiscal year, the average annualized return on equity of commercial banks stood at 14.75 percent as against around 20.66 percent around three years ago. This is because of fierce competition.

[…]This leaves banks and financial institutions with the only option of merger to raise capital, which is probably the fastest way of meeting the minimum regulatory capital requirement.

[…]merger of institutions with very little free capital would only expand the balance sheet size of the consolidated units without addressing the problems that can raise the specter of credit crises and ultimately destabilize the financial sector and the economy.

[…]This, however, does not mean mergers are ineffective in solving many problems faced by banking institutions, as they can expand single obligor limit that allows lenders to give bigger-sized loans to single parties. Mergers can also reduce operating cost, including fixed costs like salaries.

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For a brief note on the financial sector vulnerability, see the policy challenge section of Asian Development Outlook 2013 Nepal chapter.

Poverty by district in Nepal

Based on the recent household surveys and census data, the CBS has come up with Small Area Estimation of Poverty 2013 in Nepal. A general trend is that while the (rural) Far West and Mid West districts have the highest proportion of population living below the poverty line, the Terai districts have the highest number of poor people below the poverty line. The poverty line is fixed at Rs 19,261 (both food and non-food).

According to the latest figures, Bajura has the high percentage of district population (64.1%) living below the poverty line, followed by Kalikot (57.9%), Bhajhang (56.8%), Humla (56%) and Darchula (53%). The districts with the least proportion of poor as a share of the respective district’s population are Kaski (4%), Illam (7.3%), Lalitpur (7.6%), Kathmandu (7.6%) and Chitwan (8.9%). Note that at the national level, the poverty rate is 25.2% of the total population.

Now, do not get confused with the percentage of poor with the number of poor. For instance, while poverty rate in Bajura is 64.1% of that district’s population (134,062), the number of poor people below the poverty line is 85,934. Similarly, while Kathmandu has poverty rate of 7.6%, the number of poor people in Kathmandu is 128,298.

Overall, Nepal has 6,588,664 number of poor people living below the poverty line (25.16% of 26,187,059 = 6.59 million). Kailali has the highest number of poor (257,204), followed by Saptari (251,643), Rautahat (227,340), Siraha (219,656), and Bara (203,348). The least number of poor people are in Manang (2,150), Mustang (4,634), Rasuwa (13,311), Terhathum (147,17), and Dolpa (184,98).

Comparing the progress between 2001 (based on NLSS II) and 2011 (based on NLSS III), the data shows that poverty (% of respective district population) declined in 55 districts, but increased in 19 districts. Twenty districts were able to reduce poverty by over 20 percentage points.

The largest reduction in poverty happened in Panchthar (down from 52.5% in 2001 to 11.4% in 2011 = 41.1 percentage points), followed by Rolpa, Illam, Dhankuta and Khotang. Poverty increased the most in Bajura (by 16.8 percentage points), followed by Manang, Darchula, Jumla and Humla. While Kathmandu and Bhaktapur saw increase in poverty by 3.2 and 3.8 percentage points, respectively, Lalitpur saw a decline in poverty by 2.5 percentage points.

 

Now, the following comparison (at the district level) will be interesting. I will try to write separate blog posts when I have more free time as these tend to have growth and development policy implications:

• Percentage point decline in poverty, and remittance inflows and per capita remittance receipts
• Percentage point decline in poverty and migration/absentee population
• Percentage point decline in poverty and changes in education and health services
• Percentage point decline in poverty and aid concentration
• Percentage point decline in poverty and per capita public expenditure
• Percentage point decline in poverty and provision of infrastructure (electricity, roads, telephone)
• Percentage point decline in poverty and change in real estate and housing prices
• Percentage point decline in poverty, and agriculture production and agriculture productivity
• Percentage point decline in poverty and industrial value added production

More on these and poverty gap and poverty severity by district in later posts.

Cartels everywhere

I am posting the following observation on this blog because a lot of people had strong opinion about it. Context: Water association called for a strike and halted water supply since Thursday (withdrawn on Sunday).

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A toxic mix of entrepreneurs, politicians and politico-entrepreneurs guided by quick gains from business and politics = Continuation of cartels and syndicates, though illegal, who bring the government to its keens and force it to backtrack decisions made in the interest of the public. As a result, you have cartels running the show from essential items to luxury goods supply:

(i) Water cartels shutting down supply because the government is trying to enforce strict standards; (ii) Petro cartels halting supply because the government isn't increasing commission and is monitoring their businesses for regulatory compliance; (iii) Gold cartels pulling down shutters because the government is inspecting their businesses in order to stop adulteration and to make them comply with weighing standards; (iv) Truck cartels halting vehicle movement because they are not allowed to charge three times the normal fare; (v) Taxi cartels calling for sudden chakka jam because they are not allowed to rig meters and charge astronomical fares to travelers; (vi) Veggie cartels shutting down veggie supply because the government wants to lower middlemen commission and regulate the market for any wrongdoing; (vii) Bus cartels vehemently opposing new vehicle addition to specified routes even though a majority of the existing ones are best suited for scrap works; (viii) Construction cartels resorting to violence in districts to win contracts for public construction, which are hardly constructed to the standard.

Few examples of how the cartels run the political and economic spheres in Nepal. Meantime, the government is just trying to adjust to these, without an urge to go hard on them.

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Sourced from Facebook.

The importance of a strong manufacturing sector for structural transformation

Dani Rodrik writes:

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Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization. If there is one thing that everyone agrees on about the East Asian recipe, it is that Japan, South Korea, Singapore, Taiwan, and of course China all were exceptionally good at moving their labor from the countryside (or informal activities) to organized manufacturing. Earlier cases of successful economic catch-up, such as the US or Germany, were no different.

Manufacturing enables rapid catch-up because it is relatively easy to copy and implement foreign production technologies, even in poor countries that suffer from multiple disadvantages. Remarkably, my research shows that manufacturing industries tend to close the gap with the technology frontier at the rate of about 3% per year regardless of policies, institutions, or geography. Consequently, countries that are able to transform farmers into factory workers reap a huge growth bonus.

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden’s institutions.

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

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Important message: A meaning structural transformation would require “an industrialization drive, accompanied by the steady accumulation of human capital and institutional capabilities to sustain services-driven growth once industrialization reaches its limits.”

Cautionary note:

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But this time-tested recipe has become a lot less effective these days, owing to changes in manufacturing technologies and the global context. First, technological advances have rendered manufacturing much more skill- and capital-intensive than it was in the past, even at the low-quality end of the spectrum. As a result, the capacity of manufacturing to absorb labor has become much more limited. It will be impossible for the next generation of industrializing countries to move 25% or more of their workforce into manufacturing, as East Asian economies did.

Manufacturing industries will remain poor countries’ “escalator industries,” but the escalator will neither move as rapidly, nor go as high. Growth will need to rely to a much greater extent on sustained improvements in human capital, institutions, and governance. And that means that growth will remain slow and difficult at best.

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Recent depreciation of Nepali rupee: Causes and impacts

Further to the earlier blog post, here is an updated analysis of the recent weakening of the Nepali rupee.

The figure shows the daily nominal exchange rate between Nepali rupee and US dollar. The Nepali rupee, which is partially convertible, is consistently weakening against major global currencies especially after FY2011. 

The yearly average exchange rate (buying) was Rs 70.20 per dollar in FY2007. It dropped to Rs 64.72 in FY2008, then climbed to Rs 76.58 in FY2009 before dropping to Rs 74.24 in FY2010 and Rs 72.47 in FY2011. It sharply depreciated to Rs 80.73 in FY2012. It has depreciated even more in FY2013 so far, reaching Rs 93.65 on 20 June 2013 (selling rate was Rs 94.25). Between 16 July 2011 (start of FY2012) and 20 June 2013, the Nepali rupee has depreciated by about 32%. 

Nepal has been maintaining a pegged exchange rate to the Indian rupee for a long time. The peg of NRs 1.60= IRs 1.0 has not been revised since 1993. Hence, the exchange rate with other currencies depends on the movement of the Indian rupee against convertible currencies. There is little the central bank can do to influence the exchange rate of Nepali rupee vis-à-vis convertible currencies. That said, the fluctuations in exchange rate do affect current account balance (mainly trade balance and remittance inflows), inflation, debt payments, and dollar denominated obligatory transactions/investments in Nepal. More on this in a minute, but for now let us focus on the causes of the sharp depreciation of Nepali rupee against the convertible currencies. 

As mentioned earlier, the exchange rate would follow the movement of Indian rupee vis-à-vis the convertible currencies. The weakening of Indian rupee is caused by both internal and external factors. First, the slow economic performance along with the setback in passing investor friendly policy reforms/legislation have lowered investor’s confidence, resulting in weak capital inflows. This combined with the high current account deficit have led investors to sell off debt in the Indian market, which alternatively means less demand for Indian currency. Second, the rise in imports of petroleum products and gold (recently the Indian government even raised tariff on gold import to 8% from 6%) has led to high dollar demand in the Indian market, which also means less demand for Indian currency. Third, the continued slowdown and uncertainty (economic and sovereign debt) in the EU have meant that investors are still looking for safe place for investment, which traditionally is either gold or the US dollar. Hence, the demand for US dollar is going up. Fourth, investors are expecting the US Federal Reserve to curb its massive quantitative easing (QE) by the end of this year, prompting them to demand dollar well in advance in anticipation of tighter liquidity and high interest rate later on. 

Some of these are recent phenomena and might change quickly (such as the perception about the Indian economy in response to investor friendly policy gestures), leading to fluctuations in exchange rate. But, some of these are persistent ones (such as the uncertainties surrounding recovery in the EU economies), leading to higher demand for dollar. While the latter strengthens the dollar and pushes it up each year, the former induces fluctuations at higher level. Hence, Nepali rupee (following the path of Indian rupee) is consistently depreciating as well as fluctuating at high level. Indian investors are anticipating IRS 60 per dollar soon, which could mean NRs 96 per dollar. But, it is contingent upon the factors discussed earlier. 

Now, how would this impact Nepali economy? 

First, a depreciating currency usually makes exports competitive, leading to rise in export earnings. Unfortunately, Nepal cannot take full advantage of this because of the high cost of production arising from power shortages, labor disputes (high minimum wage not commensurate with productivity compared to other South Asian economies), high import content of manufactured goods (thus driving up cost of raw materials as currency depreciates), and other structural bottlenecks as well as supply-side constraints (low quality human capital, low R&D, and strikes, among others). Furthermore, the weak EU and the US economies has meant a weaker demand for imports there (our exports) as well. 

Second, it will affect imports and might worsen current account balance depending on the level of remittance inflows, which have registered a slower growth (both in dollar and rupee terms) thus far this fiscal year. For the same quantity of goods, everything else remaining constant, importers will have to pay more to purchase dollars to pay foreign suppliers. It will jack up imports bill. Usually, a depreciating currency would translate into weakening of import demand. But, since Nepal’s import is relatively price inelastic (i.e., change in quantity imported is less than the change in import price), there won’t be much impact (also petroleum fuel import is a major component of total import). Moreover, given the consumption behavior, which is hinged on remittances-backed imported goods and services, and the weak domestic production base, it is unlikely that imports will do down. That said, it might also increase tax revenue from imported goods. 

Third, the rise in import bill will be reflected in the final prices of retails goods and services. Specifically, the rise in cost of petroleum imports will either lead to worsening of the already bad balance sheet of NOC or increase prices of petroleum fuel in the market, depending on whether the government opts for price rationalization or absorption of costs in terms of subsidy (its has implications on fiscal sustainability too!). It might then have spillover effects on transport and retail prices. Ultimately, it will mean inflation, which is above 10% so far this year, will further go up. 

Fourth, there is an incentive to remit more money to Nepal when currency depreciates. We have seen this in FY2012 as well. It will positively impact financial sector liquidity and current account balance. A part of the marginal increase in cost of imported goods due to weakening currency would be offset (in terms of purchasing power) by the marginal increase in purchasing power due to higher remittance income (of course, it will be limited to remittance receiving 56% of households).

Fifth, entities such as NEA will have to make larger payments to companies— Bhote Koshi and Khimiti hydropower projects— with which it has power purchase agreement in dollars. It will worsen its already bad balance sheet. Furthermore, the country’s (foreign) debt service payment goes up when currency depreciates.

More on the exchange rate here.

Weakening Nepali rupee

On 7 October 2012, the exchange rate was NRs 82.39 per US dollar. On 20 June 2013, it was NRs 93.65 per US dollar. It indicates a nominal depreciation of about 14%. Compared to the level in 16 July 2011, the nominal depreciation is about 32%. In the last twenty days, the depreciation is about 4%. 

Since Nepal has pegged its currency to the Indian rupee, the exchange rate closely follows the path of the Indian rupee against the dollar. More on the recent rocky path of rupee later.

Higher government wages may reduce corruption in poorer countries

So says a new paper by de Haan et al. (2013). They argue that government wages have a significant negative impact on corruption when income is $8,842 or less. Very interesting findings that is intuitive as well.

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Using this new database, we construct a relative government wage indicator as the ratio of government wages to the average wages in the manufacturing sector and estimate the relationship between corruption and this indicator, controlling for other variables that previous studies found to be related to corruption. When the impact of government wages on corruption is assumed to be linear, as previous studies do, we find that one unit increase in the wage indicator, which is equivalent to raising government wages by the average of wages in manufacturing reduces corruption, measured on a scale from zero to six, by only 0.35. This result suggests that using government wages to combat corruption is rather costly, similar to the conclusion by Van Rijckeghem and Weder (2001).

However, the nature of corruption might be different at different levels of economic development. In low-income countries, corruption often consists of petty corruption, which involves tiny amounts of money, appears in a rampant manner and is easy to detect. Road bribery in India, where traffic policemen openly collect bribes from passing trucks (Bardhan 2006), or the extra payment to obtain a birth certificate in Cambodia (Feinberg 2009) are typical examples. In high-income countries, petty corruption is less common because wages are above subsistence level. Corruption in these countries, if present, involves more secret deals, brings about larger payoffs, and is more difficult to detect. Government wages will arguably be less effective to combat the latter form of corruption.

By including an interaction term between government wages and economic development, we allow the impact of government wages on corruption to vary with the level of economic development. Controlling for a large number of other determinants of corruption and country specific effects (which in our view are important because corruption changes very slowly and appears to be country specific), we find that the estimated coefficient of government wages is negative but the coefficient of the interaction term is positive. This suggests that the role of government wages in reducing corruption decreases as countries become richer.

Government wages have a significant negative impact on corruption when income is $8,842 or less. Above this income level, no significant relationship can be established. The impact of government wages on corruption is moderated by the level of income per capita. The poorer a country is, the stronger the negative impact of higher government wages on corruption is.

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