A view on excess liquidity in Nepal

When flipping the pages of various financial newspapers, we often come across
articles or news highlighting problems on excess liquidity in the country. The
banks of Nepal have been accumulating excess cash, beyond the limit prescribed
by the Nepal Rastra Bank severely affecting the Nepalese economy.

In a laymen’s language, “excess” means “surplus” and “liquidity” can be described

as “assets that can easily be converted into cash with little or no change in its
value such as cash, security, bonds, etc”. Thus, excess liquidity refers to a state
where banks possess excess deposit liabilities and a low credit demand. In other
words, money supply (deposit) is more than money demands (loans).

The old adage, “excess of anything is never good” applies even for cash and
reserves in the financial sector. The liquidity problem has discouraged people to
lace their cash in banks and financial institutions (BFIs). Banks with its liquidity
have more than sufficient cash to operate their business or advance loans to
the public, despite the public having least interest to apply for loans.

Money is a powerful tool. And, when this powerful tool exceeds an economy’s
demand or opportunity, it creates chaos and makes monetary policy ineffective.
When a huge amount of cash surge into the banks, the banks’ rates, both lending
and deposit, go down. However, the plunging loan rates do not entice the public
to borrow from the banks, as Nepal lacks business-friendly policies, a stable
government, and investment opportunities. Even the depositors do not feel
worthwhile to deposit their money in banks, due to its poor return on
investment.
Currently, one year fixed deposit hovers around 6% interest and saving deposit
rate at a pathetic 3%. Ironically, inflation stands at 10%. This means depositors
are unable to truly benefit from the deposits. Banks with excess liquidity, too,
suffer from this problem, as they try to encourage the public to apply for the
loans at low-interest rates.

The Nepal Government has certainly made earnest attempts to mop the surplus
money prevailing within the financial sectors of Nepal. Nepal Rastra Bank, the
only national monetary authority, recently issued deposit instrument worth 1
billion, in order to absorb the excess money from BFIs. Term deposits are the
deposits held by banks, with the maturity period ranging from a few days to a
year. Interest Rate Corridor (IRC) is another instrument implemented by the
Government, recently in mid- August, to ensure that the excess liquidity does not
exceed 20 billion. It keeps the interest rates within a certain band and ensures
that the interest rates in the financial market are less volatile. All these measures
by the government have improved the deposit and interbank rates in Nepal, to a
certain extent.

Although the situation of excess liquidity in commercial banks has slightly

improved, this does not guarantee that the BFIs are in the safe zone. The trend
may or may not continue in the future as the right liquidity position is very hard to
attain. In the case of Nepal, they fluctuate with uncertainty.

In this circumstances, the efforts to solve the excess liquidity problems must be
accompanied by a congenial environment for businesses to thrive in the country.
One of the reasons why the credit funds in the BFIs remained idle was due to lack
of investment opportunities in the country. People lack confidence in the
Government and its policies due to its instability and the political turmoil that
definitely pose an obstruction to their business ventures and promotion. Hence
the real sectors ranging from manufacturing to processing industries, hydropower
projects to tourism sector etc must be prioritized and given appropriate
opportunity to thrive. This will certainly give a boost to the financial sector of
Nepal.

The Nepal Government aims to achieve an economic growth rate of 6.5% in the
FY 2073/74, which might seem like a pie in the sky for Nepal to achieve. However,
a stable government, implementation of the budget on time, appropriate
business environment, and development if roads accessible to the rural parts of
Nepal would add a boost to the economy in every aspect . This, in turn, will help
to channelize the excess cash for the development of the nation and solve the
excess liquidity problems prevailing in Nepal.
Excess liquidity: Pros and cons
The current excess liquidity in the banking system is more or less the replay of the
story that hogged news headlines in 2009, but with different actors and the
situation. In that sense, Nepal’s bumpy financial system has come to a full circle in
the last five years, and moved to one extreme point from another. A quick
flashback: In early 2009 Nepal’s financial system experienced an unprecedented
shortage of liquidity. All that started with the hastily appeared huge mismatch
between inflow of cash into the banking system in terms of deposits and loan
repayments, and the outflow in terms of fresh credits.
There were three major reasons for the decline in the growth of deposits. First in
the international front, the global financial crisis rattled the global economy the
same year that squeezed the incomes of Nepali workers in the Gulf States and
slowed the breakneck growth rate of remittance. Second in the domestic front,
annoyed by the cold response to Voluntary Disclosure of Income Scheme (VDIS),
the then Maoists government threatened to investigate bank accounts and
sources of income of those not complying with the scheme. Third, the
government announced a provision that required a valid source of income while
depositing more than one million rupees in the banks.
Inter-bank lending rate (%)

All those set of actions badly sliced off depositors’ confidence, triggering two
immediate impacts. First it slowed growth rate of individual deposits to 9 percent
in 2009/10 from 32% recorded a year earlier. Second, it instigated a massive
withdrawal of cash from the banks that according to some estimates was over Rs
12 billion. In contract, the outflow of the cash from the banking system in terms
of fresh loans continued to grow at as much as twice of the deposit growth rate.
As a result, Nepali financial market faced a severe shortage of liquidity. As a
result, one-year deposit rate and the inter-banking lending rate, a quick
barometer to gauge liquidity in the market, soared to over 12 percent.
Five year down the line, the situation is exactly opposite and the economy is
struggling hard to manage excess liquidity. The cause of the problem is very
straight. Last year’s exponential growth of over 26 percent in net current transfer,
which includes remittance and pension incomes, hugely expanded money supply
in the economy. As a result, Nepal witnessed an addition of Rs 233 billion in bank
deposits whereas fresh credit expanded only by Rs 178 billion during the same
period. As a result, the banking system added fresh liquidity worth Rs 55 billion on
the top of around Rs 25 billion worth of liquidity it already had.
Similarly, huge government surplus remained one more reason for the excess
liquidity. In the last year, total government income increased by 23 percent
whereas total expenditure went up by 16 percent. As the result of government’s
inability to expense available recourses on development works, the treasury ran
into surplus of around Rs 30 billion. All these surpluses resources created a record
liquidity of over Rs 100 billion in the banking system. Though the central bank
lately used a new instrument to absorb Rs 20 billion, it is unlikely to make any
remarkable impact given the hefty liquidity piled up in the banks.
Now the biggest question is what will be the impact of such a gigantic liquidity on
the financial system. Some are already visible. The volume of interbank
lending among the commercial banks squeezed to Rs 185 billion last year
whereas such figure in the preceding year was Rs 726 billion. As a result, the
interbank lending rate – the rate at which banks lend to reach other to manage
quick cash imbalances -plunged to a record 0.22 percent whereas it was 2.72
percent in the pervious year. Similarly, weighted average rate on treasury bills
plummeted to 0.13 percent. As the consequences, the average deposit rate
declined to 4 percent but when official inflation rate, whose credibility is often
questioned, was 8 percent last year. The negative interest rate – bank deposit
rate minus rate of inflation - was 4 percent last year, which is at least 4 percent
per year, is becoming a great disincentive for depositors to put their money in the
bank.
This is the point when a time bomb starts ticking and that was how the infamous
banking crisis hit Nepal’s financial system in 2009. The chain of reactions was very
simple. In order to avoid negative interest rate and secure higher returns,
depositors slowly lured towards highly risky speculative investments such as real
estate and stock. Banks’ real estate lending and margin lending – lending against
share certificate - increased by around 18 folds between 2006 and 2009. When
the real estate and stock bubble burst in early 2010, putting at risk Rs 130 billion
worth of bank investment, it shuck the very foundation of Nepal’ banking system.
The blow to the banking system was severe that some of the banks are still trying
hard to recuperate.
Against this backdrop, the continued negative interest rate is clearly an early
warning that Nepal’s financial system is warming up for return to the baking crisis
of 2010. As the amount of deposits continues to be higher than the lending, banks
will continue to add up additional liquidity. In means, coming months will be more
challenging in the sense that increased remittance will continue to swell money
supply that will further increase rate of inflation and lower deposit rates along
with the lending rates. The additional money supply during the Dashin festival
might further worsen the situation.
The deadly combination of low deposit and lending rates along with the growing
inflation will further provoke people toward risky speculative investments.
Despite various restrictions enforced by the central bank to curtail real estate and
stock lending, chances are high that both the sectors will see another bubble in
coming months, albeit not in a scale seen before the 2010-banking crisis. And,
chances are high that the cooperatives, which are in operation without strict
regulatory policies and risk assessment mechanism, will be the inflator of the
bubble. Despite some reputational issues, the cooperatives in recent times have
been able to attract huge amount of deposits by offering deposit rate much
higher than what the banks are offering. Though, Nepal badly lacks credible
financial statistics on the finances of cooperatives, it is estimated that
cooperatives have amassed huge deposits worth Rs 300 billion, one-fourth of
deposits held by the banks. As the most of the banks are already close to the limit
imposed by central banks on real-estate and stock lending, it is the cooperatives
that will most likely emerge as the main real-estate lender after the upcoming
festival, a pick season for land transactions. Undoubtedly, Nepal made wonderful
efforts to consolidate regulations on the banking system and that produced
appreciable results. By contrast, another slowly emerging player of the financial
sector – cooperatives - remains in a sorry mess, mainly in terms of exercising
financial prudency. No doubt, a major financial disaster is brewing there, but few
people seem ready to pay due attention on the impeding risks.
Now the million-dollar question is: How to manage the swelling liquidity by
preventing a possible huge flow of deposits from the banking system to
cooperatives? One of the options available to deal with the excess liquidity is to
lure additional investment to hydropower development by bringing more
investment friendly policies. It is because hydropower is probably the only sector
that can absorb huge amount of liquidity with comparatively less risks, has a good
prospect for both internal consumption and export, and has the potential to
address the Nepal’s biggest impediment to growth. The recently announced
policy to provide a lump-sum grant of Rs 5 million per megawatt is a right step in
attracting investments to the hydropower sector.
However, unpredictable fluctuation in lending rates is still a discouraging factor.
Many investors still recall the notorious rise in lending rate after the 2010-banking
crisis. The rapid up to 5 percentage points rise in lending rate suddenly reversed
the financial viability of the hydropower project. Such an unprecedented spike in
lending rates badly tarnished investors’ confidence, compelling many to postpone
the constructions activities. As one of the policy options to deal with such risks,
the government should think of introducing a lending rate band - rate that can
fluctuate between the upper and lower limits. The policy will help investors to
predict the worst possible cost of lending and adjust returns and investments
accordingly. The special refinance facility that the central bank has been
administrating can be reformed to make such lending rate band workable.