Views of a Nepali Economist

Nepali Stock Bubble

By: Mukesh Khanal

Successful elections like the recent one in Nepal accomplish a number of things. They bring changes in government by ousting incumbents and bring opposition forces back in control of government. A renewed optimism spreads through the economy when the new government is presumed to be more democratic, free-market oriented, and investor friendly. As a result, the stock market rallies to record highs. The same has happened in Nepal according to Nepali media. Nepse, the Nepali stock market index, jumped by over 200 points on December 19 to reach 805.65 points, highest level in the last five years.

Recent unusually high stock index increments suggest that investors feel more confident to invest, and have started pouring in money into the economy. It means they have added more liquidity to an economy that is already going through a case of excess liquidity. Throughout this year, our economy has observed increasing liquidity. Nepal Rastra Bank (NRB) has already issued reverse repo five different times this past year to rein in excess liquidity. The NRB does this by selling treasury bills (t-bills), which are interest-paying promissory notes sold by NRB and bought by banks and financial institutions (BFIs) with the extra cash in their vaults. This way, the NRB absorbs or “mops” excess money supply from the market. However, the optimism that has been created among investors with recent election results has started to hurt the NRB’s efforts.

In addition to optimism from recent election results, there are four other reasons why excess liquidity has persisted throughout this past year. First, 0.2% return rates on t-bills are low while average interest charged on consumer borrowing in the market is around 4%-6%. Most BFIs are making this comparison and are deciding that they would rather wait for consumers to come asking for credit than invest in t-bills. However, consumer borrowing is at a much lower level than supply of liquidity. But, that doesn't mean t-bills are not selling; they're all sold out. However, that is not an indicator of good news. It shows the desperation among the BFIs. They don't know what to do with excess money in their vaults. So, they're buying the t-bills as the only remaining option.

Second, the financial market is still afraid of lending, in general, because it has only just recovered from a liquidity crisis that started in late 2009 and lasted for three years. The market could be practicing caution in identifying investment opportunities. They definitely do not wish to lend to real estate and housing markets which are going through a recession. 

Third, even if BFIs were in an investing mood, they are facing difficulty due to NRB’s new criteria: at least 20% of available liquidity in financial market has to be invested in “productive sector” in addition to 12% that have to be invested in hydro and agriculture. Our BFIs are so accustomed to lending their entire supply to housing and real estate that they are unable to identify which sectors are productive sectors. As a result, cash has stayed in their vaults instead of being invested.

Fourth, political instability has affected Nepal’s economic prospects as entrepreneurs and businesses have been reluctant to start new projects due to instability. As a result, they have not had the need to borrow funds. However, a semblance of political stability in the months to come may encourage them to start taking on new projects and risks. That would mean renewed demand for loans and borrowings which, in turn, would reduce excess liquidity from the market.

A general understanding among economists is that a return of risk-taking behavior among borrowers takes care of excess liquidity. If we achieve political stability in coming days, this risk-taking behavior will likely increase, and thus excess liquidity will be used up. So, why worry?

Rallying stock market is not a worry for developed economies that have low inflation. For them, increase in money supply due to rallying market increases the price of investment opportunities such as stocks, bonds and real estate without affecting prices of basic commodities such as rice, milk or vegetables. However, for a developing economy like ours, which already suffers from high inflation, a rallying stock market and subsequent increase in money supply will push prices of everything in the market higher. Everything—real estate and basic commodities—will become more expensive for consumers.

There is a second reason why we should be worried. Historical data shows that liquidity creation is always high right before a liquidity crisis. Money supply decreased after Nepali economy was liberalized in 1990. After 2001, it increased right up until the end of 2009 when a liquidity crisis hit our economy hard. Unusually rallying stock market this year is clearly a sign of another impending liquidity crisis. Some of this buoyancy will be corrected due to stabilizing remittance in the near future. Remittance has increased every passing year for last two decades, and is about 25% the size of GDP. However, because it is already huge, it will grow only marginally over the next few years, thus blunting some of its impact on money supply and the stock market. 

Any emerging economy like ours relies on cheap credit to undertake development activities. Risk takers today don’t have cheaper access to credit which, in turn, is hurting our economic progress. On top of that, we have a stock bubble in the making due to excess liquidity in our financial market. If history has taught us anything, we know the bubble is going to burst because fundamental values and principles of the financial market are going to assert themselves eventually. We have two options: the NRB should devise better monetary policies than what we have today, or we better get ready for our financial market to crash in 2016.